Year: 2012

Martin Wolf provides a cogent if sobering analysis of the euro zone crisis (FT article here; Irish Times article here).    I previously discussed the “impossible trinity” facing euro zone in posts here and here.   The euro is facing an existential threat; there are political limits to the possibility of a transfer union (including limits on potential net transfers under strengthened euro zone mutual insurance mechanisms); and the ECB does not consider a higher inflation/nominal GDP growth target as consistent with its price stability mandate. 

Martin Wolf describes the dilemma thus:

If dismantling the euro is out of the question, true federal finance is unavailable and mutual solidarity will remain limited, what is left? The answer is faster adjustment, to bring economies back to health. Indeed, that would be essential even if stronger solidarity were available. The euro zone must not turn the weaker economies of today into depressed regions, permanently supported by transfers, a policy that has blighted the south of Italy.

So how is faster adjustment to be achieved? The answer is through a buoyant euro zone economy and higher wage growth and inflation in core economies than in the enfeebled periphery. Moreover, the required growth strategy is definitely not just a matter of policies for supply.

According to forecasts from the International Monetary Fund, euro zone nominal gross domestic product will rise by a mere 20 per cent between 2008 and 2017. In the latter year, it will be 16 per cent lower than if it had continued to grow at the rate of 4 per cent achieved between 1999 and 2008 (consistent with 2 per cent real growth and 2 per cent inflation).

For the economies under stress, such feeble growth is a disaster: it means that the euro zone as a whole tends to reinforce, rather than offset, their credit contractions and fiscal stringency. They can blame the universal adoption of fiscal stringency and the policies of the European Central Bank, which let the money supply stagnate.

Something may give, and it is potentially disastrous if it is the euro.   The possibility of higher nominal growth targets needs to be part of the debate. 

On strengthening the mutual insurance mechanisms, the discussion in our Treaty referendum debate of the legal mechanisms to stop the ESM going forward borders on the surreal.   The purpose of the fiscal compact is to provide an added degree of assurance that euro zone members will pursue reasonably disciplined policies.   The idea is to give other members sufficient confidence (and a degree of political cover) to allow the mutual insurance mechanisms – probably eventually including some form of euro bonds – to develop. 

Eurobonds have returned to the forefront of the euro debate.  There are many varieties of eurobonds.  Some have been designed to mitigate the moral hazard risks that concern German officials (and many others).  The euro-nomics group (of which I am a member) have been advocating the concept of “European Safe Bonds” (ESBies) that does not involve joint and several liability, while other proposals have also been made.

Shahin Vallee recently made a presentation to the European Parliament comparing the main alternatives – the presentation file is here.

Jeremy Siegel points out in this FT article that a weakening in the external value of the euro can be important the recovery of the euro area;  Paul Krugman raises the objection that “… Europe as a whole, like America, remains a relatively closed economy. Its salvation must be mainly internal.”

Of course, trade with the rest of the world is a limited channel for the collective euro area.  However, it is important to appreciate that trade with the “rest of the world” is especially important for the peripheral countries, so that a substantial euro depreciation can be a contributory factor to the recovery process.  There is an interesting IMF paper that quantifies the role of external trade for the periphery countries – I will post a link once that paper goes online.

(The heterogeneous exposure of the periphery versus the core in relation to the external value of the euro was also much studied in relation to the very large euro depreciation against the dollar during 1999-2001. For instance, see this paper that I wrote with Patrick Honohan.)

Here.