During the run-up to the monetary union, many economists were sceptical and warned that it would not work. Their argument was simple. Europe was not an optimal monetary union because it lacked both labour mobility and the fiscal mutual insurance schemes that exist in the US. Also, nominal price formation was rigid so that we could not expect it to offset imbalances and competitiveness differences quickly. Despite those shortcomings, the sceptics considered that the costs of monetary union were not too large after all, because asymmetric shocks are not that important quantitatively.
The Eurozone was formed and it was largely accepted as an irreversible fact. The sceptics refrained from questioning its soundness as an institution for fear of being perceived as unrealistic or extreme. Mentioning that a member country might leave the monetary union some day was considered a political non-starter, so that pragmatic economists who insisted on making a difference in the policy arena did not see the point in ruining their credibility by making such suggestions.
With the Greek crisis, we are brutally reminded that such a prospect is far more real than it was assumed. In order to keep Greece in the Eurozone, other countries must foot the bill, while imposing harsh conditions that – in my view – will be fulfilled only hypothetically. So why do we want to keep Greece in the Eurozone, especially given that membership plays no small role in its current troubles?
Asymmetric trends not asymmetric shocks
The reason why the Eurozone does not work is not asymmetric shocks – their cost is constant over time and therefore unlikely to lead to the single currency's eventual demise – but asymmetric trends. Over the last decade, countries in the Eurozone have quietly but stubbornly diverged in terms of inflation, growth, fiscal performance and competitiveness.
- Some have had 2% inflation on average, others 4%.
- Some have built up trade surpluses, others are increasingly indebted with respect to the rest of the world.
- Some have kept their government budget in check, others have let debt grow.
This divergence comes from different policy choices, different institutions, and different cultures. But the common currency, contrary to the hopes of those who believed such a straightjacket would force member countries to converge in real terms, has in fact added to the divergence.
Take the example of Spain. It has enjoyed strong growth after its accession to the Eurozone, but this growth was not sustainable. It was mainly driven by a construction boom, itself the outcome of a housing bubble. As construction is not a traded good, the result has been a massive trade deficit, which reached 9% of GDP.
As the boom heated the economy (relative to its equilibrium level which involves a rather high level of unemployment), Spain has experienced consistently greater inflation than the average of the Eurozone. This inflation has in turn deteriorated its competitiveness, which has further added to its trade deficit, while making it quite painful to reallocate resources to the export sector now that the construction industry is gone. Greece has experienced similar inflation differentials and its competitiveness is even more crippled than Spain's.
What if they weren’t in the Eurozone?
Now what would have happened to such a country if it had not been a member of the Eurozone? Perhaps its central bank would have been worried about inflation and would have raised the interest rate. This would have cooled the economy down, and especially hit the oversized construction industry and perhaps even deflated the housing bubble. Or foreign investors would have taken into account the critical developments of the external accounts and attacked the currency. Its depreciation would have restored Spanish competitiveness and activity would have been reallocated from construction to exports. (The speculative attacks against the EMS in September 1992 illustrates just how quickly these corrective mechanisms may take place: The currencies that were attacked were only overvalued by some 5%.)
Eurozone membership not only destroyed those mechanisms, it exacerbated the imbalances. Since its government was able to borrow in the common currency, Spain now had the same nominal interest rate as the rest of the Eurozone. Therefore, the greater its inflation rate, the lower its real interest rate and the greater the stimulus to the economy; not only the cooling down mechanisms are gone but the common currency is a destabilizing factor. Furthermore, if some sectors (like, plausibly, construction) are more sensitive to the real cost of capital than others, then these low interest rates also magnify the bad allocation of economic activity between sectors.
The Spanish government might have wanted to react by having a fiscal contraction; but its incentives to do so were not that large. After all, it managed to reduce its unemployment rate from 20% to some 10% (it is now back at 20%). It is easier to reduce unemployment that way than through painful structural reforms, even though only the latter can bring a durable reduction in unemployment. And the low borrowing costs made fiscal consolidation less necessary from a pure accounting perspective. Thus the boom was not sustainable in the long term, it was a blessing in the short term – which is what politicians care about most...
What this example illustrates is that flexible exchange rates (or imperfect pegs that are vulnerable to speculative attacks) have disciplinary virtues. This may sound paradoxical since part of the economics literature claims that fixed exchange rates are good for stabilising inflation. But in fact that is only true if a country is somewhat averse to the trade deficits induced by persistent inflation differentials. In the case of Greece, Portugal, and Spain, this has not been the case.
Under a flexible exchange rate, a government which has trouble imposing fiscal discipline on itself faces a dilemma. If it borrows in its own currency, and eventually resorts to inflation to make up for its incapacity to balance the budget, markets will anticipate that and ask for a substantial risk premium on its debt. This was the case for the southern European countries before the European monetary union. This risk premium in turn makes the country more vulnerable to an exploding public debt and it should therefore keep a check on its public expenditure and aim for a primary surplus soon. If it borrows in foreign currency, a depreciation of its currency will bring about severe trouble, so that there is a big incentive to avoid inflation.
In a monetary union, markets will start worrying about the state of the public finances only when actual default is in sight. Meanwhile, the monetary union allows a country to borrow at low interest rates regardless of its actual economic situation. This may be a blessing insofar as the risk premium on the exchange rate risk no longer has to be paid, and the same level of expenditure may be financed at a lower cost in terms of debt. But, depending on the political context, the government is also tempted to take advantage of the low rates to further increase its expenditures. This is what has been happening in Greece to such an extent that public debt is now arguably even higher than if it had stayed out of the Eurozone.
Thus it is somewhat disturbing that we are now asked to pour money into Greece to "save the euro" (while the British, who have no stake in the euro, are spared that burden). Besides the fact that apart from Germany, the other large Eurozone economies (France, Italy, and Spain) are barely in a better shape than Greece, and besides the moral hazard effects of the intervention, it makes little sense to prolong a monetary regime which is actually one of the reasons why those countries are in trouble.
Furthermore, in a typical adjustment program, shock therapy aimed at stabilizing public finances must be associated with policies that make it possible for the economy to start growing again – a necessary ingredient if one wants the program to be politically acceptable or just to fulfil its objectives. After all, jobs are needed for the people to tolerate the hardship imposed on them, and fiscal receipts are needed for the government to avoid fresh insolvency problems five years down the line.
In the case of Greece an important obstacle to recovery is the competitiveness problem. If Greece was not part of the European Monetary Union an IMF adjustment package would presumably have involved a sharp depreciation of the currency (if it had not happened before under the sheer pressure of the markets). By insisting that Greece remains in the Eurozone, the other member countries are greatly reducing the success probability of their plan.