[This article was originally published by Deutsche Bank Group. It explores likely outcomes of the EMU.— Ed.]
Although failing to meet the criteria for an optimal currency union EMU worked fairly smoothly during the first decade of its existence. In our view the reason for this was cheap credit, which substituted for fiscal transfers to economically weaker countries.
With the disappearance of cheap credit EMU 1.0 lacked an essential element compensating for its deficiencies as an optimal currency area. In principle, cheap credit from the markets could be replaced by government transfers from stronger to weaker EMU countries or ample central bank credit. However, we would consider a “transfer union” or an “inflation union” not as stable states of EMU.
This leaves in our view only two options for EMU 2.0: A hardening of EMU or a redrawing of the boundaries of EMU such that only countries meeting the real economy criteria for a currency union are members.
We expect EU governments and institution to do everything possible to retain an EMU with a large group of countries. This requires credible and irreversible adjustment in the countries in financial difficulties and an improved economic governance structure in EMU. Most likely, it also requires start-up funding from the EU level, including from the ECB as other facilities (e.g. IMF and EFSF) lack the necessary financial fire-power.
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There is a technique in economics called comparative statics, where the change from one state of the economy to another in response to a change in some important exogenous parameters is analysed. We use this technique to derive scenarios of possible new states of EMU after the present crisis. We briefly sketch the state of EMU before the crisis, identify the change in exogenous parameters, and finally describe how EMU might look like in the future.
An EMU built on easy credit
Even if all countries did not even meet the nominal convergence requirements laid down in the Maastricht Treaty EMU was surprisingly stable during the first 10 years of existence. The reason for this was easy credit.
Robert Mundell argued in a path-breaking article in 1961 that fixed exchange rates among different economic areas require a high degree of labour market mobility (or, as was later pointed out, a high degree of real wage flexibility).1 Subsequently, Peter Kenen in a 1969 article pointed out, that fiscal transfers to some extent can make up for deficiencies in the real economy criteria for a fixed exchange rate regime (to which Kenen added a diversified production structure in each economic area).2
Although EMU met neither the Mundell nor the Kenen criteria when it was launched it remained remarkably stable for the first decade of its existence. Some observers have taken the view that this was due to a too rigid formulation of optimum currency area theory. After all, so a common argument, not even the US fits all the criteria for a common currency. We are not convinced by this explanation. Rather, it seems to us that EMU was sustained during its first decade by the ample supply of credit at very low cost. Cheap credit was a substitute for the fiscal transfers that would otherwise have been needed to compensate for the insufficient fulfillment of the Mundell criteria. Weaker economies could easily borrow to counter country-specific adverse developments (such as falling export competitiveness) and raise private and public consumption beyond the economy’s production capacity (see Charts 1-2).3
With the burst of the global credit bubble the reason for the smooth functioning of EMU, easy credit, disappeared and the deficiencies of the euro area in meeting the requirements for an optimal currency area came to the fore. A number of countries (notably Greece, Ireland, Italy, Portugal and Spain) had relied on cheap credit to fund domestic demand and neglected their international competitiveness. As a result, their unit labour costs rose strongly during the 2000s while those of Germany stagnated, and their current accounts recorded large deficits while that of Germany moved to a large surplus. With growth prospects dim and debt loads high these countries found it ever more difficult to access capital markets. The smaller countries, Greece, Ireland, and Portugal, were cut off entirely and had to request stand-by arrangements from the IMF. In response to this exogenous change in the “credit parameter”, EMU is now on its way to a new state. How could this look like?
Possible new states of EMU
Without cheap credit from the capital markets there are four new states that EMU could assume next: First, the real economy (Mundell) criteria could be met in a euro area with (most of) the present members. Second, the real economy and fiscal (Kenen) criteria could be met. Third, cheap credit from capital markets could be replaced by generous credit from the central bank. Fourth, membership of EMU could be reduced to countries meeting the Mundell-Kenen criteria. Since arrival at any one of these new states depends on the dynamics of the adjustment process some are more likely than others, and not all are stable in the long-run.
