Wednesday, 7 July 2010

The euro-crisis: necessary versus sufficient conditions of the eurozone framework

   There are two views on the causes of the current European crisis. The following quote by Wolfgang Schauble well represents the first:
   To the question of what caused the recent turmoil in the euro zone, there is one simple answer: excessive budget deficits in many European countries (FT June 2010).
   The second view (here) is that that the markets finally realized that there is no mechanism to correct external imbalances beyond self-equilibrating forces.
   The fiscal irresponsibility of Greece can partially explain the reasoning behind the first view. I say partially because Greece is such a small fraction of the EMU GDP that it cannot be the sole cause of the current crisis. It is true that during the last decade, the fiscal behavior of most other EMU's members, especially the three largest, has not been irreproachable. Nevertheless pointing to excessive deficits as the simple answer of the euro-crisis appears simplistic and ... insufficient. Consider that two of the countries most affected by the crisis are Spain and Ireland. The same two countries have been the most virtuous fiscal entities of the euro-zone, the champions of the Maastricht Treaty criteria so to speak, as the following graph shows (click to enlarge). I take stock of the Irish and Spaniard experience to conclude that lack of fiscal rectitude is not sufficient to explain the current euro-turmoil.

   Let me turn to the second view. Here I need a more elaborate and probably incomplete reasoning. We know that heterogeneity in macroeconomic performance within a currency area is normal. For example inflation, growth and unemployment rates are persistently different across the US states. The ECB is well aware of this "economic diversity" and says on her website:
   Current inflation and output growth differentials between the euro area countries are moderate and broadly in line with other large currency areas such as the US. Such differentials may result from differences in demographic trends, long-term catching-up processes, or ongoing adjustments leading to a more efficient allocation of resources. However, the persistence of inflation and growth differentials of individual euro area countries over longer periods of time, if induced by structural inefficiencies or misaligned national policies, may be worrisome and would need to be addressed by national policy adjustments (see here).
   Two parts to this statement. First the ECB appears to say that the dispersion in inflation and growth is structural and normal. After all differences between US states still persist (and appear fairly stable on the ECB graphs). But later she says that persistence in this dispersion may be worrisome. Surely inflation differentials lead to
  1. competitiveness differences which lead to trade imbalances,
  2. different real interest rates which in turn imply different consumption and investment patterns.
   Both lead ultimately to external imbalances and indeed the observed dispersion in current account across the euro zone is very large as shown in the next graph (click to enlarge).
   Naturally it is not possible to build a a measure of current account dispersion for other currency areas because ... in other currency areas there are no "within zone" current accounts. I start to suspect that the absence of external imbalances within other major currency areas influenced the debate around the Eurozone design. I report here a nice table presented in a recent e-book on the current euro-crisis published by VOX.
   The table says that with well functioning banks and financial markets current accounts are not an issue. Again I have the feeling that we have focused on conditions that are likely to be necessary but not sufficient.
   Why? European banks have been successfully intermediating the euro-area current account deficits and surpluses. The intricate web of external imbalances within the euro must resemble not to say mirror the complex network of European banks balance sheets. However the latter network is the transmission and amplification mechanisms of an eventual debt crisis. Transparent and well functioning financial markets appear as necessary to finance the current account deficits within the euro but not sufficient to avoid the build up of massive imbalances.
   I see two (complementary) options:
  1. Very strong national policies. With national banking systems supported by national fiscal authorities the euro currency area works only if the imbalances tend to self correct pushed by convergence of members’ competitive positions. The strong persistence in regional economic diversity shown above suggests that the self correcting mechanisms are at best slow. Each member must therefore (and will) adopt policies to balance his economy. Still, it might not be sufficient.
  2. Banking integration. With a European financial and banking system, and I intend European legal entities that can issue euro bonds and supported by European fiscal agency, the euro zone will work even if real convergence across states is slow.
   How realistic is the second option? A euro regulation for the banking system appears feasible. A common fiscal support for the euro banks much less. Nevertheless I suspect that the integration of the banking sector might be easier than other federalist proposals. In general I would suggest to focus the debate on the euro area functioning on sufficient conditions.

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