What is happening to the Eurozone? Are the troubles of the high-inflation countries (Greece, Ireland, Portugal, and Spain) due to excessive government borrowing that should have been reined in by the Stability and Growth Pact? Is the solution to be found in more stringent enforcement of the excessive deficit procedures?
The EU is adopting measures to strengthen the Pact and provide bailouts of governments finding themselves in difficulties. The latest recipient is Ireland – there may be others. De Grauwe (2010) argues that the problem originates not in excessive government borrowing but in excessive private borrowing. Meanwhile Buiter and Ebrahim (2010) point out that government borrowing rose in every country after the financial crisis. Perhaps there is some structural flaw in the Eurozone?
This question has recently been raised by Maurer (2010) in a perceptive analysis of real interest rate differentials and internal capital flows induced by a monetary union that faces divergent internal rates of inflation; a line of reasoning to what was known in the 1980s as the “Walters Critique” of monetary unions (see also Miller and Sutherland 1991, Baldwin and Wyplosz 2009, Baldwin et al. 2010).
What was the big idea?
When the idea of a European Monetary Unification was initially discussed in the 1970s, a fierce debate broke out between the so-called “Economists” and the “Monetarists” over convergence conditions that should be required prior to monetary unification.
- The Economists posited that deep-seated differences in wage and price behaviour and monetary and fiscal policies in different member countries should be removed prior to integration. Otherwise a single monetary policy could not fit all members.
- The Monetarists said that prior convergence was not necessary, since these differences would be eliminated by the monetary union itself.
Underlying these differences were fundamentally different views on how the economy functions, with the monetarists holding that “money is a veil” that does not affect real economic behaviour and the economists believing instead that monetary and real economic behaviours are inextricably intertwined.
Eventually a political compromise evolved which required prior satisfaction of the Maastricht Treaty conditions for convergence of nominal variables such as interest rates, exchange rates, inflation, and government debts and deficits. Since the treaty contained no reference to behaviour after entry into the union, the Pact was agreed to enforce continued observance of the debt and deficit criteria. Crucially, the pact was silent on the issue of inflation differences, which were assumed away.
Germany expected the stringent conditions of the Maastricht Treaty to prevent high-inflation, southern European countries such as Greece, Portugal, and Spain from entering the Eurozone. In the event, Germany herself had difficulty meeting the Maastricht conditions due to stresses created by German reunification and was in no position to exclude others whose qualifications might have been suspect, even Greece.
A divided union
The actual functioning of the Eurozone was proclaimed a success on its tenth anniversary in 2009. Papers appeared praising the monetary integration of Europe, which indeed had proceeded with few apparent difficulties despite dire predictions from sceptics. The rapid acceptance of the single currency and the transparency of pricing that it attained over the Eurozone has been a notable achievement. Gains in trade and financial integration have been significant and valuable. Other nations have been lining up to join the growing monetary area. Yet underlying differences in inflation rates and productivity growth have persisted, leading to split between surplus and deficit members that recalls the Bretton Woods era.
When Germany entered the monetary union with the same exchange rate for reunified Germany that the western side had lived with since 1979, the seeds were sown for an extended period of adjustment of its real exchange rate. The enlargement of Germany by a third with the inclusion of a region with much lower productivity and rapidly convergent prices and wages left the German real exchange rate significantly overvalued. But this was no problem for the hardworking and energetic Germans. They would simply hold down wage growth and inflation and raise productivity growth until the real exchange rate had come back into equilibrium. And so they did.
Yet as the German real exchange rate depreciated from its overvalued position, restoring the newly enlarged country’s competiveness, its southern neighbours were moving in the opposite direction. Greece, Italy, Portugal, and Spain faced a brighter future when they entered the Eurozone. Suddenly capital was available to them on essentially the same terms enjoyed by Germany. A vast construction boom ensued, financed by private capital eager to assist the newly credible borrowers of the formerly despised high-inflation countries of the EU. Repayment was guaranteed in euros, whose value could not be undermined by devaluation. Unfortunately, much of the construction went into housing and other nontradable goods sectors. Wages rose more rapidly than in Germany and productivity growth did not exceed the norm. As costs rose, eventually real exchange rates became overvalued and external competitiveness suffered. Deteriorating external positions could be financed by continued capital inflows, as long as not too many questions were asked about repayment.
