An Impossible Trinity?

There is an important debate taking place across the European economics blogosphere on the policy mix required to resolve the euro zone crisis.   Simon Wren-Lewis provides a good overview here, with many useful links.   The election outcomes in France and Greece will provide further impetus to this debate, though the likely direct results – e.g. a scaled-up European Investment Bank – are probably going to be of just marginal significance, even if they make good headlines. 

The core problem is the difficulty of reconciling there fundamental goals of key actors: saving the euro; avoiding a large-scale transfer union that would involve significant transfers from core to the periphery; and sticking with current definitions of euro zone price stability.   

The vulnerability of the euro has been demonstrated by the susceptibility to self-fulfilling runs on sovereigns (and banks) when they do not have their own central banks to act as lenders of last resort to the government in extremis. 

As a partial replacement, the euro zone has developed lender of last resort mechanisms (e.g. the ESM and the ECB’s bond-buying programme).   But these mechanisms entail risk of significant transfers from the strong to the weak within the euro zone.   The stronger countries have shown a (limited) willingness to run the risk of such transfers, but have required greater assurance that countries will pursue reasonably disciplined policies.  The Fiscal Compact must be seen in this light.  (See Jacob Funk Kirkegaard here.) 

Unfortunately, the massive growth challenge faced by the periphery casts grave doubt over whether this approach can work.  As noted in an earlier post, a higher euro zone inflation target could significantly ease the growth challenge.  But Germany in particular will be reluctant to allow this given their commitment to the overwhelming importance of price stability. 

In the post linked to above, Simon Wren-Lewis provides a possible mix of policies that he thinks could be acceptable and would make a significant difference: (i) the ECB accepts a symmetric inflation target around 2 percent; (ii) the need for inflation above 2 percent in stronger countries such as Germany is explicitly recognised; (iii) the ECB stands ready to cap individual-country bond yields, potentially giving easing the market constraint on their fiscal policies; and (iv) if monetary policy is not sufficient to achieve the 2 percent inflation target, the aggregate fiscal policy stance of the euro zone is used to ensure the target is met. 

On the last point, the message from Marco Buti and Lucio Pench in this Vox piece is important.   (Marco Buti has been an important intellectual force behind the development of the Stability and Growth Pact.)   They note that the EDP is sufficiently flexible to allow the aggregate fiscal stance in the euro zone to be taken into account.  

Concerning the response to shocks, it needs stressing that the Stability and Growth Pact explicitly allows for the playing of automatic stabilisers around the adjustment path, that is, the adjustment is formulated in structural terms. Acknowledging the problems inherent in the measurement of structural balances, the framework calls for an ‘in-depth analysis’ of the reasons behind a country’ s failure to meet the budgetary targets, including revisions in potential growth and endogenous changes in revenue elasticities. To these elements of flexibility, the recent reform has added the possibility of extending deadlines for the correction of the excessive deficits irrespective of a country’s individual predicament, if the situation of the Eurozone or the EU as a whole calls for a relaxation of fiscal policy.

Saving the euro, avoiding large-scale transfers and sticking with the current definition of price stability may be an “impossible trinity”.   The effort to find economically workable and politically saleable combinations of policies shows the European blogosphere at its best.

44 replies on “An Impossible Trinity?”

There is only one way to turn an impossible trinity into something that people can understand.


@PR Guy“

“The point is, they have to avoid a whole troika programme where Spain’s access to markets gets frozen and all financing is provided by official lenders.”

I don’t think anyone wants to go the Ireland route. The question of why Ireland ended up with a full monty programme is of course fascinating. Did the bank guarantee and the 2 fingers it showed to the rest of the EZ come back to haunt Ireland ?

“avoiding a large-scale transfer union”

Hmmm. When Ireland took on the debts of private banks, debts understood to be largely owed to foreign and in particular, French, German and UK banks, wasn’t that the largest scale “transfer union” that has ever taken place in the EU by reference to the size of our economy.

But now that we might want some reverse/reciprocal transfer, the rules have changed?

There’s something to be said for looking at actual data on inflation. Based on the version of the HIPC index that comes most easily to hand, inflation in the Eurozone has not been quite symmetrical around 2%, but it has not been too far off – averaging about 1.8% over time. Eurozone inflation is currently running at about 2.6%.

