THE Eurozone is currently engulfed in a combined banking and sovereign debt crisis that threatens to unravel the single currency.
The good news is that the essential pieces of a lasting solution are well understood: a banking union, recapitalisation of key banks, some debt write-offs and an inevitable transfer of wealth from creditors to debtors. The bad news is that European Central Bank (ECB) schemes, like Outright Monetary Transactions, are only buying time. Although this time is hopefully being used to put lasting solutions in place, the more difficult question is whether anything can solve the problem at the heart of the common currency project – that one size does not and never has fitted all.
The banking crisis has highlighted that the Eurozone is not an optimal currency area. In plain English, the euro has not achieved real convergence between its constituent countries, leaving it unable to manage the crisis in the periphery effectively.
To better understand this, my firm worked out what the “correct” interest rate should be – both for the Eurozone as a whole, and for individual countries. We used the so-called Taylor Rule, which states that interest rates should rise with inflation and fall if there is slack in the economy. We discovered that our rate follows the ECB rate very closely. But Greece and Spain had different situations entirely.
This is not a new problem for the euro. In fact, it’s a problem that has been reversed. In the build-up to the recession and ensuing crisis, the ECB rate was far below what the Taylor Rule implies Greece or Spain required. They therefore overheated, given an accompanying absence of tighter fiscal policy. Conversely, interest rates were probably too high for Germany. This in some way explains its relative underperformance over the period. German GDP growth averaged 1.7 per cent from 1999-2007, while Spain averaged 3.7 per cent.
The Eurozone was never an optimal currency area. The need to keep rates low for Germany led to a bubble across the periphery, which ultimately led to the debt crisis we see today.
Now that crisis has hit, the periphery nations require rates far below the ECB average. As this is already close to zero, the Taylor Rule measure suggests they now need negative interest rates. In reality, what they need is exceptional stimulus – either monetary or fiscal. Or, put another way, the region needs relative German reflation. Instead, the periphery is currently being subjected to an extremely painful, and ultimately counter-productive, process of deflation in order to gradually restore competitiveness.
So, even if the euro survives the current crisis, it has to stop itself falling into the same trap again. For a monetary union to function properly, there must be a convergence in the performance of the separate economies and a common degree of competitiveness. That will mean fiscal policy working alongside monetary policy, as one size will never fit all. In practice, the only lasting solution is a form of fiscal union, and therefore a pooling of both monetary and fiscal sovereignty.
Philip Lachowycz is an economist at Fathom Consulting.