Like Mearsheimer and Grieco , Waltz merely acknowledges the existence of other actors in the system relevant to international politics. In other words, the sovereign states are the IS's main players and, in line with other neorealists, institutions are not relevant in terms of conditioning the actions of states.
On the other side of debate, the neoliberal institutionalists Keohane and Nye discussed in how the IS is conditioned not only by individual national interests, as defined by the realists, or by the structure, according to the neorealists, but also by institutions rules that determine international politics and the organisations that help in their implementation. The need for each country to cooperate with other states, since a relation exists between them, is described by the authors as complex interdependence, a circumstance in which reciprocal effects occur between countries or between actors from different countries, or, simply, a state of mutual dependency.
Keohane and Nye argue that institutionalism and complex interdependence create greater predictability in international anarchy, which helps avoid conflicts and generates cooperation between States. The latter occurs without the existence of a supranational power imposing obedience to rules but due rather to international institutions and regimes, which formalize the expectations of each party, creating a higher level of mutual trust BURCHILL et al. As proposed earlier, the concept of international regimes within the context of institutionalism needs to be clarified.
Gilpin , pp. Keohane claims that international regimes are a necessary feature of the world economy since they facilitate the efficient operation of the international economy, thereby reducing uncertainties, lowering transaction costs and averting market turndowns. Although a hegemonic power is required to create international regimes 9 , for these to be efficient and long-lasting they need to acquire their 'own life' over time.
Hence, the participating countries learn to modify their national interests with the experience of a successful international regime GILPIN, Here, it is indispensable to make an attempt to differentiate between 'institution' and 'regime'. The first term refers to the body or organisation that promotes rules or principles. The second concerns the acondition — formal or not — of a convergence of expectations.
Hence, the term 'institution' will be used here for an organisation that promotes a 'regime'. As cited earlier, the European Commission and the European Parliament are institutions that promote principles a regime for the EU an institution. The euro is treated in this article as a regime imposed by the EU. The two points cited here will be of fundamental importance for the final section. This section demonstrates the disparities between the two central actors in the EU crisis. The aim here is to illustrate how the economic practices of each State have impacts on the European framework 'structure' for the neorealists and 'institution' for the neoliberals.
For the purposes of this demonstration, the macroeconomic indices, interest rates, gross domestic product GDP , current transactions, public debt and public deficit, as well as the institutional data on the competitiveness index, are employed. Adoption of the social market economy model from the beginning of the Cold War enabled Germany to succeed in reconciling liberalism with national savings and high levels of social security. Reunification brought progress and growth, allowing the country to become a politically and economically influential member of the international community.
Germany implemented social welfare policies integrated with a massive incentive to industrial productivity and efficiency. Gilpin discussed the duality of the German economy which sometimes tends towards US liberalism, at other times tends towards the Japanese stimulus given to savings.
Germany's national political-economic system was based on the joint coordination of private banks, large companies, industry, government and labour unions. Hence, the corporativism present in German capitalism signified greater representativeness of society and government, alongside the private sector, in the governance of the economy. Gilpin also emphasizes how the major banks performed a vital role in the German economy by providing capital to industry, as well as pointing out that labour, business small, medium and large and financial organizations also had seats on the supervisory councils representing all economic and financial sectors of the country.
It is worth recalling, however, that at the start of the s, Germany experienced an economic crisis precisely due to its maintenance of an "excessive welfare state and sclerotic labour markets" DULLIEN, , p. According to an interview given to the 'Wall Street Journal' in ZHONG, , corroborating Dullien , the main objective of the Agenda was tax reform and restructuring of the welfare state, advocating benefit cuts to boost the economy Greece went in the opposite direction.
Rather than making budget cuts, Greek economic policy maintained high levels of public expenditure, which relied on easy credit in the international market. Unable to maintain a budget surplus like Germany due to industrial and institutional deficiencies, elaborated below, Greece entered a vicious circle of requiring more credit while concomitantly imposing austerity measures.