As Maurer explains, higher inflation in these countries translates into lower real interest rates than in Germany, feeding a soon-to-be vicious circle of increased private debt and rising real exchange rates. The lower real interest rates in the high-inflation countries induced them to borrow from the low inflation countries, whose lenders could find more willing takers than home borrowers, who faced relatively higher real interest rates at the same nominal rate. These were private debts, not fuelled by government borrowing. In fact, Maurer shows that government deficits in the high-inflation countries were declining as a percentage of GDP up to the onset of the financial crisis that began in 2007 (see Figures 1 and 2).
Figure 1. Relative export price indicators
Figure 2. International net debt position of Eurozone debtor and creditor countries
Source: Maurer (2010)
What can be done?
So now the high-inflation countries are locked into an untenable position. They may not devalue to restore their external competitiveness. Instead they must take the German medicine of reduced real wages and higher productivity. The decline in the value of the euro of course helps them to the degree that their products are sold outside the Eurozone. Unfortunately that is only of small benefit. The bulk of the adjustment must be in declining relative prices and wages, or productivity gains.
The future of the Eurozone is now in question because of the revelation of its internal instability. Is there a reform of the Eurozone that can resolve its internal contradictions? This depends on the diagnosis of the problem. Many blame the high-inflation countries for running excessive government deficits and recommend fiscal contraction. While it is true that the debts of the high-inflation countries may be unsustainable, that is not the source of their problems. Solving it will not remove the real interest rate incentives for over-borrowing.
Maurer, by contrast, sees the problem as one of unsustainable external current account deficits leading to a build-up of private debt induced by real interest rate differentials. He therefore focuses on reducing current account deficits. To accomplish this, Maurer considers a series of options, beginning with fiscal austerity. But he points out this will also reduce GDP growth, worsening the problem it is trying to solve. Other options considered, but rejected, are defaulting on sovereign debt and leaving the Eurozone.
Maurer suggests correcting for the real interest rate differentials noted above by a value-added-tax-cum-subsidy on credits to be determined by the ECB. This would require fiscal actions by each of the member states, which would be difficult politically. Maurer’s solution is equivalent to having the ECB set different interest rates for different member countries. Instead, the refinancing rate can be differentiated among member countries according to fundamental conditions in each of the member economies.
This might sound novel, but we should recall that from 1914 to 1941, the US Federal Reserve System operated just such a policy, allowing the discount rate to be set district by district. The evidence is found in Banking and Monetary Statistics 1914-1941 available from the FRASER archive at the Federal Reserve Bank of St. Louis. There is no reason that rates offered by the Bank of Greece to Greek banks have to be the same as rates offered by the Bundesbank to German banks. Moreover the ECB must not discount high-inflation government bonds at the same rate as those from low-inflation countries. For that simply enables high-inflation-country banks to obtain ECB credit in exchange for bonds that have a higher default probability due to higher inflation.
It may be argued that funds will flow in the interbank market from lower rate regions to equalise the rates. It appears that German banks have already sought out higher-yielding alternatives in other markets. But they have learned, to their sorrow, and in some cases bankruptcy or bailout, that all that glitters is not gold. If the ECB charges an inflation differential to Greek banks, other banks will follow their lead. The result could eliminate the real interest rate differential identified by Maurer and repair the flaw in the system.
Baldwin, Richard, Daniel Gros, and Luc Laeven (eds.) (2010), Completing the Eurozone rescue: What more needs to be done?, A VoxEU.org Publication, 17 June.
Baldwin, Richard and Charles Wyplosz (2009), The Economics of European Integration, 3rd ed., McGraw-Hill, London.
Buiter, Willem and Ebrahim Rahbari (2010) “Greece and the fiscal crisis in the Eurozone”. CEPR Policy Insight 51, October.
De Grauwe, Paul (2010) “Fighting the wrong enemy”. VoxEU.org, 19 May.
Giavazzi, Francesco and Luigi Spaventa (2010) “The European Commission’s proposals: Empty and useless” VoxEU.org, 14 October.
Maurer, Rainer Willi (2010) The eurozone debt crisis – A simple theory, some not so pleasant empirical calculations and an unconventional proposal. Working Paper, Hochschule Pforzheim University.
Miller, Marcus and Alan Sutherland (1991) The “Walters Critique” of the EMS-a case of inconsistent expectations? The Manchester School Vol LIX Supplement June, 23-27.