Asymmetric Shocks and Other Woes of the Eurozone
June 20th, 2011
June 20th, 2011
One of the main problems underlying the current crisis in the Eurozone is that the conditions set out in the Maastricht Treaty which lay the economic foundation of the zone are not congruent with the criteria needed to form an optimum currency area. The criteria under the Maastricht Treaty namely are (i) a rate of inflation no more than 1.5 percentage points higher than the average of three EU members with the lowest inflation rates (ii) a ratio of the annual government deficit to GDP not to exceed 3% at the end of the preceding fiscal year or at least required to reach a level close to 3% with exceptional and temporary excesses granted for exceptional cases (iii) a ratio of gross government debt to GDP not to exceed 60% at the end of the preceding fiscal year (iv) that the member should have joined the exchange rate mechanism under the European Monetary System (EMS) for two consecutive years and should not have devalued its currency during the period and (v) that the long-term interest rate must not be more than 2 percentage points higher than in the three lowest inflation member states.
As Robert Mundell, the famous economist, spelt out, the conditions for an optimum currency area to be viable are that (i) the group of countries should not be hit by shocks that are too asymmetric in that one country should not be substantially worse off while others are booming (ii) there is a high degree of labor and/or wage flexibility within the group of countries and (iii) there is coordinated fiscal policy ensuring that capital is transferred from countries that are doing well to countries that are doing poorly. Members of the Eurozone do not meet most of these criteria.
First, shocks to the Eurozone are asymmetric in that the weaker countries in the periphery such as Greece, Ireland, Portugal, and Spain are hit by slow growth, low labor productivity, and lack of competitiveness whereas the German, and to a lesser extent, the French economies have relatively much higher labor productivity and are much more competitive. While this is the common explanation that has been repeated ad neusum in the popular media, the fact is that neither Mundell nor other economists since his seminal work was published saw that there is another shock to the system quite apart from the ones they pointed out.
Illicit financial flows—or illegal capital flight that are unrecorded and triggered by endemic corruption, can be compounded by legal capital flight—the sort of private capital that exits the country due mainly to a loss of confidence in economic conditions or policies. Research at Global Financial Integrity shows that in the years leading up to the financial crisis, there was massive capital flight from Portugal, Ireland, Greece, and Spain. The flight of capital involved both licit and illicit funds. This hemorrhaging of capital occurred even as Germany and France continued to attract large foreign capital inflows. But the loss of capital from the weaker members put an upward pressure on long-term interest rates in the Eurozone, higher than the rates which would have prevailed in the absence of such outflows. Moreover, illicit outflows also had an adverse impact on government revenues in the weaker members leading to ever wider fiscal deficits in those countries. The Mundellian paradigm for an optimum currency area did not foresee the potential instability of a union with the weaker members losing massive capital through legal and illegal capital flight even as stronger members attract large capital inflows.
Second, quite apart from asymmetric shocks, practical rather than legal restrictions on labor mobility within Eurozone countries created tensions and reduced the cohesiveness of the monetary union. So while on paper the Eurozone members did away with the work and visa restrictions that hampered labor mobility, in reality labor has never been very mobile between them—for example, it is extremely difficult for Greek workers to join the labor market in Germany or France due to language and skill-set barriers. Third, wages are quite sticky due to labor unions and laws so that lagging competitiveness in the weaker economies cannot be easily corrected.
Finally, there is no coordination in fiscal policy among member states of the Eurozone.
A strict control on monetary policy over the Eurozone members is not sufficient to ensure stability of the union. Because monetary control can be circumvented by foreign borrowing (i.e., foreign loans can substitute for an expansion of domestic currency), it would be necessary to complement the monetary union with centralized fiscal policy to control foreign borrowing.
Is the turmoil in Greece a harbinger of the Euro’s demise? It looks as if in spite of massive bailouts from the IMF and the EU, Greece would not be able to stave off a debt restructuring (a euphemism for debt default) for much longer. Going by the debt dynamics with Greek debt to GDP ratio at 150 percent and the ever higher rates that investors in Greek bonds are demanding, I expect a wholesale restructuring of Greek debt within one, at most two years. It’s a very somber scenario because contagion effects, in a financially globalized world, would mean that banks in major European countries which hold toxic Greek assets, can fail. There is a distinct possibility that the majority of Greeks may decide that they cannot live with the severe austerity being imposed on them by the IMF and the EU and would rather drop out of the Eurozone in favor of their own currency. In that case, other countries like Ireland, Spain, and Portugal which are also battling huge debts and years of slow growth, high unemployment, and painful fiscal retrenchment may follow Greece to free themselves of the tethers of a monetary union. But the fact is countries that decide to opt out of the Eurozone for their own currency would not necessarily avert years of austerity—an expected (and immediate) fall in the value of their currencies will also spell painful cuts in wages until domestic goods are able to compete in world markets and resulting trade and budgets deficits are effectively narrowed.