Despite the fact that the Eurozone Crisis seems to have abated recently, the question of the future of the euro remains on the agenda. How can we make sure that the Eurozone will survive? This is the question we wish to address here.
In order to answer this question it is important to start from the design failures that have been identified by economists (see in particular Baldwin and Giavazzi 2015). We stress two of these here. This will allow us to discuss possible solutions to the two problems.
The Eurozone is not an optimal currency area
- The European monetary union lacks a mechanism that can deal with divergent economic developments (asymmetric shocks) between countries.
These divergent developments often lead to large imbalances, which crystallise in the fact that some countries built up external deficits and other external surpluses.
When these imbalances have to be redressed, it appears that the mechanisms to redress the imbalances in the Eurozone (‘internal devaluations’) are very costly in terms of growth and employment, leading to social and political upheavals. Countries that have their own currency and that are faced with such imbalances can devalue or revalue their currencies. In a monetary union, countries facing external deficits are forced into intense expenditure reducing policies that inevitably lead to rising unemployment. This problem has been recognised by the economists that pioneered the theory of optimal currency areas (Mundell 1961, McKinnon 1963, Kenen 1969).
Fragility of the sovereign in the Eurozone
As stressed by De Grauwe (2011) this fragility arises from the fact that member countries of the monetary union issue debt in a currency they have no control over. As a result, the governments of these countries can no longer guarantee that the cash will always be available to roll over the government debt. This lack of guarantee provided by Eurozone governments in turn can trigger self-fulfilling liquidity crises (a sudden stop) that can degenerate into solvency problems. When this occurs it leads to a massive outflow of liquidity from the problem countries, making it impossible for the governments of these countries to fund the rollover of their debt at reasonable interest rate.
This dynamics can force countries into a bad equilibrium characterised by increasing interest rates that trigger excessive austerity measures, which in turn lead to a deflationary spiral that aggravates the fiscal crisis.
How to deal with the optimal currency area problem?
The standard response derived from the theory of optimal currency areas is that member countries of a monetary union should do structural reforms so as to make their labour and product markets more flexible. By increasing flexibility through structural reforms the costs of adjustments to asymmetric shocks can be reduced and the Eurozone can become an optimal currency area. This has been a very influential idea and has led Eurozone countries into programmes of structural reforms.
It is often forgotten that although the theoretical arguments in favour of flexibility are strong, the fine print of flexibility is often harsh. It implies wage cuts, less unemployment benefits, lower minimum wages, easier firing. Many people hit by structural reforms resist and turn to parties that promise another way to deal with the problem, including an exit from the Eurozone. From an economic point of view flexibility is the solution. From a social and political point of view flexibility can become a problem. Stressing flexibility as the way out of the conundrum risks creating enemies of the monetary union that as time moves on, will lead to an increasing political momentum favouring an exit from the union.
There is a second reason why the structural reform path should be taken with caution. This is that the nature of the asymmetric shocks has been quite different from the traditional asymmetric shocks analysed in the optimal currency area-literature. In fact business cycles in the Eurozone have been relatively well synchronised. This is shown in Figure 1.
We observe that most Eurozone countries were booming in the period 2000-07 and experienced a downturn since then. If there was asymmetry it was in the amplitudes of the same cycle. Some countries (Ireland, Spain, and Greece) experienced a very strong boom and later a deep and protracted recession. Other countries (Belgium, Germany, France, Italy, and the Netherlands) experienced a much more modest period of booming conditions followed by less intense recessions. Germany stands out as having experienced booms and busts with the lowest amplitude.
Table 1 shows the bilateral correlations of the business cycle components of GDP growth in the Eurozone. It leads to the same observation that the business cycles in the Eurozone were highly synchronised. Again Germany stands out as having the lowest correlation coefficients, although these are still quite high, exceeding 0.5 in most cases (see De Grauwe and Ji 2015b for more detail).
Figure 1. Business cycle component of GDP growth
Note: the business component is obtained by applying a HP-filter to the growth numbers.
