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The Eurozone’s Real Weakness

Mar 28, 2019 Lucrezia Reichlin

A new eurozone crisis would most likely have a less uneven effect than in 2008 or 2011, not least because its largest economies are currently weak. But if a recession hits, policymakers will find it hard to mount an effective response.

LONDON – The 20th anniversary of the euro this year is a good time to reflect on the robustness of Europe’s monetary union. The memory of the last crisis, which began in the United States in 2008, is still fresh in the minds of Europeans: the eurozone suffered more than the US, with some of its members getting hit much harder than others. At a time when the eurozone is once again showing signs of a significant slowdown, it is important to understand what happened last time. Did we learn anything in the euro’s first 20 years that could help fight another recession?

The most popular narrative of the eurozone crisis relies on the economist Robert Mundell’s theory of an “optimum currency area” (OCA), which warns against establishing a common monetary policy in a federation of different states with different levels of economic resilience. This view emphasizes that eurozone members lack the exchange-rate flexibility that might help them respond to a negative shock. To make matters worse, because the European Central Bank targets the average eurozone inflation rate, its monetary-policy stance may not be suitable for all member states. In the weakest countries, this may lead to real interest rates above the level required for full employment.

Another narrative focuses on financial fragility. In good times, some eurozone countries build up excessive leverage because of relatively low real interest rates – partly a consequence of the ECB’s one-size-fits-all monetary policy. In countries with weak institutions and poor governance, this can lead to a loss of competitiveness and excessive consumption. A crisis would then be nastier than normal, triggering a fall in asset prices and debt defaults, followed by a period of deleveraging and weak demand.

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0 Comments on this paragraph, 3 in all 3 Comments on this article

Georgios Bethanis Mar 30, 2019

I dont quite get this comment. Could you elaborate more on why high real interest rates would not allow full employment? What is the link between these two?
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David Punabantu Mar 29, 2019

The Eurozone crisis looks so similar to the Sterling crisis of 1949. In 1949, Britain devalued the pound sterling by 30%. This was a major world economic event given that the pound was and still is one of the major currencies in the world. In fact, 9 other countries followed suit then. They were Australia, India, South Africa, New Zealand, Eire, Denmark, Norway, Egypt, and Israel. Interestingly, several among those who devalued were former British colonies. They devalued by a similar margin as if their economies had the same posture of the British economy including having the same financial muscle. In reality the effect of the devaluation was much greater in India, Norway, Denmark etc as their economies had to absorb more liabilities greater than the 30 percent. This is the same crisis the Euro and the EU is facing. The German economy cannot be compared to the smaller EU states that cannot fully absorb changes on the EU as Germany can, hence Germany gets richer at the expense of other EU states that are driven into poverty.
Although in 1949 is in the past the structures today of one value still exist. Take for example the value of one Euro on the 24th of July 2013, which in value terms was equal to US$1.3196 and £0.86154. The cross rate of the Euro for both currencies on the 24th July 2013 values was 1.53167, while the US dollar to Sterling pound exchange rate on the same day was around £1 per US$1.5317.
The same value configuration was also noted on the 10th of October 2014 in the Chinese Yuan Reminbi (CNY). At this time the Reminbi was worth ¥9.88736 per Sterling pound and ¥6.13033 per US dollar which gave a cross rate similar to the exchange rate of the two transatlantic nations noted in £1being worth US$1.612.
The same pattern was again observed on the 26th of September 2014 in African currencies like the South African Rand (ZAR). At this time the Rand was worth ZAR18.2438 per Sterling pound and ZAR11.2276 per US dollar which gave a cross rate similar to the exchange rate of the two transatlantic nations where £1 was worth US$1.6249. In value terms these fixed cross-rates appear day in and day out, in many national currencies.
However, the reality on the ground in many national money markets is that the existing Sterling pound and US dollar liquidities within these national money markets do not reflect the demand for Sterling/US dollar exchange rates against their national currencies as dictated by the cross-rate position. Such nations therefore persistently lack the same trade levels between the United States (US) and the United Kingdom (UK) within their own money markets to precisely shadow the imposed IMF fixed cross-rate.
Consequently a multiple currency condition manifests. This is caused by the fact that in relation to trade, with in their own money markets, the demand for the Euro, the Chinese Reminbi or the South African Rand against the US dollar and the British Sterling pound and other Sino-African-American currencies gives real value exchange rates and cross rates that are outside the IMF fixed cross-rate system.
Could the value of the Euro be thus similar to the condition between Italy, the UK and US as talked of by the IMF director to reflect the reality of markets. Then IMF Managing Director “Mr. M. Gutt at his Harvard University address on “The Practical Problems of Exchange Rates” on the 13th February 1948, where the indirect exchange rate of the US dollar to the Sterling pound was £1 per US$2.6 as US$1 equaled 600 Lire and £1 equaled 1,560 Lire, while the direct Sterling-US dollar rate stood at £1 per US$4.” (The Practical Problems of Exchange Rates cited in Tew (1967) p.79) Here, Italian exporters were allowed to retain half their export earnings that they sold to importers, while the other half was sold to monetary authorities. In both cases the export revenue was not directly offloaded on Italy’s money markets which in turn affected the cross rate parity.
Consequently, as Italy’s money markets like many money markets in developing nations today did and do not strictly adhere to the supply and demand doctrine, Americans found it cheaper to buy goods from the UK via Italy. Italy’s restricted money market liquidities against its traded goods with specific trading partners provided certain volumes of foreign currencies which did not duplicate the fixed cross rate position found in London’s money markets. Britain objected to Italy’s position as Italy was gaining US dollars at the expense of the Sterling Area gaining those US dollar inflows. This pushed the already delicate Sterling Area’s balance of payments with the US Dollar Area into a precarious condition.
The IMF moved in to impose the fixed cross rate regime in the name of “multiple currency practices” in favour of Britain. Italy thus lost out on trade with America and Americans now had to pay more for British goods. Unfortunately the IMF move once again undermined currency cross rates in relation to existing currency liquidities within national money markets in favour of Britain. The true value of the Euro may well be a different value against the markets it operates giving free floating cross rates rather than the fixed cross rate system of the IMF
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fpr Mar 28, 2019

So obvious and well written article from a techinical point of view.
But here we are in Europe waiting for Germany to face head on its own populism. Of course that will carry a cost to the CDU-CSU but further procrastinating will be worse.
The “knowledgeable” know this but they don’t have a clue on how to undo the narrative.
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