1. Meeting the Mundell criteria: The hard EMU
EMU was originally designed as a “hard currency union” of sovereign states. To achieve this, mutual financial “bail- outs“ and monetization of government debt were forbidden. Recall that the budget constraint of a government in its broadest form is given as the sum of its capital market borrowing capacity and seigniorage from issuing non interest-bearing central bank money to the general public. Seigniorage rises when inflation accelerates. Hence, in a “hard currency regime” the government must refrain from adding to its borrowing capacity in the capital markets by boosting seigniorage through inflation. But this is only possible, when the economy is flexible enough to adjust to the government’s capital market borrowing capacity without default under all circumstances.
For the GIIPS [Note that this is the polite reference to PIIGS.—Ed.] countries to restore their capital market borrowing capacity in the new environment of tight credit comprehensive measures to reduce public debt levels and improve growth prospects are essential. Greece has tried to achieve this since early 2010 but may yet fail. Portugal’s response has been more convincing but success is still highly uncertain. By contrast, adjustment seems to progress in Ireland. Yet, the battle to save EMU is likely to be won or lost in Spain and Italy. In the former, where public debt levels are relatively low and only a part of the banking sector is in trouble, a new government seems to have a decent chance within the coming four years to make the country fit for a hard currency union by de-regulating the labour market, recapitalising the weak savings banks, and bringing government budget deficits down. In the latter, the new government’s job is harder as public debt is higher, past economic performance poorer, and the available time for the government much shorter (i.e., only a bit more than a year until the next elections in May 2013). Without a significant reduction in capital market rates, the government is unlikely to overcome recession while at the same time cutting government spending, reforming the social security, tax and education systems, de-regulating the labour market, and increasing competition in goods and services markets.
In the event, a “hard currency” union in which participating countries meet the real economy (Mundell) criteria would represent a stable future state of EMU without cheap credit. The problem is how to get there. Achieving the necessary flexibility in most of EMU may well take more than 5 years and not all countries may succeed. Hence, a concerted effort of economic policy at the national and EU level would seem necessary to promote adjustment and avoid transition to another state. To obtain assistance for adjustment, a government in need will have to give up part of its budget sovereignty. Sovereignty is regularly ceded under IMF programmes, but the cessation is temporary and reversible. A country can always decide to break the programme, although this may lead to default and, in a fixed exchange rate system, currency depreciation. At present, however, EMU is ill- equipped to manage adjustment and deal with adjustment failure. EU Treaties will have to be changed to build institutions enforcing a hard budget constraint, managing and funding adjustment when this constraint has been violated, and dealing with default and EMU exit when adjustment fails. Two years ago we suggested the creation of a European Monetary Fund capable of carrying out these tasks.4 The European authorities decided to create a European Stability Mechanism (ESM). It remains to be see whether the latter can perform the tasks of a European Monetary Fund.
2.Meeting the Kenen criteria: EMU based on inter-country fiscal transfers (“transfer union”)
To some extent, deficiencies in the real economy criteria for an optimal currency area can be made up through fiscal transfers (outright or via joint debt issuance). However, to make permanent and sizeable fiscal transfers from stronger to weaker member countries politically sustainable monetary union would need to be complemented by much closer political union. Substantial parts of national sovereignty would have to be permanently surrendered to a central EU government, which would decide on the mix between economic flexibility and fiscal transfers in a democratically legitimate process. Such a political union would be inconsistent with a union of sovereign nation states and require a federal structure for European states. However, in view of existing language and cultural barriers among European nations, a political federation of European states seems hardly possible in the foreseeable future. Hence, policy makers most likely will shy away from creating what is commonly called a “transfer union”. In any event, it would in our view not represent a stable future state of EMU if it were tried.