Table 1. Correlation coefficients of cyclical components of GDP growth (1995-2014)
Source: Eurostat and authors’ own calculation using Hodrick–Prescott filter approach.
If there is asymmetry in the business cycle movements in the Eurozone it is in the amplitude of these cycles. This asymmetry led to a situation in which countries in the group experiencing the highest amplitudes were hit very hard when the recession came, leading to an explosion of government debt. That’s when the second problem of the Eurozone stepped in. Markets singled out these countries, leading to massive capital outflows from the first group of countries to the second one. The whole of the Eurozone was destabilised. This problem risks popping up each time the Eurozone is pushed into a recession. Each time some countries will be hit more than others. As a result, large internal capital flows risk further destabilising the system.
- The implications for the governance of the Eurozone from the finding of the overwhelming importance of the cyclical and temporary component of output growth is that efforts at stabilising the business cycle should be strengthened relative to the efforts that have been made to impose structural reforms.
We are not implying that structural reforms are unnecessary, but rather that efforts at creating mechanisms aiming at stabilising the Eurozone business cycles should be strengthened.
Inter-country versus inter-temporal smoothing
There have been many proposals made to create a fiscal space at the Eurozone level in the form of a common unemployment insurance system (see e.g. the Four Presidents report 2012, Enderlein et al. 2012, Beblavy et al. 2015, Alcidi and Thirion 2015).1 The proposals for such an insurance system have very much been influenced by the standard assumption made in the optimum currency area theory that shocks are asymmetric, i.e. than when one country experiences a recession, and thus increasing unemployment, the other country experiences a boom, and declining unemployment. This facilitates the workings of the common unemployment insurance system. The booming country transfers resources to the country in a recession and thereby smoothens the business cycles in the two countries. Technically and politically such a system encounters relatively few problems.
Problems arise when business cycles are relatively well synchronised but of very different amplitudes in the different member countries. In that case most countries will tend to experience a recession at about the same time, but in some countries the recession will be mild, and in others very intense. This creates both an economic and a political problem. First, countries with a mild recession are asked to transfer resources to countries experiencing a stronger recession. This tends to reduce the intensity of the recession in the latter country at the expense of making it more intense in the former country. It is not clear that this is welfare improving. Second, it is likely to create important political problems in the former country that is asked to transfer resources when the economy is not doing well.
Another way to formulate the previous insights is the following. The traditional proposals for a Eurozone unemployment insurance mechanism are predicated on the view that there is a need to smooth differences in unemployment changes across countries. The insurance mechanism is intended to smoothen these inter-country differences. We have noted however that this is not the typical asymmetry in the Eurozone. Most countries are likely to experience a boom and a recession at about the same time, with different intensities and amplitudes. There is therefore relatively little need for inter-country smoothing of business cycle movements. The more pressing need is to smoothen volatilities over time.
The previous analysis suggests that common unemployment insurance schemes should put emphasis on smoothing over time and not so much on inter-country smoothing. This can be achieved by allowing the common unemployment insurance scheme to accumulate deficits and surpluses over time. The fiscal rule that could be imposed is that the insurance scheme balances over the business cycle.
In principle, inter-temporal smoothing could be done at the national level, by allowing the national budgets to do the job. However, the large differences in the amplitude in the business cycle movements makes such a purely national approach problematic, as it leads to large differences in the budget deficits and debt accumulation between countries. These differences quickly spillover into financial markets when countries that are hit very hard by a downward movement in output are subjected by sudden stops and liquidity crises. This is likely to force them to switch off the automatic stabilisers in their national budgets (De Grauwe and Ji 2015). In addition, these liquidity outflows are inflows in some other countries in the monetary union, typically those that are hit least by the recession.2 Their economic conditions improve at the expense of the others. Stabilisation of common business shocks with different amplitudes at the national level makes the system unstable.
