Winner of the New Statesman SPERI Prize in Political Economy 2016

Thursday 19 April 2012

The EuroZone as One Country

Or does the fact that it is not matter for its overall macro policy

               The Eurozone is undertaking more austerity than either the US or the UK (see here), yet its overall budgetary position is much more favourable than either of these two countries. Can this be right, at a time when the Eurozone is in recession? If we thought about the Eurozone as a single country, then clearly it is not. Everything that is wrong with current UK policy would be even more wrong in the Eurozone. The question I ask here is whether the fact that it is not one country changes this assessment.
               The Eurozone is like one country in having a single central bank. The ECB’s nominal interest rate is stuck at their equivalent of the zero lower bound. One possibility would be for the ECB to effectively raise the inflation target, and hope that this in turn raised inflation expectations and thereby stimulated demand: NGDP targets and all that. However it almost certainly will not do this. Furthermore, its inflation target is 2% or less, and it appears to be thinking about significantly less than 2% at the moment (see the quote from Draghi reported here). So given this constraint on conventional monetary policy, what should fiscal policy do?
               For the Eurozone as a whole the situation is no different from the US, or the UK. A recession in which interest rates are at the zero lower bound is not the time to undertake austerity. The Euro area as a whole should be reducing its underlying budget deficit much more slowly. It needs a large fiscal stimulus relative to current plans. But can we translate this aggregate conclusion into action to be undertaken at the individual country level?
               I do not think a social planner in charge of the Eurozone that treated all its citizens equally would have a problem. They would reason as follows. In aggregate we need a large stimulus relative to existing plans. In addition, we need a significant inflation differential between Germany and non-Germany to open up. Suppose 2% is the optimal inflation rate, and we need a 2% gap between Germany and non-Germany (which is probably a lower bound on the inflation gap required). We could have 2% (Germany) and 0% (non-Germany), or 3% and 1%. The latter will be preferred on simple convexity grounds – it is better to spread the pain equally. In addition, the difficulty of reducing inflation when it is already near zero is well known, so it would be less costly to raise inflation in Germany. A large part of the stimulus would therefore go to Germany, raising inflation above the optimal level from the German national point of view. Kantoos disagrees, but note that this would also be the effect of the ECB successfully raising the aggregate inflation target.
               However this is academic, as we do not have a Eurozone central planner. In principle non-Germany could compensate Germany to achieve the optimal aggregate outcome, but it is unclear what non-Germany has to offer. So let us take it as a constraint that Germany will not adopt a large stimulus. It may also do its best to counteract the impact of any expansionary ECB policy on its own economy (see Kantoos again). This means that we cannot have as large a stimulus for the Eurozone as a whole as we could if it was one country. We have to go for 2% and 0% rather than 3% and 1%, which means lower Eurozone output. But does it mean the current level of austerity is correct?
               At present austerity in non-Germany is being driven by each country’s bond market. If the Eurozone really was one country, which issued Eurozone debt, this would not be happening. Just as savers are happy to buy UK or US debt, they would happily buy Euro debt. (No one buying UK debt is too worried about the widening North-South divide in the UK!) The Euro is highly unlikely to default on its debt because the ECB can print Euros.
               Germany has ruled out Eurobonds, so are we back to our previous problem? No, because the ECB can act as if they existed, by (indirectly) buying national governments debt when the market will not. As Jonathan Portes notes, this is why the crisis appeared to go away over the last few months. Buyers of non-German debt are worried about default, and the ECB can rule out default by being the buyer of last resort (through proxies if necessary: for the wisdom or otherwise of this indirect approach, see here and here). The reasons why it chooses to do this in what appears to be an erratic and unpredictable way were discussed by Fred Bergsten and Jacob Kirkegaard at VoxEU, and I commented on this here. While this might have been appropriate for some countries a year or two ago, the strategy is now doing significant harm. My own view (and more important others) is that the ECB is too concerned about moral hazard, and not concerned enough about the impact of austerity on non-German output, with the result that we are seeing much more austerity than is necessary. The ECB could still exercise fiscal discipline by varying the rate at which it capped the interest rate on non-German debt. This could be done on a country by country basis, and perhaps should be (see here and here).
               Instead the ECB appears to be using market sentiment as an index of national fiscal discipline. This puts national governments in an impossible position (see, for example, this from John McHale). They can try and demonstrate that they will not default by piling on the austerity, but in the process they may actually be making their longer term fiscal positions worse.
               Using market sentiment as an indicator of fiscal sobriety is particularly inappropriate at the moment, as market concerns may be much more focused on the health of national banking systems and the knock on effects if governments are required to rescue national banks. (See this discussion of ‘sudden stops’ at Bruegel, and beware of commentators who know what the market is thinking.)  To the extent that this is true, austerity will make things worse. As the economy contracts, more loans go bad, and banks balance sheets worsen. Perhaps ($) the ECB is beginning to realise this. But without clear signals and statements from the ECB that no further fiscal tightening is required, there is a real danger that national governments may continue to tighten too quickly.
               Viewing the Eurozone as a single country clearly indicates a substantial easing of both fiscal and monetary policy. German national self interest, combined with the need for non-German competitiveness to improve, does moderate the amount of fiscal easing that can occur, but there is no reason why the ECB should reduce aggregate inflation on this account. However the amount of aggregate fiscal austerity that this implies is still considerably less than is currently being enacted. Here the ECB has the ability to remove the constraint imposed by national government bond markets, and it should do so before the degree of austerity currently being enacted does lasting damage to the sustainability of the Eurozone.


  1. Excellent article - Thank you!

  2. All this is fine more or less
    Though the target inflation rate versus a switch to a NGZP for the euro area might suggest itself as widening the short term national inflation gap between spiigs and the Teutonic iron maiden

    But what u leave out is the forex rate the euro needs a significant adjustment against it's major eastern trading partners
    on the Eurasian land mass

    Why this very clear picture requires such herby jerky commentary from trained macronomists
    Strikes me as more then remarkable
    One can't imagine Roy Harrod stumbling over what has to be done at this conjuncture

    The multi cap algorithm is a nice notion
    It could be formalized quite easily using various ratios and weights that generated predictable caps
    For all zone member states


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