Op­ti­mis­ing the Eu­ro­zone

Financial Mirror (Cyprus) - - FRONT PAGE -

The eu­ro­zone is fac­ing a bleak eco­nomic out­look, with growth re­main­ing stag­nant and the threat of de­fla­tion loom­ing large. The economist Martin Feld­stein, who was skep­ti­cal of the ini­tia­tive from the start, now calls it a “fail­ure.” Is Feld­stein right, or could the eu­ro­zone be­come the “op­ti­mal cur­rency area” that its cre­ators be­lieved it to be?

An­swer­ing this ques­tion re­quires, first and fore­most, an un­der­stand­ing of the costs and ben­e­fits of var­i­ous ex­chang­er­ate sys­tems. The In­ter­na­tional Mon­e­tary Fund was es­tab­lished 70 years ago to man­age an “ad­justable peg” sys­tem – a hy­brid sys­tem in which ex­change rates were usu­ally fixed to the US dol­lar, but could be ad­justed oc­ca­sion­ally to im­prove the coun­try’s com­pet­i­tive po­si­tion in ex­port mar­kets.

For the first few decades, this sys­tem leaned heav­ily to­ward “peg,” owing to the US dol­lar’s di­rect con­vert­ibil­ity to gold. This brought sig­nif­i­cant sta­bil­ity to the global mon­e­tary or­der, fol­low­ing the com­pet­i­tive de­val­u­a­tions of the 1930s that some econ­o­mists con­sid­ered dam­ag­ing.

But the fixed ex­change-rate sys­tem also un­der­mined the United States’ ca­pac­ity to man­age its bal­ance of pay­ments. That is why, in 1971, Pres­i­dent Richard Nixon uni­lat­er­ally aban­doned the dol­lar’s con­vert­ibil­ity to gold, leav­ing ma­jor cur­ren­cies’ ex­change rates to float against one another.

Such a sys­tem pro­vides im­por­tant ad­van­tages – most no­tably, it en­ables the US Fed­eral Re­serve to pump money into the econ­omy to pre­vent or halt a re­ces­sion. But it also car­ries se­ri­ous risks, ex­em­pli­fied in the trade im­bal­ances that emerged in the 1980s.

From 1980 to 1985, the US dol­lar ap­pre­ci­ated by 50% against the cur­ren­cies of Ja­pan, West Ger­many, France, and the United King­dom; Amer­ica’s cur­rent-ac­count deficit was ap­proach­ing 3% of GDP; and its top four com­peti­tors had mas­sive sur­pluses and neg­a­tive GDP growth. In or­der to cor­rect th­ese im­bal­ances, the five coun­tries signed the Plaza Ac­cord, in which they agreed to in­ter­vene in cur­rency mar­kets to de­value the dol­lar.

It is against this back­ground that the euro was born, with the goal of boost­ing Euro­pean economies by ex­pand­ing their “lo­cal” mar­ket, low­er­ing trans­ac­tion costs, and fa­cil­i­tat­ing the flow of in­for­ma­tion. In 1991, the loss of mon­e­tary-pol­icy in­de­pen­dence seemed like a worth­while trade-off for Europe’s economies; to­day, it seems that it may have been a mis­take.

In fact, Amer­ica’s ex­pe­ri­ence in the 1960s should have warned the eu­ro­zone’s cre­ators that ty­ing na­tional mon­e­tary au­thor­i­ties’ hands might not be such a good idea. That would not be the case if the eu­ro­zone op­er­ated ac­cord­ing to Robert Mun­dell’s vi­sion of an op­ti­mal cur­rency area, with labour and cap­i­tal ad­just­ments re­plac­ing ex­change-rate adjustment, and shocks be­ing ho­mo­ge­neous (rather than asym­met­ric). More­over, Ger­many’s ex­pe­ri­ence with re­uni­fi­ca­tion sug­gests that po­lit­i­cal union is in­te­gral to such a union’s suc­cess.

The eu­ro­zone’s per­for­mance has not met any of th­ese cri­te­ria. Most no­tably, eu­ro­zone coun­tries have faced pow­er­ful asym­met­ric shocks, to which their lack of in­de­pen­dent mon­e­tary-pol­icy in­stru­ments made it vir­tu­ally im­pos­si­ble to re­spond. As a re­sult, they have strug­gled with re­cur­ring eco­nomic cri­sis.

To un­der­stand the cor­rec­tive power of mon­e­tary pol­icy, one need only con­sider Ja­pan’s re­cent progress in es­cap­ing from decades of stagfla­tion. Mon­e­tary ex­pan­sion was one of the three key fea­tures of Prime Min­is­ter Shinzo Abe’s eco­nomic strat­egy – an ap­proach that could have been im­ple­mented years ago to halt the yen’s sharp ap­pre­ci­a­tion. The prob­lem was that Bank of Ja­pan Gov­er­nor Haruhiko Kuroda’s pre­de­ces­sors be­haved as if they were bound by a fixed ex­change-rate regime.

Un­like in Ja­pan, eu­ro­zone coun­tries’ fail­ure to im­ple­ment bold mon­e­tary-pol­icy mea­sures is not a choice. The only avail­able mon­e­tary-pol­icy tool is to change col­lec­tively the euro’s value rel­a­tive to out­side cur­ren­cies. But use of this tool is con­strained by the wide dis­crep­an­cies among in­di­vid­ual coun­tries’ ap­petite for in­fla­tion­ary or de­fla­tion­ary price lev­els.

To be sure, Euro­pean eco­nomic in­te­gra­tion – a process that, one might say, cul­mi­nated with the eu­ro­zone’s es­tab­lish­ment – also brought clear po­lit­i­cal ben­e­fits. As Robert Schu­man promised when he con­ceived the idea of a Euro­pean Com­mu­nity, in­te­gra­tion has pre­vented the re­cur­rence of war be­tween Ger­many and France. But whether mon­e­tary union on such a large scale was nec­es­sary to achieve this goal is du­bi­ous. In any case, the eu­ro­zone ex­ists – and, at this point, it would be ex­ceed­ingly dif­fi­cult to dis­man­tle it fully. Given this, the goal to­day should be to move to­ward an op­ti­mal cur­rency area.

For starters, Europe’s lead­ers must recog­nise that the eu­ro­zone, as it is cur­rently con­sti­tuted, is larger than Europe’s op­ti­mal cur­rency area. Some of its mem­ber coun­tries – cer­tainly Greece, and prob­a­bly Italy and Spain – need an in­de­pen­dent mon­e­tary pol­icy. Oth­er­wise, they will con­tinue to go from one cri­sis to the next, with coun­tries that do fall within the op­ti­mal cur­rency area – for ex­am­ple, Ger­many and France – fac­ing the con­se­quences.

Once mem­ber­ship in the eu­ro­zone is op­ti­mised, the next step will be to en­sure con­tin­ued progress to­ward po­lit­i­cal con­sol­i­da­tion. The re­sult will be a stronger, more ef­fi­cient eu­ro­zone – one in which the ben­e­fits re­ally do out­weigh the costs.

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