Introduction
The key point of my talk is that EMU has two very different types of problems, depending on whether you think of the short or the long term.
- The short-term one is a combination of excessively low growth, massive sovereign debt because of the links between weak banks and governments, and no way out (weak banks increase sovereign debt, which translates into weak banks).
- The long-term one is that two very different types of economies were integrated into EMU, without a political mechanism that compensates for the negative effects of these differences.
1. The origins of the crisis
According to most commentators, the ECB, the European Commission, the OECD, the IMF, etc., the problem of EMU is lack of (fiscal) discipline. The Stability and Growth Pact was too weak, which allowed countries such as Greece, Spain, Italy and others to run excessive budget deficits even when they should have saved, and now we pay the prize for that. The problem with this argument is that it is very weak across EMU (excluding Greece from the sample means there is not even a correlation between pre-crisis debt levels and sovereign bond yields today). Why, for example, are Ireland and Spain in the cross-hairs of financial markets, when they ran budget surpluses for most of the first eight years of EMU, while Belgium, with a debt/GDP ratio around 100% for most of the first EMU decade is essentially ignored?
Most importantly, perhaps, this argument confuses cause and effect. A current account deficit needs to be financed, through debt, public or private; the bigger the current account deficit, the larger the debt to finance it. The problem, then, is that government borrowing comes after the worst financial crisis in history – when governments bailed out banks, economic growth collapsed (and has not really returned), and debt/GDP ratios soared. The problem is the same, but hidden in banks’ balance sheets, for private debt (and could throw up some interesting surprises: keep an eye on private debt in DK and NL over the next few years).
Where, then, did these current account imbalances originate? Imagine, to make things easier, that EMU consists of two economies of equal size, called DE (i.e. Germany and its immediate neighbours in north-western Europe including Austria), and RE (for Rest of Europe). At some point after the start of EMU, DE’s inflation rate is, because of its more strongly coordinated wage-setting system, slightly below RE’s; they average two per cent, which is the ECB’s inflation target. Since the ECB sets its interest rate for all members to reflect the difference between the target and the actual (i.e. the aggregate/average) inflation rate of DE and RE, the real interest rate (the nominal interest rate that the ECB sets for all minus the country-specific inflation rate) is therefore lower in the country with high inflation (RE) and higher in the low-inflation country (DE).
This set-up has three effects, which are not very well understood. One, monetary policy is effectively pro-cyclical. The country with higher inflation faces a more accommodating monetary policy than it should, because the bank’s target is lower than its actual inflation rate and vice versa, the opposite of what would happen if monetary policy were decided for each country individually. The lower real interest rate that RE has faced during the first ten years of EMU has, with the exception of Italy, also fed into a path of higher growth in RE, fuelling (wage) inflation. At the same time, the tighter than necessary monetary policy has imposed further disinflation through wage moderation on DE. The very small differences in inflation that existed at the start of EMU thus have become more pronounced in the second round.
The differences in wage setting between DE and RE are crucial in these dynamics. Not only did different wage-setting systems put DE and RE on different tracks from the start; in addition the ability of DE to counter inflationary pressures through wage coordination around more slowly growing unit labour costs is almost perfectly mirrored by the inability of RE to do so. Since inflation is more of a problem in RE, the lack of capacity to disinflate implies that RE slowly but steadily lost competitiveness relative to DE – without being able to make up for that through trade outside EMU.
Finally, domestic dynamics matter a lot in this story. Imagine that the aggregate inflation rate in a country is the (weighted) average of two inflation rates: one for that part of the economy exposed to foreign competition and the other for the part of the economy that is sheltered from competition. Inflation occurs when wages rise faster than labour productivity and employers pass on the cost increase to consumers (to make things easier, imagine the implied productivity rate for the sheltered sector, i.e., total labour productivity rate in the economy minus the exposed sector’s). Unions in the exposed sector have a serious incentive to keep their own inflation rate under control; else it prizes itself out of the market. But they also have a serious incentive to keep the inflation rate in the sheltered sector under control, because of their weight in the aggregate inflate rate, or, at the very least, compensate through productivity-driven deflation. Interestingly, where sheltered sector wages closely followed exposed sector wages, current accounts moved in surplus, and vice versa.
2. Where do we go from here?
‘If I wanted to get there, I would not start from here’, as the joke goes. But we now are here.
The first thing to note is that a lot has changed in EMU over the last few months and weeks: Draghi’s OMT, Greece’s reprieve, the deceleration of the austerity agenda by the European Commission – almost every day brings something new. Against the background of what appears, prima facie, both a softer and an enhanced version of fiscal policy coordination mechanism, organized by the Commission, EMU as a political entity has come a long way. No one can deny that things have moved.
