The Eurozone’s Founding Mistake

It really was predictable. Take away the ability to control national interest rates, and you create a potential for patterns of demand to diverge, leading to movements in competitiveness that would have to be painfully unwound later on. The good news was that you could use countercyclical fiscal policy to moderate these movements - an entirely conventional macroeconomic idea. But it was not what the architects of the Euro wanted to hear.

This is how my paper just published in Global Policy starts. So instead of countercyclical fiscal policy, we got an obsession with budget deficits and the possibility of fiscally profligate governments. Even with this obsession the Eurozone failed to spot its one member that was behaving in this way until it was too late. But in looking in the wrong direction, the Eurozone allowed just the kind of competitiveness imbalances to take place that fiscal policy might have been able to do something about.

This is not wisdom from hindsight. Before the Euro was established, I was among a large group of economists suggesting that fiscal policy should be used countercyclically by Eurozone members. That work continued after the Euro was established: here and here are just two examples. It had no impact on policy. There was a lot we did not foresee. It is particularly ironic that the first major asymmetric shock to hit the Euro area, that would cause these large competitiveness imbalances, was arguably a consequence of the creation of the Euro itself. But the point remains that a method of handling these things, which was entirely conventional in macroeconomic terms, existed and was ignored.

Now in saying this I find myself in the rather unusual position of disagreeing with Martin Wolf. He has argued (here for example) that a country like Spain could not have done more in terms of fiscal policy to counteract its housing boom. I have heard many others make the same point - you think Spain should have been running even larger surpluses? they ask incredulously. The answer is simply yes: by looking at fiscal surpluses you are looking at the wrong indicator. Here is what happened to consumer price inflation from 2000 to 2007.

	2000	2001	2002	2003	2004	2005	2006	2007
Ireland	5.3	4.0	4.7	4.0	2.3	2.2	2.7	2.9
Spain	3.5	2.8	3.6	3.1	3.1	3.4	3.6	2.8
Portugal	2.8	4.4	3.7	3.3	2.5	2.1	3.0	2.4
Euro area average	2.2	2.4	2.3	2.1	2.2	2.2	2.2	2.1

 

Inflation was significantly above the Euro area average year after year. If the average inflation rate had been 10%, or even 5%, this might not have been a big deal, but when the inflation target was 2% or less, that makes reversing these trends very painful. Looking at budget surpluses during a property led domestic boom can be very misleading, as Karl Whelan argues in the case of Ireland.

There may be many reasons why the Eurozone ignored this advice. One was probably a belief among some that countercyclical fiscal policy was either ineffective or dangerous. (The ordoliberal logic on this has never really been spelt out, and it seems more like an article of faith.) Another was an almost mystical belief that the creation of the Euro would diminish the importance of asymmetric shocks or the extent of asymmetric structures.[1] Yet another was a view that the far greater danger lay in the reduced fiscal discipline that being part of the Euro would bring, and any countercyclical role would only encourage this ill discipline. Yet we now know (and I do not think anyone really foresaw this) that this last argument is completely wrong. Not having your own central bank means that market discipline on Euro members’ fiscal policy will be much greater, once it is understood that national default can occur.

I do not think this point has sunk in yet among many macroeconomists. The standard line, backed by academic papers, was that joining a common currency would reduce market discipline on fiscal policy. Yet that analysis ignored default, and the possibility of a bad equilibria generating a self-fulfilling crisis. Countries will not forget the events of 2010-12 in a hurry, so the danger now is that we have too much, not too little, market discipline influencing fiscal policy. 

Ironically, the architecture of the Stability and Growth Pact sent all the wrong signals. By stressing the dangers that individual countries might free ride on the Eurozone, it suggested that such actions might be in the national interest for any country that could get away with it. That is why attempts to control national budgets at the Eurozone level can be counterproductive as well as unnecessary. It is far better to build national institutions that can make sure countries develop appropriate fiscal policy which is in their national interest. In an ideal world the Commission might play a coordinating role, but given its current mindset it would be best if it just stayed out of the picture.

So while the details of the Euro crisis were not foreseen, the palliative medicine that would have made that crisis much more manageable was available, but those in charge decided not to take it. What turns this serious policy error into a tragedy is that policy makers continue to make the same mistake. The Fiscal Compact is exactly the opposite of what the Eurozone requires right now. (I have cited the Netherlands as a clear example of this.)

This makes me both optimistic and pessimistic about macroeconomics as a discipline. Optimistic because the subject has so much potential to do good: basic ideas, long understood, yet clearly not obvious to some, can help prevent disaster. (Those who claim that macroeconomics is the weak point of the economics family should take note.) Pessimistic because even when those disasters occur, the macroeconomic wisdom continues to be ignored.  

[1] If anything, formation of a currency union should allows greater national specialisation, which of course has the opposite effect.