Why the Euro cannot work

This text is the basis of my intervention tomorrow (30 september 2014) at the Institut de l’Entreprise, in a debate with Hans-Werner Sinn.

When the Euro was created, most economists were actually skeptical. They contended that macroeconomic shocks were asymmetrical across countries, that prices were sticky and that labor mobility was very low. They generally rejected the idea that Europe was an optimal currency area. At the same time, however, they also thought that while the costs outweighed the benefits, both were small. Estimates circulated that showed that asymmetrical shocks were not that important quantitatively. A number of idealists concluded that the economic costs were worth paying in exchange for an additional step on the glorious road to European unification.
Yet the subsequent experience was not one of asymmetric shocks, but asymmetric trends. Some countries accumulated inflation differentials and large trade deficits with respect to other countries. They appeared unable to curb the sharp increase in unemployment that they experienced during the crisis. As a result the Euro appeared not only as far more costly than was expected, but also as doomed.
Why did we observe such asymmetries? I argue that this is because of structural differences across countries. Some countries have better functioning labor and goods markets that others, because they are less, or better, regulated. As a result their equilibrium level of activity is higher, meaning higher wages and living standards, and their equilibrium unemployment rate is lower. Their economies will be closer to an “optimal” allocation of resources.
In general these discrepancies should not prevent those countries from sharing the same currency. If prices were flexible, or if the ECB could harmonize inflation across countries so as to prevent permanent imbalances from arising, the fact that some economies are less efficient than others would not be incompatible with a monetary union. Such a union would simply settle in a situation where the less productive countries have lower wages and the same price level as compared to the more productive ones.
But monetary union is problematic if governments retain fiscal sovereignty and use it in a discretionary fashion to inflate their economy so as to overcome their structural problems.
Prior to monetary union, Italy always had more inflation than France. And France always had more inflation than Germany. Why was that so? Because the Italian economy was less efficient than the French one, itself less efficient than the German one.
In the short run, governments pick their preferred point on an output/inflation trade-off. In a nutshell, this trade-off tells us that if you create more inflation than expected, firms can sell their goods at a higher price relative to wages, because wages are sluggish and were set in advance on the basis of inflation expectations. Therefore the government can buy an expansion by creating an inflationary surprise, that is by having more inflation than was expected by private agents. Absent such a surprise, the economy settles at its equilibrium output level. But this level is lower, and more undesirable, in Italy than in Germany, because the former economy is plagued by more structural rigidities than the latter. So the Italian government, left to itself, will naturally be tempted to select a higher inflation rate than the German government.
This attempt at creating surprise inflation is hopeless, however, because private agents will anticipate it. Therefore, the Italian government will end up having higher inflation without actually boosting its economy. Italy ends up with both more inflation and more unemployment than Germany. This implies, under flexible exchange rates, that the Lira will continuously depreciate against the D-mark, thus offsetting the competitiveness losses associated with higher inflation in Italy.
The preceding argument is the standard analysis of monetary policy credibility which Robert Barro and David Gordon made more than three decades ago. Discretionary monetary policy by governments create an inflationary bias; their attempts to stimulate output is defeated and one only gets more inflation instead. This bias is larger, the lower the equilibrium rate of output compared to the optimum; that is, the more the economy is crippled by rigidities such as barriers to competition. A consequence is that monetary policy should be based on rules rather than discretion. Hence Italy should refrain from trying to expand its economy beyond its equilibrium level of activity by creating inflationary surprises, by having some commitment against such moves, like, for example, an independent central bank.
Indeed, some of the Euro-enthusiasts at the time pointed out that one benefit that could be derived from European Monetary Union is that governments could solve their credibility problem by delegating monetary policy to the ECB. That is, they would not longer be able to select their preferred point on the inflation/output trade-off in a discretionary fashion, simply because inflation was now controlled by the ECB.
This argument turned out to be wrong. Despite losing monetary autonomy, governments can still choose their preferred point by using fiscal policy. While the ECB controls the average inflation rate of the Eurozone, any individual government can still try and implement an inflationary surprise; all it has to do is to engineer some stimulus to aggregate demand (by raising public expenditures or the budget deficit), to move up along its own output inflation trade-off. Just like monetary stimulus in a country with its own currency, this attempt eventually does not work, because people take it into account in forming their inflation expectations. So, again, one gets more inflation instead of more output–with far worse consequences. The independent ECB eliminates the inflationary bias on average but does not eliminate differences in the inflationary bias across countries.
