The state of the Union

Even before it began, Europe's moment as a major world power in the 21st century looks to be over. Richard Haass

The euro is in danger…If the euro fails, then Europe fails. If we succeed, Europe will be stronger. Angela Merkel

I think of the current state of the EMU as the result of three events. The first event is the political decision to adopt a common currency leaving EMU members without automatic mechanisms to adjust to external imbalances beyond self-equilibrating forces. The second event is the global financial crisis with her consequences including the recognition that large shocks are not an historical curiosity. The third event is the sudden comprehension by the financial markets of the first event.

The next figure partially summarizes the state of the EMU. The data are from the ECB and are used to set the stance of monetary policy.

Two sub-periods are evident: the pre-crisis and the post-crisis periods. The first 8 years show the performance of the ECB in controlling inflation ad stabilizing it around 2%: impressive. Equally impressing is the inflation oscillation that started in 2008 and is still unfolding. The EMU public debt to GDP ratio was stable at roughly 70% (10% more than the Maastricht rule) until the global financial crisis. The decline in output and the consequent worsening of public finances have now increased the debt to gdp ratio to almost 80%. Similarly the EMU public deficit has fluctuated around the -3% Maastricht limit until it ballooned during the crisis. Notably the EMU area has always had a fairly balanced current account and her actual net external position is small. The EMU growth has averaged 2.3% from 1999 to 2007 to later collapse and the EMU unemployment rate moved around 8.5%.

I see a picture of a sufficiently solid although static euro area that was hit by a large shock. There could be some concerns regarding the control of inflation (personally I am more worried by the downward trend of the inflation rate that excludes energy). The unemployment performance is unsatisfactory but this is not the picture of a collapsing economy. To observe the large imbalances that are threatening the euro we have to shift to a disaggregated picture.

The next figure depicts the state of the individual members of the EMU.

The heterogeneity within the euro is large in every dimension. Some states have very large debts, some have very large current account deficits, some have both and other have incredible unemployment rates for a modern democracy. The crisis has potentially put some of the weakest states in an unsustainable debt position exacerbated by large external imbalances. The heterogeneity per se is not a sufficient condition for questioning the existence of the euro area (and weights matter). For example the US states are very different in terms of employment, fiscal stance, size, productivity, ratings, etc (see here and here). The EMU has to design and adopt the minimum set of adjustment mechanisms that have to be present within a common currency area. There are many proposals that are discussed such as a common bond market and a larger fiscal integration. For the latter it could be interesting for europeans to know how much of the adjustment to the current shock is achieved in the US through automatic stabilizers such as unemployment benefits and how much is achieved through labor mobility (workers migration).

What is really necessary is for the EMU leaders to decide if they want to continue the integration of Europe (and how: a centralized state or the Europe of regions) or decide to go back to the now obsolete nation-state paradigm. A shadow is rising within Europe and it requires courage to dissipate it.