In the next section, the asymmetries between Greece and Germany are illustrated through a comparison of macroeconomic indices for the period between and , i. To ensure a clearer understanding and greater objectivity, only key moments from the period in question are demonstrated. The Maastricht convergence criteria stipulate that the nominal long-term interest rates of the member states should not exceed 02 percentage points of the average rate of the three countries with the highest price stability.
However, from onward, as the height of the financial crisis begun in the United States, interest rate in Greece 4. In , it reached a level Germany presented a rate of 3. Source: Adapted from Eurostat Until , the variations in GDP of Germany and the euro zone, since the introduction of the single currency in , remained below Greece's economic growth. Following the global crisis, however, Greek economic growth experienced a greater impact and, unlike Germany and the EU average, was unable to recover.
From to , the growth rate of Greek GDP fell from 3. Analysis of GDP alone, however, is not enough to explain the situation of the eurozone. It is important to evaluate the balance of payments, that is, generically, the difference between exports and imports of goods and services. Krugman and Obstfeld argue that, as well as measuring the size and direction of international loans, the balance of payments reveals changes in a country's net foreign wealth. A balance of payments deficit indicates that imports exceed exports. On this point, the disparity between the balances of Germany, Greece and the eurozone average is clearly perceptible.
While Germany showed a deficit only over the first three years following adoption of the euro In , Greece attained the record of Source: Eurostat An exponential increase in long-term interest rates, associated with the balance of payments deficit, has exposed Greece's vulnerable situation within the eurozone. Without liquidity, the country needs loans, which have become more scarce due to the investment uncertainty generated by speculation of a Greek default.
Germany, along with France, bought Greek government bonds, as well as granting relatively low-interest loans to the country. Nevertheless, German debt accompanied the evolution of the eurozone, reaching In relation to the public deficit, i. Although Germany exceeded the limit from to , and again from to , the maximum level reached was 4. Analysing these macroeconomic indicators shows that Greece during the period under study here did not fit the conditions for eurozone membership, insofar as the country's macroeconomic indices were incompatible with the single currency regime.
It is worth observing, however, that when the country joined the single currency it met all the convergence criteria. According to the financial analysis website Enterprise Investor, citing the report by Eurostat, Greek public debt in was actually 4. According to the website of the World Economic Forum , based on a comparative study of world countries and Europe, Germany occupied the third place in terms of competitiveness within the EU and the fifth place globally, while Greece was ranked in the last position in the EU block and the eighty-first compared to all countries in According to Lynn , p.
However, Germany obtains important advantages from EU membership, exports being one of the key elements in its competitiveness. Four of the five top destination countries for German exports are also members of the European Union.
It is equally necessary to demonstrate, briefly, how financial deregulation policies played a fundamental role in the spread of the crisis. On this point, the world clearly experienced major changes at the end of the s. The end of the bipolar world, evinced by the fall of the Berlin Wall and the subsequent collapse of the USSR, brought multipolarity to the fore and confirmed the supremacy of the capitalist ideology personified by the United States. The dominance of the information age also intensified along with the phenomenon of globalization. Now it was possible to move large quantities of capital through diverse financial institutions, and not just through the traditional banking system, both quickly and efficiently.
As the portfolio of financial operations, investments and actors expanded, so the risks and uncertainties related to the financial market increased. Hence, the widespread deregulation of markets enabled the frenetic movement of capital between countries, allowing underdeveloped economies to receive vast quantities of money in record time to tackle social and economic issues and, on the other hand, permitted developed countries to multiply their wealth ROUBINI and MIHM, A prime example of the consequences of such financial deregulation was the subprime crisis originating from the dynamics of the US domestic housing market in Since , looking to stimulate consumption, the US market had been selling house mortgages at low and attractive interest rates.
With the domestic market awash with credit, many people who wanted to own a property were able to do so. As a result, the housing market underwent intense growth and property was made available to virtually everyone who presented low risks to the loan banks, based on their credit history and proof of income. But, seeking to earn even more profits, the loans were soon extended to people with an uneven credit history subprimes , which led to non-payments and soon after to the banks repossessing properties and placing them back on sale on the market.
