Solving the current quagmire will require hard choices.
Albert Einstein is rumored to have quipped that doing the same thing over and over again and expecting different results is the definition of insanity. If he were alive today, Einstein might say this is the definition of some key euro-zone policymakers.
German leaders, in particular, want the euro zone to continue and flourish, while opposing its further fiscal and financial integration. Chancellor Angela Merkel and German central-bank head Jens Weidmann have both pushed back against proposals to reduce the euro zone’s risk of economic shock through further integration. Without German support, these reforms are all but dead.
A euro zone without such integration is, however, a recipe for continued crises that could lead to its demise. The common monetary policy that the euro necessitates for the region is causing serious economic distress in many member states, and that distress is the key centripetal force in the European Union.
The two figures below show why the euro zone continues to be a political tinderbox. They show the results of a 2017 Pew Research Center poll for nine countries on two questions related to leaving the EU.
The first figure indicates that while a majority of citizens in each country want to stay in the EU, the desire to leave is closely tied to the state of the economy. A 1 percent increase in the amount of slack in the economy — in the “output gap,” which is the difference between an economy’s actual and potential output — leads to a roughly five-percentage-point increase in the share of the population desiring to leave. It would not take an unprecedented economic crisis, in other words, to get a sizable share of an EU country’s residents interested in leaving the euro zone.
The second figure reveals an even broader undercurrent of Euroskepticism. It shows how economic conditions relate to support for holding a referendum on leaving the EU. Naturally, the base level of support for a referendum is higher than that for actually leaving, with some countries having more than 60 percent of their population backing one. Again, Euroskeptic sentiment is closely tied to the amount of persistent slack in the economy since 2009. (Similar results hold if one plots the poll results against the average unemployment rate since 2009.) All of this suggests that the currency union is one political or economic shock away from breaking apart.
The Proximate Cause of Economic Pain
As the above figures show, some euro-zone economies have fared much worse than others since the crisis. A major reason for that divergent performance is that one monetary policy cannot work equally well for very different economies.
This challenge can be illustrated using Taylor Rules, which seek to establish what interest-rate targets the European Central Bank (ECB) should set based on changes in inflation and slack in the economy. Studies that estimate Taylor Rules for regions in the euro zone find that different interest rates should have been used across the currency union since its inception in 1999. The ECB’s interest-rate target was too low for the “periphery” countries during the boom period of the early-to-mid 2000s, but it was set too high during the crisis years after 2008. For “core” countries, on the other hand, interest rates have been closer to ideal. Taylor Rule analysis therefore suggests that ECB policy has been persistently destabilizing for the periphery economies since 1999.*
Looking at the total amount of money spending in the euro-zone countries further illustrates the divergence between core and periphery countries. The ECB is the final arbiter over the path of total money spending in the euro zone over long periods of time. The figure below shows a measure of total money spending — also known as nominal GDP — for the core and periphery regions of the euro zone. In the core, ECB policy has kept total euro spending a bit below but close to its pre-crisis trend path. The peripheral countries, on the other hand, have experienced a sustained fall below their pre-crisis trend path:
Now consider the paths of two specific countries, Germany and Italy. Germany’s total money spending has grown above its pre-crisis path, while Italy’s is still falling below its pre-crisis path. This divergence explains why Germans can view ECB policy as too accommodative at the same time that peripheral countries like Italy see it as too tight. There are many differences between these countries that one would expect to affect real economic growth. But with independent monetary policies, the total path of spending could be stable in each country notwithstanding these differences. The euro makes simultaneous stability in each country impossible.
The consequences of this divergence in monetary-policy outcomes can be seen in the figure below. It shows the average gap between nominal GDP and its pre-crisis trend path for the eleven largest euro-zone economies and their average unemployment rate since 2009. Again, since total money spending is something central banks control over long periods, like the time frame in this chart, the NGDP gap is likely a cause of the unemployment rate. For some parts of the euro zone, then, ECB policy has been a persistent destabilizing force.**
The Ultimate Cause of Economic Pain
The U.S. contains states with very different economies, too, so one might well ask how the Federal Reserve can get monetary policy right for the entire “dollar zone.” The answer is that the dollar zone is closer to being an optimal currency area (OCA) than the euro zone.