A peculiar thing is that inflation in two of the countries in trouble is running above average, while that in Germany is running a bit below average at 2.3%. Inflation in Italy is 3.6%, and that in Portugal is 3.1%. Inflation in Ireland (2.1%), Greece (1.4%), and Spain (1.7%) is running below that for Germany, but not by so much as to allow a very rapid gain in competitiveness.

I guess the key points that I see emerging from this are:
1) Symmetrical inflation targeting around 2% may not make much difference.
2) Inflation-targeting measures at the level of the euro area alone don’t appear to be enough. It looks like there is a need for geographically targetted action to suppress inflation in the periphery and boost it in the core.

“(iii) the ECB stands ready to cap individual-country bond yields, potentially giving easing the market constraint on their fiscal policies; and (iv) if monetary policy is not sufficient to achieve the 2 percent inflation target, the aggregate fiscal policy stance of the euro zone is used to ensure the target is met.”

iii is basically what the political class in the periphery and near periphery (France for example) in effect experienced after EMU via bond yield convergence and the Great Moderation. It conditioned them, and their electorates to be cushioned from the competitive realities of the emerging economies. The return of compressed bond yields, and the politics they have become used to is what they are angling for. From the German perspective, the problem with this is that it is unlikely to encourage reform.

iv is dependent on overall global deflationary/inflationary trends. If deflationary, this fiscal policy response becomes very political – and, importantly from the German perspective, very likely anti-reform.

The appropriateness of the application of Keynesian solutions in the EZ is not black and white. There is a mixture of glaringly obvious structural shortcomings – which strongly suggest it is inappropriate and will just reinforce silly arrangements, and clearly cyclical ones – for which it is appropriate.

Economists should be encouraging politicians to segregate the two.

Differential inflation targets are not going to solve structural problems that existed decades before the launch of the euro.

The changing model of globalisation, European ageing and rising public spending burdens, suggests that there are no simple panaceas.

Rather than just looking at the issue as core v periphery, there is a European growth crisis and Germany cannot be blamed for example for the fact that France has had a trade deficit every year since 2002 and its 2011 deficit was more than 3 times Germany’s surplus with the rest of the EMU.

There is certainly much that can be done to improve the internal market including language competence in for example Ireland.

In a decade, it will be harder to find business in emerging markets and all countries face the challenge of running their economies prudently.

On transfers, these become an issue when there’s a perception of corruption. Ireland hasn’t paid a net cent to the EU budget since 1973 and there wasn’t a strategic reason for doing so.

We should have been paying into the system when were able to afford it and we complain only when the rules are adverse.

Issues such as tax harminisation are also relevant.

@Bee Cee Tee
I would not hold too much stock in those inflation metrics – they are calculated via a Euro vs a specific basket of Goods.

They do not take into account wage deflation which is merely inflation with a twist.
To see the Industrial collapse of Europe I merely watch the energy & transport data…… its quite something as it is harder although not impossible to mess around with the TPES.

Somebody probally the US pegged China is gaining our energy ration because the banks that came home to the Europa Mammy made some bad slave arbitration bets in 2007.
Unfortunetly the European treasuries allowed these vultures shit in the nest as they have no concept of independence from the banks.

The inflation withen the OECD of the 70s was a quite different beast – despite 2 nasty spikes the energy ration increased during that time…. the OECD energy ration has been declining for 10+ years now – especially withen Europe.
This is a direct result of the financing of slave arbitrage which was more profitable for a time then rational fixed capital formation withen a resourse poor Europe.

I am afraid The Vultures are coming home to roost.

@ MH

“Differential inflation targets are not going to solve structural problems that existed decades before the launch of the euro.”

The FT at the weekend said that Spain last had 25% unemployment in 1994. Credit masked that for a while but it’s back to the future.

No simple panaceas but the ez is going nowhere without action on current account imbalances. The european project is suffering a lot of collateral damage in the meantime. The IT ran a feature on saturday asking if anyone in the country could say they still loved Europe. Anti europe sentiment is far worse in greece.

Competitiveness has both price and non-price components, and it is possible to trade one off against the other. Big enough inflation differentials for a long enough period will sort out the competitiveness problems that arise from the long-standing structural problems, although by depressing real incomes. A combination of inflation differentials and structural improvements will sort them out faster and with better outcomes for living standards. Structural improvements by themselves will take a long time to work, even in the unlikely event that they are designed and implemented well.

Differential inflation rates are required to tackle the price component of competitiveness. My point earlier was that differential targeting of inflation rates is required to achieve sufficient inflation rate differentials. The data suggests that simply targeting inflation rates at the level of the euro zone will not have much impact, at least if the target continues to be in the region of 2%.