National stabilisation efforts do not work and introduce an element of instability in a monetary union, mainly because it leaves the countries most hit by the business cycle shocks unable to stabilise. Thus when business cycle shocks dominate it will be necessary to follow a common approach to the stabilisation of the business cycles. This can be provided by a budgetary union. By centralising part of the national budgets into a common budget managed by a common political authority, the different increases in budget deficits following from a (common) recession translate into a budget deficit at the union level. As a result, the destabilising flows of liquidity between countries disappear, and the common budgetary authority can allow the automatic stabilisers in the budget to do their role in smoothing the business cycle. In fact, because a common budget also generates implicit inter-country transfers the countries with the deepest recession will profit from the automatic stabilising features of the common budget most. As a result, a common budget provided the most effective way to stabilise the business cycle.
It is clear, however, that a budgetary union in which a significant part of national taxation and spending is transferred to a European government and parliament is far off. It cannot, therefore, be invoked today to solve the lack of stabilisation at the European level.
In addition, most common insurance mechanisms now being proposed (see Beblavy et al. 2014) have a relatively small inter-temporal smoothing component, amounting to no more than 0.1% to 0.2% of GDP over the business cycle, certainly insufficient to produce a significant inter-temporal smoothing at the EU-level. Fortunately, there are possibilities to enhance stabilisation at the Eurozone level that do not require a full budgetary union.
A proposal: A stabilisation fund
Here is a scheme that can provide some stabilisation at the Eurozone level. A stabilisation fund would be set up. This could in fact be the existing European Stability Mechanism (ESM). During recessions, the ESM would buy national government bonds and issue an equivalent amount of ESM-bonds (Eurobonds) backed by the participating member-countries. During booms the EMS would do the opposite, i.e. buy back the ESM-bonds and sell the national bonds into the bond markets. In doing so, there would be no net accumulation of ESM-bonds over the business cycle.
How does this scheme contribute to stabilisation at the Eurozone level? During recessions national budget deficits increase automatically. Put differently, national governments have to issue new government bonds. We have argued that this process is likely to lead to destabilising capital flows, as some countries’ recessions are deeper than others. This leads to more bond issues in the countries hit by the deepest recessions than in the countries experiencing mild recessions. The bond buying operations by the ESM would then tend to support the government bond markets in the Eurozone in general, but at the same time the support would be strongest in the government bond markets of the countries experiencing the deepest recessions. As a result, the EMS-buying operations would tend to unify the government bond markets and would reduce the scope for destabilising capital flows within the Eurozone. This would be a significant achievement.3
There are many technical issues to be solved here. In particular, in order to avoid a net accumulation of EMS-bonds over the business cycle, the EMS would only be allowed to buy bonds corresponding to the cyclical component of the government budget. This makes the computation of reliable structural government balances imperative.
How to deal with the fragility problem?
Let us now turn to the question of how to deal with the second problem of the Eurozone, its fragility.
The ECB has a central role to play here. By promising to provide unlimited support in the government bond markets in times of crisis, it can stop liquidity crises that are likely to emerge each time the Eurozone experiences a recession; liquidity crises that destabilise the system leading to large capital outflows from some country to other countries in the same monetary union.
The ECB recognised this problem when it started its OMT-programme in 2012. This certainly helped to pacify financial markets at that time and avoided the collapse of the Eurozone.
The issue arises of how credible the OMT-programme is for future use. The credibility problem arises from the fact that when using the OMT programme the ECB will have to decide whether the crisis it is facing is due to a liquidity or a solvency problem. If it determines it is a liquidity problem it should step in; if it decides it is a solvency problem it should not. In the latter case the other governments should decide whether or not to support the troubled government.
This creates huge political problems that the ECB cannot take on. It is generally very different to determine whether the problem is due to lack of liquidity or to insolvency. The difficulty to be sure makes it difficult for the ECB to step in without creating political controversy. In the latest Greek crisis the ECB decided that the Greek problem was one of insolvency of the Greek government and therefore it refused to support the Greek government bond market, precipitating the crisis and leading to intense political conflicts in the Eurozone.
All this will lead to doubts about the willingness of the ECB to provide liquidity to future governments in times of crisis. As a result, the credibility of OMT is limited, which means that it is not an insurance mechanism that will stabilise the markets in future crises.