The creditors of the property purchasers sold the mortgages to large investment banks and other financial institutions. Consequently, the entire financial system was involved in the purchase of mortgages from the US domestic market 11 , which was a determining factor in the crisis erupting in the United States. For Roubini and Mihm : "The disease crisis spreads most readily and quickly among those who are weak and lack immunity.
In the recent crisis, many economies in Europe shared the same vulnerabilities as the US economy. Greece was the most critical patient of this 'flu'. The media has repeatedly used the term 'Greek crisis' to classify the moment experienced by the EU. The first impact felt by Greece, which depended heavily on loans, was the hike in interest rates, which made taking out loans on the international market extremely expensive.
Consequently, at the start of , a rescue package was granted to Greece. After it achieved little effect, however, the eurozone finance ministers approved a new billion euro package in It is important to stress that this problem could have been minimised with loans at lower interest rates. However, as cited earlier, the lack of confidence generated by the crisis made obtaining loans from the market extremely difficult. Roubini and Mihm also emphasize that in the European Central Bank ECB equivocally increased interest rates and the EU members primarily responsible for steering economic policy, like Germany, took belated measures without looking to provide stimuli for more vulnerable economies like Greece's.
After approval by the Greek parliament as a requirement for obtaining the second rescue package, the series of austerity measures imposed by the Troika EU, ECB and IMF led thousands of Greeks to take to the streets in protest. A third Greek rescue plan was approved in July in which more cuts to social benefits and an increase in taxes were agreed Other authors, such as Truger , Dullien and Dodig and Herr argue, in contrast to what was discussed previously by Lynn and Bagus , that the economic policy of austerity imposed by Germany, as the most influential member of the EU, on critical countries has been more harmful than remedial.
Or, in the words of Yanis Varoufakis , former finance minister of Greece and professor of economics at the University of Athens:. The problem is simple: Greece's creditors insist on even greater austerity for this year and beyond — an approach that would impede recovery, obstruct growth, worsen the debt-deflationary cycle, and, in the end, erode Greeks' willingness and ability to see through the reform agenda that the country so desperately needs. Underlining Varoufakis's evaluation , the cure has indeed been worse than the disease Truger , p , p. Dodig and Herr , for their part, conclude that the Troika's measures place the burden of the crisis on critical countries, such as Greece, and that the increase in austerity measures leads to a fall in GDP the vicious circle cited earlier.
Finally, Dullien argues that the German model cannot be imitated by the rest of Europe, since this would entail lower investments in education, technological innovation and long-term growth. The author therefore suggests that the other European countries should analyse which aspects of German reform can be implemented in their own domestic contexts Two aspects should be taken into account here. Dullien emphasizes in succinct form that the German model should not be copied by the members of the eurozone since it was based on reducing investments in education, research and technological development, as well as wage moderation.
Adoption of the first aspect would lead to a loss of the spillover effect 15 and, consequently, to slower technological progress, which would undoubtedly have negative effects on an economy still recovering from crisis. Adoption of the second could reduce prices, leading to deflation of the debt, which would harm the financial system and reduce the amount of credit and aggregate demand available. Dodig and Herr discuss the behaviour of exports from eurozone countries during the crisis.
This circumstance determined a new increase in the competitiveness of the German economy, which ultimately profited from the deficits of the most critical countries. As described earlier, Europe after the Second World War increased interstate cooperation, culminating in the institution of the EU. The third strategy is favored by those figures, such as Merkel, who want to use the current crisis to advance the development of a political union. They call for a fiscal union in which those countries with budget surpluses would transfer funds each year to the countries running budget deficits and trade deficits.
