Rethinking the crisis of EMU
Now that Mario Draghi's 2012 promise to do 'whatever it takes' to save the euro appears to have borne fruit, in the sense that the immediate EMU crisis seems behind us, let's take a fresh look at how we got into this mess in the euro-zone in the first place. According the Brussels-Frankfurt-Berlin consensus, the causes are clear for all to see: exactly the fiscal profligacy that Theo Waigel's, Helmut Kohl's fiscal lieutenant during the Maastricht years and architect of the now defunct Stability and Growth Pact (SGP), warned us for in the 1990s. But, as many observers have pointed out, until the onset of the crisis in 2007 all countries in EMU except Greece ran, averaged over the period 1999-2007, a deficit within the 3% limits imposed by the SGP. In fact, Germany, the grumpy headmaster of the current cohort, ran among the larger deficits in the group in the early 2000s. The real problem, as many point out, lies elsewhere: massive current account deficits in the GIPS (and in Ireland after 2007 but not before) against permanent surpluses in the north. Current account surpluses, in turn, are balanced by capital account deficits: the surplus countries export their surplus to deficit countries via banks and sovereign debt, thus stoking an asset inflation boom – which ended up being unsustainable.
So far there is not all that much new under the sun. But this analysis leaves us with a feeling of incompleteness: how exactly we got there is considerably less well understood than what happened once we ended up there. In essence, two very counterintuitive mechanisms reinforced each other to produce these imbalances.
One is monetary policy, which has, in its consequences, effectively been pro-cyclical since EMU's inception. Imagine, for ease of exposition, that EMU consists of two economies of equal size, called DE (i.e. Germany with its north-west European neighbours, including Austria) and RE (for Rest of Europe). At the start of EMU, DE's inflation rate was, because of its more strongly coordinated wage-setting system, slightly below RE's; they average two per cent, which is the ECB's inflation target. Since the ECB sets its interest rate for all members to reflect the difference between the target and the actual (i.e. the aggregate or weighted average) inflation rate of DE and RE, the real interest rate (the nominal interest rate that the ECB sets for all minus the country-specific inflation rate) is therefore lower in the country with high inflation (RE) and higher in the low-inflation country (DE). These differences between real interest rates and domestic institutions have several consequences that are poorly understood.
First of all, the country with a higher inflation rate in effect has a more accommodating monetary policy than it should, because the bank's target is lower than its actual inflation rate. The country with a lower inflation rate, on the other hand, will have an unnecessarily restrictive monetary policy, which will not have a significant effect on price dynamics (since inflation is low already), but only on growth. Note that the opposite would happen if monetary policy were decided for each country individually: if inflation in DE were to fall, DE's central bank would almost certainly lower the nominal, and therefore effectively the real, interest rate; if inflation rises in RE, RE's monetary policy would tighten. None of that happens in EMU, where rising inflation is implicitly rewarded through a falling real interest rate. This pro-cyclical dynamic is partly compensated by a lower real exchange rate (RER) in the low-inflation countries, which improves competitiveness and therefore exports. However, this compensation effect is limited to the export sector, which makes up at most half of the GDP of small economies in EMU and not more than a quarter of output in large economies.
The second ill-understood effect is that the lower real interest rate that RE has faced during the first ten years of EMU feeds into a path of higher growth in RE, fuelling higher inflation. At the same time, the tighter than necessary monetary policy imposes further disinflation through wage moderation on DE. The very small differences in inflation that existed during the first round (the start of EMU) thus have become more pronounced in the second round (rising asset prices fuelled inflation in RE, externally imposed disinflation further reduced prices in DE) and the perverse pro-cyclical effects gain in strength, pushing inflation rates and competitiveness of DE and RE on sharply diverging paths.
The second basic mechanism has to do with the differences in wage setting between DE and RE. In contrast to standard economic theory, in which decentralised, flexible labour markets offer the fastest adjustment mechanisms, the countries that have done best over the past five years (and frequently also before) have been those with strong trade unions and highly coordinated wage-setting systems. Different wage-setting systems mattered at the start of EMU, since they put DE and RE in different relative positions, with lower inflation in the former. But, in addition the ability of DE to counter inflationary pressures through wage coordination is almost perfectly mirrored by the inability of RE to do so. Since inflation is more of a problem in RE (though hidden under the beneficial effects of very low real interest rates), the inability to disinflate implies that RE slowly but steadily loses competitiveness relative to DE. In itself that does not have to be deeply problematic: if RE can grow through trade outside EMU, it can compensate its falling competitiveness within EMU through rising competitiveness outside EMU. But EMU is essentially a closed trade area, with only about ten per cent of GDP leaving the single currency zone, most of which goes to other EU member states. Within such a closed trade bloc which, in addition, has faced a relatively low growth regime since its inception, DE's rising competitiveness must imply RE's falling competitiveness. Trade in EMU has, in effect, become a zero-sum game in which one's gains are another one's losses, and DE's improving competitiveness and current account surplus are mirrored in current account deficits in RE.
The crisis of EMU is, from a longer-term perspective, the result of this combination of a pro-cyclical monetary policy and divergences in domestic wage-setting institutions pushing inflation differentials out in every bargaining cycle. The effect is a dramatic drop in competitiveness in the higher-inflation countries and a dramatic increase in competitiveness in the others, reflected in the current account imbalances within EMU that we see today.
Such current account surpluses and deficits exist in every monetary union, of course. Take the US or Germany before EMU: both large countries contain sub-regions that are more and less competitive, and the policies of the central bank were probably also more or less always wrong for any individual sub-region. But both these countries – and Italy, and Spain, and Belgium, all countries with important inter-regional economic disparities – were also political unions, with a constitution that produced and imposed a common destiny and a fiscal regime that compensated for these divergences within countries. As wealthier regions grew faster, they contributed more taxes to the central pool, and poorer, slow-growing regions drew on that pool to raise their fortunes. Inflationary pressures in the first thus were eased while deflationary pressures in the second were compensated by cheaper money from the wealthier regions.
Perhaps such a transfer arrangement would have helped EMU in the past – and thereby made the current problems more digestible. Had the fast-growing Spanish and Greek economies been forced to transfer funds to the slow-growing Germans in the first ten years of EMU, it would probably have been easier to ask the faster-growing Germans today to help the stagnating Greek and Spanish economies. A political union, especially one involving fiscal transfers (which it should lest it be an incomplete union), creates solidarity and trust. And trust likely would have engendered more trust, up to the point where Greece might have taken German pleas for a more effective taxation system closer to heart than they have done over the past five years, with a proverbial knife against their throat.
But history does not really appreciate words like 'perhaps'. Turning back the clock and redoing EMU, this time with a political union (and slightly less paranoid central institutions, perhaps ;-) is impossible. And instituting it now does leave a bitter aftertaste: last time I checked neither the Germans nor the Greeks were asked about their forced marriage – even if it looked like the right thing to do for EMU, it is fuelling anti-EMU sentiment. That means we are probably saddled with a crisis of EMU that continues for a long time: a complete, coherent reorganization of the single currency is not in sight, but European political will is too strong for a break-up. It is going to get a lot worse before it will get better.
Bob Hancké es profesor de ciencia política en el Instituto Europeo de la London School of Economics. Su libro más reciente (en el que desarrolla algunas de las ideas de este artículo) es Central Banks and EMU: Labour market institutions and monetary integration in Europe (Oxford University Press, 2013).
La crisis de la Unión Monetaria Europea