A first mistake in the design of the euro was that the single currency was pushed through as a political decision. Political leaders and their economists didn’t think that it would make much difference to macro policy. But it has made an enormous difference. Common monetary policy requires coordination elsewhere that European nations are not prepared to adopt – in particular in fiscal policy and in the other functions of the Central Bank, especially in its role as a lender of last resort.
A second mistake was that the founding fathers paid insufficient attention to the requirements for entry. The Maastricht criteria were about right – at the very minimum (low debt, low deficits, low inflation) – but were not strictly followed. The countries that joined the euro clearly did not satisfy the criteria for an “optimal currency area” and yet they were admitted without concerted efforts to bring their economies in line with the core countries, especially Germany.
A third mistake was about governance. Important discretionary decisions need to be made in crisis and the mechanisms for making them were not in place.
How can one correct imbalances between countries that do not satisfy the criteria for an optimal currency area? There are three main channels:
– Migration
– Fiscal transfers
– Internal depreciation
Migration is too small in Europe and it is not wanted, anyway, either by countries in recession or the ones that would receive the immigrants. Fiscal transfers are not allowed by the Maastricht treaty but they take place anyway, via the European Stability Mechanism. They certainly help, but they are not enough.
This leaves internal depreciation. Internal depreciation takes place when prices and wages fall in the domestic economy and these substitute for exchange rate depreciation. Just as exchange rate depreciation makes domestic goods cheaper in international markets, a domestic deflation will reduce costs and also makes domestic goods more competitive. This policy, which was the most favoured one by Germany, was forced on the programme countries but it has proved a complete failure.
Failure was on two fronts. First, how do you reduce wages and prices? Exchange rates are very flexible and respond to news and announcements. The news that the central bank will buy assets with new currency could bring the exchange rate down overnight. But wages don’t fall in this way. They fall only after a prolonged recession and rise in unemployment. So the implementation of internal depreciation alone, before it could have any effects on the economy, caused a deep recession with massive increases in unemployment.
Second, although internal depreciation reduces costs, it also reduces aggregate demand for goods and services. Wages are at one and the same time costs to a producer but income to a consumer. In Greece and elsewhere, the large fall in wages reduced demand by more than it reduced costs. So although costs came down and exports held up in the face of recession, domestic demand collapsed and this has had a bigger recessionary impact on the economy than any expansionary impact from exports. This is a new lesson for economic policy makers which the German policy-makers do not seem to have learned.
Dealing with debt
High debt was the result of excessive borrowing in the first few years of the euro, either by sovereigns or by the private sector from the banks. When the economy reversed and the number of non-performing loans accumulated, private debt became banking debt and banking debt became sovereign debt. Apart from repayment facilities and the like, more drastic measures were taken on two occasions by the eurozone; the 60% debt haircut in Greece in 2012 and the bail-in, or deposit haircut, in Cyprus of about 60% of GDP. The European Union is saying that neither will happen again. In summary, the Greek haircut was a failure because of miscalculation of its impact and the Cyprus one was cruel on the population but a “success” from the Eurogroup point of view.