3. Cheap central bank credit: The “inflation union”
In principle the effects of the disappearance of cheap capital market credit can be offset by a generous provision of cheap credit from the central bank. However, although this would avert default of illiquid and insolvent countries and hence an immediate collapse of EMU, it would most likely only create a transitory state. The use of central bank credit as a substitute for real economic and fiscal adjustment would eventually lead to rising inflation and trigger the exit of EMU member countries with lower inflation preferences. Indeed, monetization of government debt has induced the break-up of monetary unions among sovereign states before, notably that of the Latin Monetary Union (among a number of mostly southern European countries) before WWI.
4. Redrawing the EU’s geography: Core EMU within a diverse EU
Last but not least, the Mundell-Kenen criteria for a common currency could be achieved by reducing the number of EMU member countries to those closest to meeting the criteria. This would leave us probably with a small EMU around the French-German couple (which for historical reasons would be determined to keep the euro). Most likely, such a union would also include the Netherlands, Luxembourg, Austria, Finland, and Belgium, the latter possibly in its two separate parts. Any shortfall in meeting the real economy criteria for the currency union would be covered by the fast-track creation of closer political union. We would regard such a small EMU more likely than a complete break-up into national currencies because of France’s insistence on the continuation of at least a core-EMU, a demand Germany cannot refuse for historical reasons. Of course, France has never liked the idea of a core-EMU in view of its strong commercial and financial relations with Southern Europe and concerns about German economic dominance. It would therefore insist that the economies of the participants in the core-EMU be managed via a tight regulatory system, a pro-active industrial policy, and perhaps a nationalized banking sector. Industrial policy and a nationalized banking industry would be used to arrange permanent fiscal transfers from stronger to weaker EMU members. The countries outside of EMU would form a large group with economies and currencies of vastly different strength and quality, held together by the common market of goods, services, capital and labour.
Replacement of private credit by central bank credit through Target 2
If cheap private credit was necessary to sustain EMU during the first decade of its existence and cheap private credit has disappeared, why has EMU then not already collapsed into one of the above described states? The answer is that with the decision of the ECB to provide unlimited funds to banks at a fixed rate against a wide range of collateral in its weekly refinancing operations cheap private credit has been replaced by cheap central bank credit to sustain the system. Commercial banks no longer able to fund themselves in the private markets, mostly in southern European countries, turn to the ECB as their primary or only source of funding. Thus, the banking sector of a country unable to fund net payments abroad arising from the country’s current account and / or private capital account deficit—in other words a country with a balance of payments deficit—turns to the ECB as the lender of last resort.
The reserve money provided by the ECB to the banks of this country then flows through the euro area’s inter-bank payment system “Target 2” to the banks in countries with current and / or capital account, i.e., balance-of-payments, surpluses.5 Since the beginning of the financial crisis the ECB has replaced more than EUR670bn in private credit from a few balance of payments surplus countries to the deficit countries (Chart 3). As the reserve money accumulates in the balance-of-payments surplus countries and banks at present are reluctant to increase private sector credit, the banks in these countries have turned into net lenders to the Eurosystem (Chart 4). If continued, the replacement of cheap private credit by central bank credit will create an excess supply of reserve money that will eventually lead to inflation.
Hard or core EMU?
The GIIPS group has embarked upon efforts to come closer to the Mundell critera for currency union. Although the prospects for achieving this goal are very doubtful in the case of Greece and still uncertain in the case of Portugal they look good for Ireland and perhaps fair for Italy and Spain. Since public support schemes at the EU and international level (provided by the EFSF and the IMF) are probably insufficient for the funding needs of the latter two countries, help by the ECB in accessing the private capital market—in other words a “start-up funding” of the adjustment efforts—will probably be needed. Of course, involvement of the ECB raises the risk of moving to an “inflation” union and will happen only as a measure of last resort.