Posted in previous thread in error.


Is it possible to eradicate the structural deficit and meet the obligations of the bank guarantee, including underwriting NAMA, with a sizeable slice of the EU in economic decline?

Regarding the impossible Trinity, I still think the right and least costly way forward is to put countries that would require an IMF programme if they were not under the euro umbrella through the equivalent of an IMF programme.

No fiscal transfers to Member States. Hand insolvent financial institutions to their creditors. Liquidity from the ECB to keep solvent financial institutions liquid so that Member States in distress can retain the euro, and to eliminate liquidity barriers to fulfilling deposit guarantees. Ideally, a bit more flexibility on euro zone price stability. IMF-style writedowns for creditors of the sovereign (including ECB), IMF-style conditionality and IMF-style liquidity funding.

@John McHale

One area of debate that has not been discussed in the issue of using differing VAT rates to rebalance trade and consumption between EU states.

Some EU VAT rates are as follows:
Hungary 27%
Finland 24%
Poland 21%
France 19.6 going to 21.2%
Italy 21% from 20% going to 23% later this year.
Spain 18% going to 20% in 2013?
Germany 19%.

For instance a 2% vat reduction in Germany and a 2% increase in VAT rate in peripheral countries should have the effect of rebalancing consumption to some degree.

Some people will recall the 35% luxury vat rate of the 1980s.


It’s (still) the Banks Stupid .. or the Black Hole of The Financial System Crisis ……..

As concerns about Spanish banks grow, leading economists are warning that Europe’s banking system urgently need to be overhauled, otherwise the entire monetary union could be in jeopardy. The continent’s leaders missed their chance to reform the system in the wake of the 2008 financial crisis, and are now paying the price.

It is not not totally about the Banks. About two thirds of the increase in the debt in Ireland is due to spending in excess of taxation. My spies tell me that SI insurance payouts exceed social insurance income by 4bn.
Non means tested SW benefits equal income tax.

@ John McHale

“The effort to find economically workable and politically saleable combinations of policies shows the European blogosphere at its best”.

It could also be argued that it shows it at its worst i.e. its concept of “politically
saleable” is entirely divorced from reality.

Gideon Rachman has a more realistic take on the raw politics now in play.

As MH and others have pointed out above, the disparities in economic performance pre-date the creation of the euro and what has happened is a return to the status quo ante e.g. the lack of budgetary discipline in France, the unemployment situation in Spain, bond spreads etc. etc.

The problems in the real economy have to be tackled as the absolute priority.Talk of “saving the euro” is, in my opinion, entirely misplaced. It is in no danger.

The likelihood of France siding with Greece in the political tug-of-war now beginning is, in my opinion, zero. Hollande will, willy-nilly, however, become an advocate for some easing of the bail-out conditions for Greece in return for an even higher level of external tutelage. The arguments for distancing Ireland from Greece increase with every passing day. This not, however, evident in the referendum debate (that on the Week in Politics yesterday having reached a new nadir).


EZ crisis is mainly a Financial Crisis … (and dodgy capital flows

In IRL – I have never disputed the fiscal side which we could/can manage … but rail against regressives, waste, and sheltered sectors into goughing and tax hiding … shouldering the Banks makes us unsustainable and has destroyed the Irish sovereign …

At EZ level a Financial Crisis is being spun as a Fiscal Crisis ….

There are many reasons to vote NO – at the mo we are heading for certain default ….

@ John McHale

As a thought experiment, I suggest you transpose your ‘trinity’ to Ireland, where the counties represent Eurozone countries, sharing a common currency.

If we consider the collection of counties to still be ‘Ireland’, how do you think policies play out in terms of how citizens of different counties would feel about being ‘Irish’?

Might I also recommend a good youtube explanation of Sectoral Balances & ‘accounting identity’.!

@ David O’Donnell

It is both a financial crisis & +euro system+ crisis (both predicted & predictable).

The fiscal crisis, of course, is an effect (by inherent design), not a ’cause’.

Yes indeed, we should vote NO and if there’s an option on the ballot that tells political leaders & their economics advisers to get a proper education in macro economics & the operation of a fiat monetary system, prior to engaging in negotiations for a radical reform of the Euro system, then tick that box too.

I would not wish the IMF on my worst enemies. When Jim Flaherty (Canadian Finance Minister) states at G20 and similar gatherings that EZ countries have all the tools at their disposal to counter a run on any group of countries or banks within the EZ. His argument is that the IMF is for those who cannot truly not help themselves.