In exchange for these transfers, the European Commission would have the authority to review national budgets and force countries to adopt policies that would reduce their fiscal deficits, increase their growth, and raise their international competitiveness. This transfer arrangement has already happened with Greece and Italy. The case of Greece has been the most dramatic. By last October, Greece was unable to borrow in the global capital market and therefore had to depend on credit extended by the ECB and the International Monetary Fund to pay civil servants and maintain its social welfare programs.
Merkel and Sarkozy summoned Greek Prime Minister George Papandreou to Brussels and told him that he must abandon the plan he had announced to hold a national referendum on the austerity measures being imposed by the other eurozone members. They told him that instead he must persuade the Greek parliament to accept the tough strategy to reduce the budget deficit created by Merkel and Sarkozy or face expulsion from the eurozone. Papandreou agreed and forced the necessary legislation through parliament. He then resigned, and Lucas Papademos, a former vice president of the ECB, was appointed as a temporary prime minister with the responsibility of implementing the budget cuts designed in Brussels.
But the subsequent parliamentary defections and public riots have shown how much the Greek people resent being forced by Germany to change their economic behavior, accept layoffs of government employees who thought they had lifetime jobs, and reduce demand at a time of double-digit unemployment and rapidly falling GDP. At the same time, many voters in Germany resent sending money to the Greeks and seeing the rules of the ECB undergo radical change. But Italy does depend on the support of the ECB to limit the rise of the interest rate for its government bonds.
France and Germany pressured Italy to adopt new budget policies, leading to the resignation of Prime Minister Silvio Berlusconi in November and the appointment of a technocrat government committed to resolving Italy's fiscal problems. The euro has thus caused tensions and conflicts within Europe that would not otherwise have existed. Further steps toward a permanent fiscal union would only exacerbate these tensions.
Greece's budget deficit of nine percent of GDP is too large to avoid an outright default on its national debt. With Greece's current debt-to-GDP ratio at percent and the current value of Greece's GDP falling in nominal euro terms at an annual rate of four percent, the debt ratio will rise in the next year to percent of GDP. Rolling over the debt as it comes due and paying higher interest rates on it would raise the total debt even more quickly. Even if a more general write-down of Greek debt were to cut Greece's existing interest payments in half, the deficit would still be six percent of Greece's GDP and the debt-to-GDP ratio would rise to percent of GDP at the end of 12 months.
And this does not even take into account the adverse effect the debt write-down would have on Greek banks. The Greek government would be forced to provide payments to Greek depositors, further increasing the national debt. To achieve a sustainable path, Greece must start reducing the ratio of its national debt to GDP. This will be virtually impossible as long as Greece's real GDP is declining. Basic budget arithmetic implies that even if Greece's real GDP starts growing at two percent up from the current seven percent real rate of decline and inflation is at the ECB target of two percent, the deficit must still not exceed six percent of GDP if the debt ratio is to stop increasing.
Since the interest alone on the debt is now about six percent of GDP, the rest of the Greek budget must be brought into balance from its current three percent deficit. Cutting the interest bill in half and simultaneously balancing the rest of the budget would reduce the ratio only very slowly, from percent now to percent after a year, even if no payments to bank depositors and other creditors were required. It is not clear that financial markets will wait while Greece walks along this fiscal tightrope to a sustainable debt ratio well below percent.
The situation in Italy is much better. Italy already has a slightly positive growth rate and a primary budget surplus, with tax revenues exceeding noninterest government outlays by about one percent of GDP. The country's total budget deficit is about four percent of GDP; a reduction of the deficit equivalent to two percent of GDP would be enough to begin reducing the ratio of debt to GDP.
That should not be difficult to achieve, since government spending accounts for roughly 50 percent of GDP. The prospect of a declining budget deficit has already reduced the interest rate on new government borrowing from 7. Eliminating the budget deficit and starting to shrink the debt ratio more rapidly could bring the interest rate back to the four percent level that prevailed in Italy before the crisis began.
Even if the eurozone countries reduced their large budget deficits and thereby alleviated the threat to the commercial banks that have invested in government bonds, another problem caused by the monetary union would remain: the differences among eurozone members in terms of long-term competitiveness, which leads to sustained differences in trade balances that cannot be financed.
