There are certain conditions needed to make a common currency across diverse economies a success and the Eurozone is clearly not satisfying them (see Frankel 2015, VoxEU 2015). In 1990 it was closer to satisfying them but since then member states have moved further apart from each other. In 2016 the Eurozone is too large to manage from the centre and there is a lot of diversity in the economies of member states to leave the management to the invisible hand of market forces. Whatever action has been taken or is still being considered to ensure that crises of the kind and magnitude of the 2010-12 one are not repeated, there is bound to be many instances in in the future which will require an alternative corrective action to exchange rate adjustment.
Internal migration is one such alternative corrective mechanism. Countries in crisis with high unemployment, which would normally experience a depreciating exchange rate, could instead export labour to the better-performing countries. This clearly is not an acceptable solution in the Eurozone, politically, culturally or economically. Mass migration causes political friction, as we are currently seen with Britain at the forefront, Europeans don’t like moving in big numbers, as we are seeing with the high unemployment countries, which are losing some but not much of their workforce, and economically the required mobility is simply too large and too slow to take the place of exchange rate movements, even if the other conditions were met.
Capital investments from the rich to the poor in times of crisis are also not a solution, as we have seen in the debt crisis. Far from increasing investments to the programme countries of the south, northern Europeans withdrew their capital in large numbers, making the crisis worse. Capital controls to stop the counter-productive outflow should be unthinkable in a monetary union – although imposed as an emergency on two occasions, in Cyprus and Greece.
The Troika’s favourite solution, strongly supported by Germany and some others, is internal depreciation. But it has been a dismal failure in Greece and elsewhere. Greece is the country that has fulfilled the requirement to implement internal devaluation. Unit labour costs and real average earnings fell by 20%. Prices fell by much less, partly because of imported intermediate and final goods which have fixed prices in euros and partly because of domestic monopolies. The result was the wished-for rise in competitiveness, with exports rising and imports falling. But with such a big fall in real earnings domestic demand fell by even more. Because domestic demand is much bigger than export demand, the fall in domestic demand completely overwhelmed the rise in exports. The internal depreciation led to a Keynesian negative consumption multiplier, which worsened the recession. Investment did not rise because of poor domestic prospects – and malfunctioning banks – and public investment collapsed because as part of the internal depreciation the Troika imposed also cuts in spending and increases in taxes (in the words of Joseph Stiglitz, in reference to France not Greece, the Eurozone went for negative balanced budget multipliers, instead of stimulating the economy with positive balanced budget multipliers).
A second aspect of internal depreciations is related to the channels through which they can be brought about. Whereas exchange rate adjustments are brought about quickly through news, internal depreciations require wage adjustments that are resisted, unless the alternative is worse for the worker and his union. The only mechanism that can bring about a fall in wage costs in decentralised economies is a big rise in unemployment. So even to implement the policy of internal depreciation, which is supposed to bring the country out of recession, the country has to be shocked by a bigger recession first. This again happened in the programme countries in the Eurozone.
Exchange rate adjustments within the Eurozone
The logical conclusion is that internal depreciations are not a substitute for real exchange rate adjustments within the Eurozone and actually make the situation worse. In the absence of a market mechanism that can substitute for exchange rate flexibility, the only credible corrective mechanism remaining is fiscal transfers. Small fiscal transfers through the European Stability Mechanism have been effective, although the emphasis is on recapitalising the banks rather than stimulating the economy. The European Investment Bank and European Bank for Reconstruction and Development are doing a good job focusing on investment, but their contributions are too small and move too slowly to act as an effective substitute for exchange rate flexibility.
If the Eurozone is to withstand future shocks governments have to be in a position to persuade their parliaments (and voters) that in times of crisis they might have to transfer large amounts of money to the badly affected countries. In order to make this argument there is need of more fiscal discipline within the Eurozone and closer fiscal supervision, so that any need for fiscal transfers that arises is not the result of misconduct by any members but it is genuinely the result of bad luck or external shock that affect some members more badly than the others. In order to facilitate this transfer and the closer supervision the Eurozone needs closer fiscal union, with Eurobonds and a supervision mechanism that goes beyond the existing one.
The mechanism in place today for fiscal supervision is clearly much better than it was in 2000, thanks to the Fiscal Compact and the much closer watch by bodies such as the Eurogroup. It is doubtful whether a country could get away with the policies that caused the fiscal imbalances since 2000 without a lot of pressure from its partners to come back in line. But I would support an even stricter formal mechanism, such as a Fiscal Policy Council, without executive powers, modelled on the successful Fiscal Policy Councils in existence, such as the one in Sweden.
Alleviating the need for fiscal transfers
Institutions and policies in place today, six years after the debt crisis, have mitigated the risks of another Great Recession, at the cost of slower rate of economic growth throughout the Eurozone, but they have not done enough to alleviate the need for fiscal transfers in future when new crises arise. In order to Reboot the Eurozone there is need for an ever-closer fiscal cooperation, with potentially large transfers permitted and with closer supervision needed in normal times to avoid risks, but preferably without the strict counter-productive conditions of the European Stability Mechanism as in current practice.
Frankel, J (2015), “International macroeconomic policy coordination”, VoxEU, 9 December, available at http://www.voxeu.org/article/international-macroeconomic-policy-coordination.
VoxEU (2015), various authors, “Rebooting the Eurozone: Step 1 – Agreeing a Crisis narrative”, 20 November 2015, available at http://www.voxeu.org/article/ez-crisis-consensus-narrative.