Countries that have a lower equilibrium rate of output for structural reasons will then systematically have a higher inflation rate than the Eurozone average, and at the same time they are likely to be more profligate in terms of government spending, since this is the lever used by the government in its quest for higher output. Indeed, most of the countries in crisis (Portugal, Greece, Italy) had both greater inflation and greater budget deficits than Germany, while France stood in the middle between these two categories. (One exception, however, was Spain: There, the construction boom delivered enough stimulus which spared the government from having to use fiscal policy. While Spain did accumulate an inflation differential with respect to the rest of the Euro area, its budget situation was sound).
This situation had two important consequences.
First, as aggregate demand was larger, those countries tended to run persistent trade deficits. These deficits were financed by capital inflows at interest rates that were lower than before, because interest rates had essentially converged between all Eurozone countries. These capital flows, per se, are not problematic. It is normal for capital to flow from richer to poorer countries. And one of the benefits of the Euro was that the inflation-prone countries were no longer subject to a “peso problem”, by which they had to pay an interest premium on borrowing to compensate for devaluation risk. However, a number of countries, like Greece, took advantage of those low rates to run a Ponzi game with public debt. And the mystery, to me, is that it took ten years for private investors to realize that default risk had replaced devaluation risk and that they should ask for a greater return on Greek debt than on German debt.
Second, the inflationary differentials gradually accumulated over the years to cripple those countries’ competitiveness, which further depressed activity and raised the demand for an activist fiscal policy, as illustrated by the recent protests against austerity in those countries. This led to mass unemployment and to countries being “stuck” because they had to implement austerity while being unable to substitute foreign demand for domestic demand, because this would have required a large devaluation.
The competitiveness problems were compounded by adverse supply-side policies, like for example the 35-hour week in France, which further widened the gap between France and Germany in terms of equilibrium output.
If this analysis is correct, no amount of debt relief or austerity may save the Eurozone. The imbalances will resume immediately after one exits the crisis. There are three way to tackle this issue, other than dismantling the monetary union. One possibility is implementing structural reforms so as to raise the equilibrium output level. Another is for the inflation-prone countries to implement some built-in device to impose some fiscal discipline upon themselves. For example, some economists have advocated for independent fiscal policy committees. The idea is to prevent politicians from stimulating the economy in a discretionary fashion, which, as we have seen, is counter-productive. Finally one may also envisage a fiscal policy union, which in my view would deepen the democratic deficit and create more problems — such as free-riding — than it would solve. But Euro enthusiasts are keen to take advantage of the crisis as an argument for further integration.
One should note that the growth and stability pact turned out to be unable to countenance those problems. It was designed to prevent public debt in the Eurozone to increase to such levels that the ECB would be tempted to abandon its inflation target and to monetize it (and we are right there). But this is not the only issue: a country can inflate without running a budget deficit — a balaned-budget increase in government spending would work — and yet its selection of a higher inflation rate will nevertheless prove problematic. Furthermore, the European Union has proved unable to impose sanctions on countries that violated the Pact. In this context, it seems that bureaucratic solutions like fiscal policy committees, similarly, are wishful thinking.
So we are just left with structural reforms. But it is unlikely that all Euro area members will implement such reforms so as to end up with exactly the same inflationary bias. A country may be more regulated than another for different reasons. This may be due to sheer policy mistakes that are easy to eliminate. Or it may be due to the ability of some interest groups to preserve their rents. Or it may be due to different “collective preferences” for the size of the welfare state. Countries with more generous welfare states will have more tax distortions, and therefore a larger inflationary bias. It is not obvious to me that such countries are actually willing to live with the negative economic consequences of their generous welfare states, as opposed to believing they are having a free lunch. But it is certainly conceivable that a country would rationally prefer having a bigger government in spite of higher taxes. To align the inflationary bias with that of the other countries, the European Union would have to force it to reduce the size of its government against its will. It does not seem much better than forced transfer of fiscal sovereignty to Brussels.