But it is also important to think for a moment about what is either not discussed or highlight developments that run in the opposite, or at least a very different, direction.
- The big ideas of fiscal union, burden-sharing, economic government, etc. are off the table. The idea of Euro-bonds is now officially dead; banking union probably will never exist (without a resolution mechanism?)
- The challenge to OMT before the German Constitutional Court is probably not very dangerous per se, but it adds uncertainty now and in the future, since this (halfway credible) right-wing challenge of the CSU-CDU may weaken Merkel and the FDP enough for them/her to lose the election.
- We are not out of the woods yet on sovereign debt: think of Cyprus, Slovenia, Spain, and Italy – and do not ignore France. Practically every one of the countries in the southern hemisphere of EMU is potentially a ticking time bomb. And if all are forced to go through a sustained austerity programme, deflation will hit the north much harder (as we saw in 2013).
- Finally, there is an inherent tension between technocratic decisions that try to neutralise threats – which, almost by definition, have to be quick — and the need for democracies to bring a stable majority of voters on board. The crisis of EMU has made that democratic deficit bigger, both in perception and in reality.
As to the longer-term problems: yes, current accounts are being rebalanced, but primarily through deflation, i.e., falling imports, not through improvements in relative competitiveness. Put differently, instead of investing in technology and skills, economies/business is saving. This is of course a standard Keynesian response by firms: in the absence of stable high growth perspectives, the bears win. The occasional stock market rallies over the last year have struck me as doping effects of the monetary expansion programmes that the central banks have initiated, not built on high-growth expectations.
But that leaves us with the question how the current account imbalances that have grown within EMU can be corrected without entering a period of sustained deflation. Before exploring that question, a short excursus on current accounts within a monetary union. Everybody has a current account – think of your marriage, for example: you and your partner run permanent current accounts (ups and downs). Yet since you are one political-economic unit, you do not (under normal circumstances) think of those as balances (if you do, you are on the way to a separation…).
In a similar way, Berlin runs a current account deficit against, say, Bavaria. But within one political union that can be resolved through redistribution: in this case, the Finanzausgleich, whereby a part of VAT goes into a common pool, which is then redistributed according to relative GDP. Wealthier parts of Germany pay more and poorer parts take out more, in the hope that these funds will spur growth. The same happens in the USA, where Washington collects taxes as a proportion of growth, and redistributes accordingly. The absence of such a redistributive political-economic arrangement is the key reason for the persistence and the violent effects of these current account imbalances in EMU.
A structural adjustment in the debtor economies that would be built on gaining (relative) competitiveness without internal deflation is hard to envision for many of them. What do Greece, Portugal or even Spain, by far the best-placed of the Southern European economies, export that the creditor countries in the north needs? And how will economies that have been relatively poor at developing domestic wage-setting institutions that would allow an upward shift in labour productivity and translate that into rising real wages manage to build them today?
In addition, current account deficits are reflected in capital account surpluses: Greece and everyone else’s current account deficit has to be financed, through money borrowed from elsewhere – ironically, German savings that find their way into Greece, for example, through the financial system to buy German goods. Adjustment therefore has to be symmetric for it to be successful – but that would imply that the north accepts a dramatic deterioration of its competitive position, precisely at a time that growth in these economies is more or less constrained to exports.
France is a case in point here, which shows that the dynamics underlying EMU are particularly diabolical. French companies have not suddenly become lazy laggards: their ULC and labour productivity growth figures between 1999 and 2008 were not very different from Germany’s during that period. But Germany gained just a little bit more competitiveness – essentially to make up for the loss of competitiveness since the unification, the ERM crisis and the over-valued exchange rate with which the country entered EMU. France is in many ways still the high-performance economy that it became in the early 1990s. In a slow-growing monetary union, however, that is not enough (unless there is a redistributive mechanism along the fiscal federalism lines that I explained earlier), and Germany’s small relative annual gains in competitiveness translated into France’s losses – despite the fact that France did not do anything wrong. France’s predicament is a consequence of the interaction between Germany and France in the new regime of EMU, not of a lack of domestic adjustment in France.
Plenty of dark linings in what is by any standard an already dark sky, therefore. The future of EMU is far from certain: while I do think that the chances of a break-up are considerably smaller today than they were about a year ago, they are not approximating zero. Instead, they hover in what I think of as the uncomfortable 30% zone — enough to produce a false sense of security, and thus keep the pressure off Berlin to sign up to structural solutions which involve a Keynesian reflation and a banking union (I don’t think austerity and structural adjustment in the debtor countries are the solution, since that leads to even slower growth).
Bob Hancké, LSE, European Institute
For the Greek Public Policy Forum, 2nd Annual Chania Forum 2013, 27-28 September 2013
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