Eurozone delusions

I have already had a number of interesting comments on my previous post which illustrate how confused the Eurozone macroeconomic debate has become. The confusion arises because talk of fiscal policy reminds people of Greece, the bailout and all that. That is not what we are talking about here. We are talking about what happens when the Eurozone’s monetary policy stops working.

If Eurozone monetary policy was working, the Eurozone would be experiencing additional (monetary) stimulus everywhere, and average inflation would be 2%. Because Germany through 2000 to 2007 had an inflation rate below that in France and Italy, it now has to have an inflation rate above these countries. Something like 3% in Germany and 1% in countries like France and Italy for a number of years. If ECB monetary policy was working, Germany would get no choice in this, because it is part of what they signed up to when joining the Euro.

Monetary policy is not working because of the liquidity trap, so we instead have average Eurozone inflation at about 0.5%, with Germany at 1% and France/Italy at nearer zero. That implies a huge waste of Eurozone resources. That waste can be avoided, in a standard textbook manner, by at least suspending the Stability and Growth Pact (SGP), and preferably by a coordinated fiscal stimulus.

Why is this not happening? There are two explanations: ignorance or greed. Ignorance is a non-scientific belief that fiscal stimulus cannot or should not substitute for monetary policy in a liquidity trap. Greed is that Germany wants to avoid having 3% inflation, because it controls fiscal policy.

Those that say that Germany would be ‘helping out’ France and Italy by agreeing to suspend the SGP and enact a stimulus therefore have it completely wrong. If things were working normally, Germany would be getting a (monetary) stimulus, whether it liked it or not. What Germany is doing is taking advantage of the fact that monetary policy is broken, at the rest of the Eurozone’s expense. Germany gains a small advantage (lower inflation), but the Eurozone as a whole suffers a much larger cost.

Often greed fosters ignorance. It is unfortunate but not surprising that many in Germany think this is all about Greece and transfers and structural reform, because that is what they keep being told. How many of its leaders and opinion makers understand what is going on but want to disguise the fact that Germany is taking advantage of other Eurozone members I cannot say. What is far more inexplicable is that the rest of the Eurozone is allowing Germany to get away with it.

       

Should the Eurozone’s fiscal rules be abolished?

Yes, I know it sounds an outlandish question, but it is unclear to me what the rationale is for fiscal controls imposed at the Eurozone level? A simplistic answer is that they are designed to stop future debt crises. However, if you ask any Eurozone government whether it wants to avoid another debt crisis, they would say emphatically yes. And this is not just words - they are taking highly unpopular measures to reduce their current deficits. So why do these efforts need to be augmented and directed from the European/Eurozone level? (1)

Let’s go right back to the formation of the Euro. A standard rationalisation for the Stability and Growth pact (SGP) was the following. With its own currency, there is market discipline on a government spending too much or taxing too little. As government deficits rise, so do interest rates. This may be because deficits lead to excess demand and inflation, and the central bank raises interest rates to counteract this, or it may be because inflation or default risk increases. Put that same economy into a monetary union, and that discipline is diluted. In particular, there is only a union wide interest rate, and the impact on inflation in the monetary union as a whole may be small. Individual union members may therefore not internalise the impact that their deficits have on the union. (One classic reference is Beetsma and Uhlig.)  

So it was thought that a monetary union reduces fiscal discipline, and therefore it needs to do something to reverse that. Hence the SGP. In the years after the formation of the Euro events seemed to confirm this model. Interest rates on government debt for all member countries tended to converge, and fiscal discipline was very hard to maintain. But the former now looks like an aberration, caused perhaps by a combination of a belief that no Eurozone economy would ever default, and a general pre-crisis downgrading of risk.

What we now have appears to be precisely the reverse of the argument behind the SGP. Market discipline is too great: interest rates on government debt for certain Eurozone members are ‘too high’, leading to a danger of self-fulfilling default (De Grauwe). Markets react much more to increases in individual Eurozone members government debt than similar increases in other countries, mainly because the former do not have a ‘lender of last resort‘ - their own central bank. The ECB’s OMT is designed to counteract that tendency.

So do markets reduce fiscal discipline within the Eurozone, or intensify it? It seems very difficult to believe that we will go back to the pre-2007 situation any time soon, given the extent of the current crisis. If this is true, where is the rationalisation for generalised fiscal controls at the European level? If there is more market discipline within the Eurozone than outside it, there is no need for Eurozone imposed fiscal controls to supplement that market discipline.(2)

An important distinction here is between conditionality ex ante and ex post a debt crisis. Conditionality ex post, when institutions or other countries provide loans the market will not provide, is inevitable. However the myramid fiscal rules that replace the SGP are ex ante, and apply to countries with no incipient debt crisis (like the Netherlands, for example). In the rest of the world, we have the IMF, and the only ex ante conditionality it imposes is the need to cooperate in Article IV consultations. Why is the Eurozone so different?

One argument is that recent events show clear contagion within the Eurozone. Greek problems raised interest rates for other Eurozone members, in a way that might not happen to - say - South Korea if Japan defaulted. However I would suggest that this was largely due to uncertainty about what the ECB would do. To say we need the Eurozone’s fiscal rules because the way the Eurozone handles a debt crisis is unclear sounds lame indeed.

Another argument is that if emergency loans are required, other Eurozone countries will suffer potential losses on those loans, so they have an interest in preventing crises ex ante. However exactly the same is true for the IMF and the rest of the world. Indeed, my own view is that it would be far better - post OMT - if any emergency loans for a future Greece were provided by the IMF alone, because that reduces potential conflicts of interest.

A similar argument that I can imagine being made refers to the ECB and OMT. However, although I have misgivings about it, OMT does come with conditionality, so once again there is no obvious need for measures ex ante. Now of course you could argue that with OMT, the Eurozone goes back to the position pre-crisis, where market discipline on individual governments was reduced compared to outside the Euro. I think at that point the argument is getting rather desperate.

So why is the Eurozone obsessed with its fiscal rules? I can think of one clearly bad reason. (Actually I can think of many bad reasons, but this post is already long.) Eurozone governments still do not know what to do if a future Greece emerges. How does it differentiate between a future Greece (where default is required) and a future Ireland (where it is not)? The answer at the moment seems to be that the fiscal rules will ensure there will never be another Greece. That sounds like wishful thinking, particularly if other countries join. Unfortunately here the Eurozone has form. A common response before 2000 to those who argued that the Eurozone needed a strategy for dealing with asymmetric shocks was that this was not a problem because the formation of the Eurozone will itself eliminate asymmetric shocks. We all know what happened next. 

(1) Of course, if the goal is a European superstate, this is not a very interesting question. Given recent events, I do not think a European superstate is a realistic option, and even if it was I would be worried about governance issues. I should also emphasise that I am all for fiscal rules, backed up by independent fiscal institutions, at the national level. 

(2) Wherever there are spillovers from one country’s actions to another, there are potential gains from international policy coordination. Spillovers will be greater among union members. However I do not think the Eurozone’s fiscal rules can be classed as policy coordination.