Funds are flowing into the German black hole where it earns less than the rate of inflation. Germany is being paid to store funds that are badly needed by the rest of the EZ. The job of the heavily indebted countries is pry those funds lose and put them to good use. If Germany is paying 1.56% per annum it would be unconscionable to charge Ireland, Italy, Spain more than a 50% mark up or 2.4%. As for Greece and Portugal they are riskier investments and 3% would be justified.

If we vote NO then all bets are off and the Gov’t will do the decent thing and resign.

Struggling economies will need to provide improved conditions for promoting the establishment of new businesses but also it’s important to promote foreign investment.

It’s possible to have harmonisation of corporate tax, with low rates on a regional basis.

In the current system, Ireland enables US companies to suck in revenues from both big and small countries and on an EU basis, these companies pay very little tax.

In fiscal 2011, Microsoft’s net income in Ireland should have been €5.4bn, based on its 40% net income/revenues ratio worldwide.

It paid €76.5m — a rate of 1.4%.

Ireland is in effect facilitating US companies to evade large amounts of tax that should be paid in Europe.

It’s interesting that there is no outrage when there is a gain from bending the rules suit.

Why is a transfer union such a problem?
Germany already has a transfer union with richer areas paying for poorer ones.
The US. India, Russia, Brazil etc are all large countries with large populations and transfer unions.
In an ‘optimum currency area fiscal transfers are included, according to Mundell.
A fiscal union is needed.
The phrase you can’t have your cake and eat it comes to mind.

Tks John for the set of articles. They variously set out a schema of problems and their solutions, but each fail to come to grips with the central problem. I’ll briefly survey the problems posed.

The problem is the ballast tanks on the Titanic, Ireland, Portugal, Greece, Spain are compromised. The problem has been generated in terms of the disparities in the eurozone between the core and the periphery. The articles address the question of austerity and examine slow and fast track merits of the austerity model. Inflating your way out of the problem, John’s 4% his own target, is dealt with, as another approach.

But the articles leave out the major cause of the the euro’s problems. The problem lies in the engine room of the euro Titanic, the banking system. Ireland is in the throes of a banking crisis switching into a sovereign crisis. “Bancia’ in Spain, a merger of 7 Caja savings banks, is now reluctantly announced as requiring a ¢10 bn state bailout. We’ve been there, this is the beginning of the rollercoaster of debt
with ¢10 bn only admission price to the real fun ahead. It will be interesting to see how Prime Minister Rajoy responds when the banks again come knocking on his door.

Likewise in Greece, the state of its public finances has detracted away from the state of its banking system. Its in a worse state than Ireland’s. Large institutional money fled the Irish banking system, but Irish depositors stayed on board. In Greece all have fled. Both France and Germany are on the hook for Greece and Ireland and the state of their banking system is not as strong as they would have you believe.

No proper solution to the banking crisis in Europe has yet been found. Inflating away the problem will not inflate away the problem In a word of freely floating currencies breathing in inflation would erode confidence in the euro and hasten its demise. Austerity and the deficit problems of EMU members do need to be addressed, but in themselves they will not cure the debt problems locked into the european banking system. LTRO has papered over the cracks and dimmed the problem on the sovereign side to some extent, but lending is not taking place, the generators in the engine room of the Titanic are largely compromised if not shutting down.

I believe there is discussion about a european banking union that would operate similar to the FED with I presume the ECB’s equivalent of Fed’s FOMC being the ECB’s ESM. The political obstacles to this are tremendous. The devastation wreaked by the breaking up of the euro banking system as democracies are sucked into the hole of the private banking system of the euro, would be tremendous.

An orderly break up of the euro is best. Greece, Ireland, Portugal and Spain are leading candidates for state backed, independent public banking systems that should focus on employment and the real economy, instead of band aid for a virtual banking system that has sucked blood from the EA peripheral economies until there is no blood left 🙁

The debt/GDP ratio can be changed by
a) redcing debt
b) increasing GDP
c) growing D < growing GDP
Its not clear that this implies austerity.

Just been chewing the fat with a couple of politico PR Guys over on ‘the mainland’ (that’s Europe, not the UK). They kept talking about Greece “doing an Ireland” (i.e. go back and vote again until you get the ‘right’ result).

What if…..

Alexis Tsipras (leader of the second placed left-wing Syriza party) actually manages to form a government?

