17 July 2012

Stefan Collignon: Three economic errors and a funeral

While eurosceptics are already preparing the funeral, europhiles keep praising the single currency in the hope of avoiding its premature death, writes Collignon for Social Europe. He lists three major errors which he says will prevent the euro from recuperating its health.

First Error: The euro area is a fixed exchange rate regime

It is a common mistake to reason about the euro as if the euro area is a fixed exchange area. It is not. The European Monetary System, which lasted from 1979 to 1993, was such a system, but in monetary union, there are no exchange rates, because everyone uses the same currency, the euro. The central bank creates money and provides domestic reserves to banks, which have unlimited access to liquidity as long as they are solvent. In international economics with different currencies, by contrast, countries can run out of foreign reserves and become illiquid. Foreign exchange is the international budget constraint. Countries must, therefore, balance current accounts or generate capital inflows in order to preserve their foreign reserves. The exchange rate is the price for foreign currency, and it adjusts to balance demand and supply in the exchange market. Within the same currency area, however, the price for domestic money is the interest rate, and money is the domestic budget constraint, which is generated by the central bank keeping money scarce.

This makes the nature of the crisis in the euro area fundamentally different from international exchange crises. In monetary union the first priority must be maintaining financial stability and the integrity of the banking system... The top benchmark for dealing with Europe’s banking crisis must be a consideration of its systemic aspects.

Second Error: The debt crisis was caused by fiscal profligacy

European authorities have spent an enormous amount of time and energy in tightening the constraints on fiscal policy, because they believe that the debt crisis was caused by “irresponsible governments” borrowing excessively. While this may have been true for the Greek Karamanlis government between 2007-9, a quick look on the data shows that European debt ratios were falling in southern Europe before the financial crisis in 2008, and only shot up when the world fell into its deepest recession since the 1920s. 

However, a fundamental difference between Europe and America is the lack of financial coherence. While Obama can issue treasury bonds in a deep financial market, the 17 euro-dwarfs believe it is useful to “discipline” Member States by markets. Yet, imposing risk premia on government bonds as high as 7 per cent (not to mention the 24 percentage points spread on Greek debt), makes public debt unsustainable and therefore increases financial instability. While the European Central Bank has provided liquidity to European banks, the euro area is missing a financial tool that minimises the negative spillover effects from national fiscal policy to all others. Eurobonds, or Union Bonds, as I have suggested, could accomplish this task.

Third Error: The euro area suffers from current account imbalances

It is often argued that even in monetary union, “foreign” debt must be repaid by current account surpluses, but this is wrong. First of all, a euro-denominated debt is not “foreign”; it is debt in our common currency. Secondly, if I owe money to my bank, I do not pay it back by paying with apples or cabbage or giving lectures on economics, but by transferring money. In a currency area, money is supplied by the banking system and if I need to pay my debt, I need to generate an income that allows me enough to save and service my debt. Hence, what is needed to make intra currency area deficits sustainable is economic growth in the local economy to service local debt and not lower net imports.

These three errors taken together are highly likely to kill the euro patient off. We may not want to see this happen. We may praise European integration and its wonderful new tools but if we continue this line of thought, we may soon come to bury the euro.

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