What could pave the way for ECB intervention? First, the countries in financial difficulties, notably Italy and Spain, would have to implement credible economic and fiscal adjustment programmes. Second, there would have to be agreement on a new fiscal governance structure for EMU which ensures that economic and fiscal adjustment presently under way continues until all countries are fit for a hard EMU and remain so in the future. To this end, the European Council is likely to agree on changes or additions to the EU Treaties at its December 9 meeting. When both conditions are fulfilled, more forceful ECB intervention (e.g. by imposing a cap on bond yields at, say, 5%) would seem plausible in the face of a further increase of market tensions. Intervention could be rationalized by the need to create monetary conditions in Italy and Spain allowing the adjustment programmes to succeed. Although the German members in the ECB’s Governing Council rejected ECB intervention in government bond markets in the past and may well do so in the future, there will most likely be a large majority in the Council in favour of such intervention when the time is ripe. A drop in capital market rates in Italy and Spain would give the new governments there at least a fighting chance for successful economic adjustment and fiscal consolidation.
Whether the efforts will eventually be successful or fail will probably be decided in early 2013, when Italy prepares for the next regular elections. First positive results of the Monti government would set the stage for the election of a new government with the mandate to continue the adjustment effort. Against this, dire economic conditions at that time could lead to the election of a government hostile to reform. In the first case, chances for the creation of a “hard EMU” would rise significantly, in the latter the risk of continuous monetization of southern European government deficits and debt by the ECB would rise sharply. The ECB could then stop intervening and trigger a move towards a core- EMU as described above. On the other hand, ongoing monetary funding of government deficits and debt would raise inflation expectations and trigger efforts in inflation- averse countries to leave EMU and create a new, more stable common currency. Most likely, these efforts would be led by Germany. However, as in our above described fourth scenario, we would expect France to stick to Germany in case the latter left EMU, followed by the Benelux countries, Austria and Finland. In this case the final state would again be a new core-EMU, surrounded by the old (Latin) EMU and the remaining EU countries with their national currencies.
With the disappearance of cheap credit EMU 1.0 lacked an essential element compensating for its deficiencies as an optimal currency area. In principle, cheap credit from the markets could be replaced by government transfers from stronger to weaker EMU countries or ample central bank credit. However, we would consider a “transfer union” or an “inflation union” not as stable states of EMU. This leaves in our view only two options for EMU 2.0: A hardening of EMU or a redrawing of the boundaries of EMU such that only countries meeting the real economy criteria for a currency union are members. We expect EU governments and institutions to do everything possible to retain an EMU with a large group of countries. This requires credible and irreversible adjustment in the countries in financial difficulties and an improved economic governance structure in EMU. Most likely, it also requires start-up funding from the EU level, including from the ECB as other facilities (e.g. IMF and EFSF) lack the necessary financial fire-power.
Thomas Mayer is Chief Economist for Deutsche Bank Group and is Head of DB Research.
1. Robert A. Mundell, A Theory of Optimum Currency Areas, American Economic Review No. 51 (1961), pp. 657-665.
2. Peter B. Kenen, The Theroy of Optimum Currency Areas: An Eclectic View, in Mundell and Swoboda (eds.), Monetary Policy Problems of the International Economy, Chicago 1969, pp.41-60.
3. There is an interesting parallel to the role of cheap credit for fulfilling the economic aspirations of low income private households in the US. As Raghuram Rajan has argued, cheap credit made up for the limited earnings capacity of these households due to insufficient education (see. R. Rajan, Fault Lines, Princeton 2010). Similarly, cheap credit allowed low income economies in EMU to narrow the consumption gap to more dynamic or richer economies.
4. See T. Mayer, “The Case for a European Monetary Fund”, Intereconomics, May/June 2009, pp. 138-141, and Daniel Gros and Thomas Mayer, “How to deal with sovereign default in Europe: Towards a Euro(pean) Monetary Fund”, CEPS Policy Brief No. 202 / February 2010.
5. For a more detailed discussion see “Euroland’s hidden balance of payments crisis”, GEP from 25 October 2011.