On Monday Paul De Grauwe and others wrote a letter to the Financial Times in which they warned that the Eurozone was ‘on the road to macroeconomic disaster’. They wrote: “Today’s leaders, however, behave like cult followers who refuse to avail themselves of the treatment that will save their lives”. Yesterday Fred Bergsten and Jacob Kirkegaard at VoxEU sound a much more optimistic note about the ability of European leaders to see their way through the Eurozone crisis. They say “We therefore believe the Eurozone crisis – despite the superficial appearance of the opposite – is well on the way towards stabilisation and resolution.”
(A digression. It has just been announced that Fred Bergsten will retire from running the Peterson Institute this year. He established that Institute as a major voice in international macro. This is just a small personal anecdote. In 1998 I did some work with Rebecca Driver for the Institute on equilibrium exchange rates. At the time the Yen was around
160 140 per dollar, and our analysis suggested an equilibrium rate around 100. There was a small presentation of our work to some influential journalists at the Institute. One found the implications for the Yen incredible, and after grilling me, he turned to Fred and said ‘do you support this’? Many in his position would have been equivocal: something like ‘it’s an interesting view, but of course blah di dah’. After all, I was a relatively new academic hardly known in the US. Instead Fred replied ‘yes, I support it’.)
So two very different views, but one reason for this divergence may be that they are mainly looking at different crises. Although Bergsten and Kirkegaard note the competitiveness problem I discussed here, they focus on government debt. They note that, although the ECB has the capability of ending the crisis, to do so would create too much moral hazard. To quote: “Were the ECB to cap governments’ financing costs at no more than 5%, for instance, Eurozone politicians would probably never take the essential but painful decisions.” In other words, it is in the ECB’s perceived long term interests to allow a crisis to persist, because this will spur on institutional reforms that will avoid a similar debt crisis occurring in the future.
To some the idea of progress via crisis might seem far too chaotic. Why, for example, cannot the ECB systematically buy or sell government bonds in the market to achieve announced target interest rates for particular countries, and reduce interest rates for those countries that make progress in tackling debt problems, but raise rates for those that do not? In one sense this is what the market is doing, but while the market might have the general level of interest rates too high because of problems of multiple equilibria, the ECB could provide incentives in a more moderate and controlled way. Perhaps, but I doubt whether the ECB would want to play such an openly political role.
Under this view, the ECB’s policy is working just fine. European politicians are being forced to make changes (and in some cases are being forced from office when they do not), and institutional progress is under way. Because such changes are difficult politically they are bound to be slow and erratic, which is why the apparent crisis will continue for some time to come. But, so the argument goes, if at any stage the crisis appeared to be becoming critical, the ECB would step in to avoid this happening.
Paul De Grauwe and his colleagues are worried about a different crisis, a crisis of external imbalances. I think I’m right that as far as my discussion here is concerned, this is equivalent to a crisis of competitiveness. Eurozone countries running current account deficits have been losing competitiveness, and vice versa. To cure this crisis requires deficit countries to restrain demand, and surplus countries to expand demand. Now the first part of this cure is of course identical to the cure for excessive government debt – it requires fiscal austerity. The key difference is the second part, which involves expansion in surplus countries.
It is the absence of expansion in surplus Eurozone countries (which means Germany in particular) that leads De Grauwe et al to be so pessimistic. They see a “decade of economic stagnation entailed by current policies “. If European policy makers do not change course, they “will bear the responsibility for the implosion of the eurozone and, in the end, the failure of the whole European project”. Many others share this concern about a Eurozone recession: see Martin Feldstein for just one example.
We can put it this way. If the problem is simply one of government debt, and we have good reason to believe there is too much debt in most Eurozone countries (including Germany), then general austerity is the order of the day. Whereas the markets believe Germany will undertake austerity of their own free will, in other countries neither the markets nor the ECB believe this, so we need a continuing but controlled crisis to force these countries to act. However, if the problem is external imbalances and competitiveness, we have a danger of ‘competitive austerity’. We need more austerity outside Germany than within Germany to correct imbalances between the two. The more Germany adopts a contractionary fiscal policy the further countries outside Germany are forced to go. The end result is not only general stagnation within the Eurozone, but recession so acute in some countries that political turmoil may follow, possibly leading to the breakup of the Eurozone.
In other circumstances, competitive austerity might not be a problem, because the ECB could counteract any general stagnation by reducing interest rates. There are two reasons why this is not a way out today. First, by raising interest rates last year, the ECB appears to be too preoccupied by short term inflation, so they may not act when they should. Second, and more fundamentally, they are close to a zero lower bound, and so have lost the ability to prevent a second recession through monetary policy. So unlike the case where the problem is risk premia on government debt, the ECB cannot be sure to act effectively in a Eurozone recession.
This suggests that the key problem for the Eurozone is similar to that faced by the US, the UK and others. Too much austerity in the short term is holding back or even killing the recovery from the last recession, because monetary policy has lost its power in a liquidity trap. In these other countries this excessive austerity will ‘only’ result in significantly higher unemployment for many years to come. In the Eurozone the consequences could be more dramatic.