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.