I was trying to recall – when the previous group of Greek leaders had to sign something in blood to assure the Troika that they would continue with the terms of the bailout after the election, was it Papandreou who signed for PASOK or Venizelos? If Venizelos didn’t sign personally, could he be a wild card?

Just asking.

Alternatively, I hear that Greek generals are pretty good at filling political vacuums 😉

@Philip II

I agree with you fully with the debt:GDP but the TASC contribution this morning deals with the 0.5% structural deficit and argues that growth will not be enough by itself to reduce a 3.5% structural deficit in 2015 (as claimed by TASC) to 0.5% and TASC argues that structural deficits need policy changes, or in the common parlance, more austerity.

@J Mch

An additional thought.

Back to the basic idea of either higher inflation targets, or (and in reality likely accompanied by) higher inflation in Germany than elsewhere.

This would have implications for Bund prices that would reinforce German dislike of the idea.

If the market thought there might be such a policy and in particular, if that might be expected to increase credit-worthiness of periphery bonds, there would be a scramble to exit Bunds at current prices.

@ PR Guy

Venizelos was Finance Minister, he had to sign it i assume. Literally it actually may have been his signature on a lot of documents, in the same way that Noonan physically signs lot of Irish laws. And ND, Pasok and Syriza all hate each other, dont see them getting a government together.

Re Greece “doing an Ireland”, it struck me that one of the more plausible outcomes of a new Greek election is that the Syriza vote goes up, putting it in first place with a 50 seat bonus, and allowing it to form a government without ND, Pasok, the communists or the far-right outfit.

@Bond Eoin Bond

“And ND, Pasok and Syriza all hate each other, dont see them getting a government together.”

I can’t see them signing up to this anyway:

Alexis Tsipras’s conditions for forming a new government with either of the two ‘mainstream’ Greek parties (Hat tip Ekathimerini)

1) The immediate cancellation of all impending measures that will impoverish Greeks further, such as cuts to pensions and salaries.

2) The immediate cancellation of all impending measures that undermine fundamental workers’ rights, such as the abolition of collective labor agreements.

3) The immediate abolition of a law granting MPs immunity from prosecution, reform of the electoral law and a general overhaul of the political system. According to Keep Talking Greece, that would include abolishing the 50-seat bonus for the party which wins the most seats.

4) An investigation into Greek banks, and the immediate publication of the audit performed on the Greek banking sector by BlackRock.

5) The setting up of an international auditing committee to investigate the causes of Greece’s public deficit, with a moratorium on all debt servicing until the findings of the audit are published.


“it struck me that one of the more plausible outcomes of a new Greek election is that the Syriza vote goes up, putting it in first place with a 50 seat bonus, and allowing it to form a government without ND, Pasok, the communists or the far-right outfit.”

Plausible they could top the poll but even with the ‘additional’ 50 seats, they are still going to need to do a deal with someone else for another, what, 40-50+ seats to have a working majority? But I’m sure that the dirt will be dug and whatever else needs to be done to undermine the credibility of Syriza and its leader before the second election takes place.

Oh look, here’s a folder I found detailing 159 incidences of corruption carried out by Syriza MP’s-in-waiting. It fell off the back of a lorry guv. Happens all the time.

@ PR/Bee

was talking to a Greek economist there today, he reckons Tsipras/Syriza will actually lose votes if anything if it comes to a new election, no one figured they’d do this well, and a lot of people voted for him as a protest vote, but that their vote wouldnt actually propel him into power. ND/Pasok now letting Tsipras become the “extremist” and show that he has no real strategy or plan other than a complete bankruptcy of the Greek state and a probably EZ exit.

@PR Guy,
If they can cut a deal with anyone it will be with Democratic Left and Independent Greeks, which I think have 52 seats between them this time around.

@Bond Eoin Bond

“ND/Pasok now letting Tsipras become the “extremist” and show that he has no real strategy or plan other than a complete bankruptcy of the Greek state and a probably EZ exit.”

I suspect you are right. I’m assuming ND/Pasok are ‘playing for a draw’ (rerun of the election).

Do away goals count double in Greece?

@ PR

with their inventive statistics, they can probably amount to whatever you want.

@ John McHale

FYI on the acceptance by the Bundesbank of a higher inflation rate in Germany to compensate for deflationary impacts in the periphery. “Half a loaf is better than no bread”.

“Aber die Deutschen sind nicht dumm”.

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