Being an OCA means the monetary authority does not have to get monetary policy perfectly right for each region. That is because an OCA has economic “shock absorbers” in place that allow for a gentler adjustment to inappropriate regional monetary policy. For example, imagine the U.S. economy is booming while Michigan is in recession. The Fed tightens policy to keep the national economy from overheating. This tightening could prove disastrous for Michigan residents — except they can move to booming states like Texas or California, collect unemployment insurance and other federal safety-net benefits, or take wage cuts to stay employed. Moreover, they know their financial assets will be safe in their banks and that they could tap into capital markets to borrow if needed to get through the recession. In short, the OCA theory says that even if a regional economy is subject to destabilizing monetary policy, it can still be a viable part of a currency union — so long as there is some combination of labor mobility, fiscal transfers, price flexibility, and a safe financial system that insulates the region from monetary shocks.
The euro zone lacks the requisite shock absorbers to be considered an optimal currency area.
The euro zone lacks these shock absorbers. Labor mobility in the euro zone is limited, there is no meaningful euro-zone fiscal-transfer mechanism, euro-zone wages and prices are not very flexible, the euro-zone banking system is fragile and stuck in a “doom-loop”, and euro-zone financial markets are not fully integrated. The euro-zone project, in other words, is incomplete and susceptible to further crises. If a country’s business cycle is out of sync with that of the currency area as a whole, that country is likely to find a common currency destabilizing. It has the power to take some steps to make itself a better fit for the currency area — similar to how Spain has increased its shock absorbers via structural reform to make its labor markets more flexible and to firm up its banks — but it is not clear that this approach is enough, or that other periphery countries even have the institutional capacity to follow it.
French president Emmanuel Macron has pushed hard for greater fiscal and financial integration in order to create more shock absorbers. There is, however, another way to ameliorate the problem, albeit one not much more likely to appeal to Germany: a higher euro-zone inflation rate.
As seen in the figure below, the region’s trend inflation (as measured by the harmonized consumer price index) has run far below any reasonable interpretation of the ECB’s target of “below but close to 2 percent.” It has averaged close to 1 percent since the Great Recession in 2008. Had the ECB let inflation run closer to 2 percent, the higher inflation would probably have been seen first in the regions closest to full employment. That is, the additional money spending created by a looser monetary policy would have run up against capacity constraints in the “core” countries first. Prices in core countries would have thus risen relative to prices in the periphery — boosting the periphery’s exports.
Higher inflation, in other words, would have worked in a way similar to a fiscal union, transferring resources from the core to the periphery. It would have acted as a shock absorber. As I have argued elsewhere, a total-money-spending or nominal-GDP-level target for the ECB would be an effective way to achieve higher inflation without the costs of an ad hoc increase in that rate.
The Path Forward: Integrate or Separate
So where does this leave the euro zone? For now, euro-zone officials are still kicking the can down the road, but at some point they will face a fork. One path will force further integration upon the euro zone, along the lines of Emmanuel Macron’s proposal and better ECB monetary policy. The other path will lead to the separation of the euro zone. As Ashoka Mody shows in his new book, the 20-year history of the euro zone suggests the latter path is more likely. Breaking up the euro zone, though, need not end the EU. As suggested by Ambrose Evans-Pritchard and Ramesh Ponnuru, the periphery could keep using the euro while the core could exit and adopt their own currency: Call it the Deutschmark 2.0. This approach would minimize the financial stress from the breakup of the currency union.
Neither path will be easy, but doing the same thing over and over again in the euro zone and expecting different results is futile. European policymakers should start making the hard choices now rather than waiting until these choices are forced upon them by the next euro-zone crisis.
* Some may question whether Taylor Rule analysis is appropriate starting in 2015, when the ECB started its quantitative-easing program (QE). Since then, ECB policy has not been implemented solely through targeting interest rates. To the extent QE actually makes a difference in the economy, however, it should be reflected in inflation and the output gap and therefore in the Taylor Rule. Consequently, Taylor Rule analysis can be still be informative even in periods of unconventional monetary policy.
** Some, including Robert Hetzel and myself, go further and argue the ECB was also the cause of the euro-zone crisis.