New textbook: Frictions and Institutions

My e-textbook, Frictions and Institutions is now downloadable online for free at bookboon.com.

Click here to download Frictions and Institutions

This book is based on my lectures on labor market institutions at Humboldt University Research Training Group and IMT Lucca in August and September 2013. It is a textbook which also contains some original research; the latter is presented in a “raw form”, which is relatively close to the way the ideas were originally formulated. Hence there is little dressing up and sweeping under the carpet, which I believe has pedagogical advantages for an audience of graduate students expecting to develop a career in research.

The goal is to induce the student to work with matching models and to perform the required analysis. This is why many analytical results are presented as exercises for the reader. Also, there is substantial emphasis on proving analytical results as opposed to constructing and calibrating a dynamic stochastic general equilibrium model. Mastering the analytics is important because the economic effects being analyzed are explicitly present in the terms of the analytical equations, and interpreting them correctly is a crucial skill any applied theorist should have.

The book introduces the reader to the now largely standard Mortensen-Pissarides (1994) matching model of the labor market, and then builds a number of applications of this model that allow us to study the distributional effects of various labor market policies and institutions. The motivation is simple: many such institutions are considered as harmful for job creation, yet politically difficult to reform. We want to know why, and the framework developed in this book allows us to find out who gains and who loses from those “rigidities”. These rigidities generate conflicts of interest among workers who are otherwise identical but may be in different current situations in the labor market. The currently unemployed have different preferences from the currently employed, and the latter may also differ by the situation of their firm: Workers in firms that are doing well have different interests from workers in firms that are doing poorly.

After having introduced the basics of the matching model, the book considers a number of specific institutions. For each of those institutions, the effect on the welfare of different kinds of workers is computed. The outcome is also compared to the first best, which in most examples coincides with the market outcome if the famous “Hosios conditions” hold. These conditions state that the surplus from a match should be allocated between the two parties in proportion to the relative importance of their search input in generating new jobs, which turns out to be equal to the elasticity of that input in the matching function. That is, the more a given side of the market is important in the job creation process,
the greater the share of the surplus that we want to give it.

I start with employment protection. An important distinction is made between employment protection as a device that enhances the workers’ bargaining power versus employment protection as a tax on separations. I then study the gainers and losers from unemployment compensation. The analysis, by assuming risk neutrality, ignores the insurance dimension of such policies and focuses on its effects on welfare through wage formation and job search. Finally, I study the role of one specific active labor market policy – a subsidy to job search – in a model where workers differ by their productivity level. It is shown that in addition to the usual congestion externality, job search generates a externality on the average quality of the pool of unemployed.