This problem does not exist in standalone countries. The commitment of the central bank to support the sovereign of a standalone country in times of crises is unconditional. As a result, its credibility is 100%. This may come at a price though, because it also implies that the credibility of the central banks’ commitment to price stability is less than 100%. Paradoxically, one may argue that the commitment of the ECB towards price stability is stronger than in standalone countries precisely because the commitment of the ECB towards the support of the 19 different national governments is weak.
The only way to solve the lack of credibility of the ECB as lender of last resort in the government bond market is by creating a budgetary union that includes the consolidation of a significant part of the national debts. Such a consolidation mimics the relation between the central bank and the government that exists in standalone countries. It makes the credibility of liquidity support of the sovereign watertight and eliminates the danger of destabilising capital flows within the union. Clearly such a consolidation can only occur if it is embedded in a political union, characterised by a central government that has the power to tax and to spend.
We have identified the conditions under which the Eurozone’s fragility can be eliminated making it possible for the monetary union to survive. But these conditions are politically very intrusive, requiring a very large transfer of sovereignty from nation states to a central Eurozone authority. The conclusion can only be that this is politically impossible today.
History teaches us that what one considers politically impossible at one moment of time can quickly change and become possible when conditions become extreme. Nevertheless, today a political union such as the one we have spelled out appears for most of us to be out of reach.
There are two possible reactions to this situation. One is to despair and to conclude that it would be better to dissolve the monetary union. It will never work anyway. The other reaction is to say, yes it will be very difficult, and the chances of success are slim, but let’s try anyway. That is the position we are taking.
If one takes this attitude one quickly comes to the conclusion that success can only occur by following a strategy of small steps. A revolutionary approach will simply not work.
What are these small steps?
We see essentially two.
- One is to create some fiscal space at the level of the Eurozone.
An example is a common unemployment insurance scheme that would insure the cyclical component of unemployment (so as to minimise moral hazard problems). This insurance scheme should have a large component of insurance over time. We have made a proposal for a business cycle stabilisation effort that could complement such an insurance scheme.
- Another small step is to start with a limited programme of debt consolidation.
That must take care of moral hazard issues that naturally arise with such schemes. The best way to achieve this is by introducing an element of co-insurance. This can be done by limiting the common issue of government bonds to a given percent of GDP, e.g. 60%. What exceeds this limit must be issued by the individual government (see Delpla and von Weizsäcker 2010).
These are small steps. Even these small steps, however, encounter severe hostility and will be difficult to take. Yet these steps will have to be taken if we want to avoid the future disintegration of the Eurozone.
Our task as economists is to make this choice clear to the rest of the population; we should tell them that if they want to keep the euro, steps towards more political union are inevitable. If they do not want to take these steps, they will have to say goodbye to the euro.
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Baldwin, R, and F Giavazzi (2015), “The Eurozone crisis: A consensus view of the causes and a few possible solutions”, VoxEU.org, 7 September.
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De Grauwe, P (2011), “The Governance of a Fragile Eurozone”, CEPS Working Documents, Economic Policy, May.
De Grauwe, P and Y Ji (2015), “Has the Eurozone Become Less Fragile? Some Empirical Tests”, Journal of Policy Modeling, 2015, vol. 37, issue 3, pages 404-414.
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Hoffmann, M and T Nitschka (2012), “Securitization of mortgage debt, domestic lending, and international risk sharing”, Canadian Journal of Economics, 45(2), 493-508.
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1 There is an older literature making similar proposals. See e.g. Italianer and Vanheukelen(1992), Hammond and von Hagen(1993) and Mélitz and Vori(1993).
2 This is confirmed by the empirical work of Furceriand and Zdzienicka (2013) and Hoffmann and Nitschka (2012) who find that during recessions risk sharing through financial markets declines dramatically.
3 The proposed stabilisation fund resembles the proposal made by Drèze and Durré(2012). The Drèze&Durré proposal, however, is a pure inter-country insurance mechanism imposing that the fund balances its books at each moment in time. Note also that the scheme proposed here is very different from the OMT-programme of the ECB that is intended to be used in times of crisis. In addition, OMT is conditional on programmes of austerity and tends to be procyclical.