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.