Frictions and Institutions

The attack on meritocracy and the new oligarchy

Ever since Pierre Bourdieu stigmatized the “reproduction of elites”, these elites have felt guilty. That their children’s achievements compare to theirs is perceived as a sign of unfair privilege. And prominent members of those elites do not miss an opportunity to publicly complain about “reproduction” and lack of social mobility, even though privately they spare no money, effort, time and connections to lift their progeny as high as possible in the social ladder.
Reproduction is what life is made of. That social structures reproduce themselves should therefore come as no surprise. Parents transmit genetic, human, financial, and social capital to their kids; this is not only a natural “default” outcome but for many people such transmission is the most important purpose in their life.
For Marxists and partisans of “social justice”, this is unfair because you do not choose your parents. Some kids are lucky to be born in an educated, wealthy family; others are unlucky.
Traditionally this problem had been corrected by putting in place a public education system which was supposed to give everybody the ability to acquire human capital and to progress in society despite an unfavorable initial environment. This system was based on strict meritocratic criteria and was meant as giving opportunities to those who had the will and capacity to seize them; it was not meant to be evaluated on the basis of statistical data regarding the relative outcomes of various social groups.
The system was deemed fair because it was meritocratic, regardless of its outcomes. If indeed the elites reproduced themselves, this was just tough luck for the non-elites who had been on average incapable of seizing their opportunities. Whether or not the system is fair depends on its design and not on its outcomes.
In the era of political correctness, this perception is no longer tolerated. The system has to deliver “equality of outcome”, otherwise it is considered as biased. Furthermore, any person who would claim that the system is fair could be cornered into admitting that members of those groups who do comparatively worse are less deserving, and from them easily accused of racism, sexism, and so forth. This, despite that it is generally the Marxists, not the conservatives, who insist on categorizing individuals by sex, ethnicity, class and other collective characteristics.
As a result the guilty elites are gradually eroding the meritocratic system that brought them to the top, by introducing arbitrary criteria meant to promote “diversity” (a conveniently vague concept) in the recruitment process for elite schools and positions.
So what does it mean to promote “diversity”? To answer that question, we need to note that the criteria by which the system is being evaluated have changed. In 7th century China, participants in the Mandarinate contest had their exams copied by a bureaucrat, so as to make sure that the graders could not recognize the handwriting of the candidates and indulge in favoritism. In the 21th century West, instead, elite educational institutions boast of the proportions of various “disadvantaged groups” in their recruitment, while relying on increasingly opaque and arbitrary procedures.
The two processes go hand in hand: if I am targeting a given statistical distribution for the personal characteristics of my students, I cannot at the same time abide by strict rules that apply to all individuals equally.
The most transparent I could get is to have a segmented recruitment process, by which there would be a fixed number of slots for each group. In such a situation, though, it would be all too obvious that those who are admitted to school X in capacity of their belonging to some anatomical group, are not in the same category as the others. The equality of outcome agenda would simply defeat itself if it were to use such obvious means. Instead, it has to rely on opaque means in order to preserve the illusion that the preferred groups are thriving in a process which does not systematically favor them, but instead relies on criteria that are supposed to have less of a disparate impact on the disadvantaged.
These techniques range from having an admission meeting in order to demote members of the non-preferred groups who would have made it on meritocratic criteria, so as to make room for members of the preferred groups who would not have made it (up to the point where the statistical targets are met), to getting rid of some parts of an entrance exam on the grounds of their alleged disparate impact, and replace them by tests that leave considerably more discretion to the admission committee.
As an example of the first method, I once briefly participated in an NSF-style body in the French university system which was in charge of allocating an important set of grants. After discussing the academic merits of the candidates and ranking them, we then counted the number of people who resided outside Paris and the number of women. If the result was not deemed acceptable by the president of the jury, then some men and some Parisians were demoted from their ranking and replaced by provincials and women. Since I was very uncomfortable in contributing to a process that I do not approve of, I did not last long in that jury, especially given that the president greeted me and the other members by complaining that there were not enough women in the jury (I guess they appointed me just to let me know). This Darwinian elimination process guarantees that the jury will eventually be mostly made of yes-men (and women) who will never challenge its non-meritocratic criteria.
As an example of the second method, the French elite school Sciences-Po has decided to withdraw its general culture test from its entrance exam, on the grounds that “disadvantaged groups” — like recent immigrants — would perform poorly because their background made them less acquainted with mainstream higher French culture (similarly, Pierre Bourdieu advocated that selection at school should emphasize mathematics, which is less culturally loaded than humanities). There were also talks of getting rid of the English language test, on similar grounds that the disadvantaged groups were less proficient in foreign languages, having fewer opportunities to live and vacation abroad. Somebody must have pointed out that English is used to communicate in the modern professional world, and that maybe, just maybe, social mobility would not improve if the Sciences Po graduates, regardless of their family background, were incapable of speaking English. So the English test was finally maintained, but the general culture exam was suppressed.
Which brings the following interesting question: How long can an elite survive, if it recruits its members so as to get rid of any of the characteristics that make it legitimate as an elite? If these people are not more knowledgeable, more proficient in English, nor better at logical reasoning than the average Joe, on what grounds do they hold privileged positions in society? This is of course exactly the question that the eighteenth century enlightened liberals were asking on the eve of the French Revolution. We may speculate that competition in labor markets will do to educational institutions that abandon meritocracy what the French Revolution did to the aristocratic system.
The new criteria that Sciences Po uses heavily favor those applicants who have an “interesting” and “diverse” profile. The fair exam principles borrowed from the Chinese Mandarinate system were well received in a Catholic country for which salvation is a reward for good actions (the selective exams reward hard work, and all candidates who were admitted had “suffered” in preparing the exam; therefore they tend to believe that their suffering was rewarded). By contrast, recruiting “interesting people” is a neo-Calvinist concept borrowed from U.S. universities. Salvation is now an outcome of pre-destination, not of your actions. In fact Sciences Po is remarkably opaque in disclosing how you become an interesting person, because they do not want people to develop a fake personality in order to make it to the school. As a result of the new system, some 40 % of a class had to take no written exam [1] and was admitted on the grounds of a bogus motivation letter which was at best written by their parents, and a 20 minute interview on no specific topic.
The important point here, though, is that these loose criteria, while contributing to the goals of apparent equality of outcomes, at the same time provide the oligarchy with considerable discretion in order to co-opt its members. It is very easy to decide that members of influential networks (financial contributors, political acquaintances, colleagues’ children, media pundits…) just happen to have kids whose profile is wonderfully interesting and diverse. After all, nobody can disprove you and it may even be true! It is easy to imagine that a family located at the center of power has more opportunities for a challenging, original and diverse experience than the children of a regular electrical engineer or manager of a medium-size supermarket in some dull provincial city. And, when one compares these boring middle-class people, whose only claim to upward mobility is hard work and academic excellence, to the Chosen who cannot be bothered being asked demonstrating their skills, all talk of the elite reproducing itself suddenly vanishes [2]. One only opens Bourdieu’s grave when it is convenient.

NB: [1] This ignores specific procedures for foreigners and applicants from “disadvantaged neighborhoods” who also waive any written exam.

[2] The trick is not to distinguish, in the statistics and in the rhetoric, between relatively high skilled workers earning a fair wage on their human capital, and the actual oligarchy in control of power. The dismantling of meritocracy benefits the latter at the expense of the former.