A more comprehensive measure that factors in net investment income reveals that Germany has a current account surplus of five percent of GDP, whereas Greece has a current account deficit of nearly ten percent of GDP. Put another way, Germany can invest in the rest of the world an amount equal to five percent of its GDP, whereas Greece must borrow an amount equal to nearly ten percent of its GDP to pay for its current level of imports.
But since Greece is part of the eurozone, this automatic adjustment mechanism is missing. Greece faces the persistent problem of a rising current account deficit, which has now reached ten percent of GDP, because Greece's productivity output per employee increases more slowly than Germany's, causing the prices of Greek goods to rise relative to the prices of German and other European goods.
More specifically, if output per employee in Germany increases by three percent a year, real wages can also grow by three percent. If the ECB keeps inflation in the eurozone at about two percent, German wages can rise by five percent a year. If Greek wages also rise by five percent a year while productivity in Greece grows by only one percent a year, the prices of Greek goods and services will increase two percent faster than the prices of German products.
That increase in the relative prices of goods and services would cause Greek imports to rise and exports to stagnate, creating an increasingly large trade deficit.
Euro Crisis Aggregate Demand Control Is European Single Currency Weakness
This problem could be avoided if the annual rise in Greek wages were limited to two percent less than the rise in German wages. This may, of course, be politically difficult in the highly unionized Greek economy. But limiting the growth of Greek wages would address only further deterioration of Greek competitiveness in the future. Stopping a further decline in Greek competitiveness would not correct the existing annual current account deficit of nearly ten percent of GDP that Greece must continue to finance.
Eliminating the existing current account deficit would require making Greek prices much more competitive than they are today, by reducing the cost of producing Greek goods and services by about 40 percent relative to the cost of producing goods and services in the rest of the eurozone. Since that is not likely to be achieved by increased productivity, it must be achieved by lowering real wages relative to the real wages of Germany and other countries in the eurozone. This would be a very painful process, achieved at the cost of years of high unemployment and declining incomes.
These are exactly the economic policies that would be needed for a recovery in Southern Europe, but the German government has been consistently pushing for counterproductive policies and even seems to be unwilling to acknowledge German economic history. This claim is obviously ridiculous and rests on a number of faulty assumptions. First, what is important for savers is not the nominal interest rate but the real interest rate the nominal rate minus inflation. Second, the ECB has little influence on the real interest rate, which is determined by structural factors in the real economy.
The real interest rate is determined by savings and investment behavior.
It should be noted that German savers directly contribute to the low real interest rate by exporting capital to the rest of the world during a time when there is an excess of desired savings on a global scale. Furthermore, the U. The Fed was able to increase the Fed funds rate twice over the last year as the U. Ironically, more expansionary monetary policy in the beginning of the crisis would have assured a higher level of interest rates right now, but neither the Bundesbank nor the Merkel government seems to understand that. As a consequence, most countries have reduced their current account deficits or surpluses, Germany being one of the few notable exceptions.
This is capital that was not invested in Germany. German individuals and companies are building up their net foreign asset position abroad instead of investing at home. It is not entirely clear to me why this is a desirable policy, especially since returns on foreign assets have been far from spectacular in recent years U.
Domestically, macroeconomic policy also has been nothing short of a catastrophe. Last year year German government bonds were periodically having a negative yield. The German government could thus borrow at zero interest rates on a year horizon. Under current economic conditions, given the low level of interest rates, the government could run a sizeable budget deficit while still maintaining a stable debt to GDP ratio if this seems to be desirable. Infrastructure investments would be basically paying for themselves right now.
There are certainly many roads and highways that need to be repaired. German Universities are mediocre in international comparison and small countries like the Netherlands or Sweden are outperforming a much larger country like Germany. How can it be that the entire economic discourse is about the cost of debt, which is non-existent under current economic conditions, while the costs of insufficient investment in infrastructure and education are completely forgotten.
I could go on, but will stop for now. Needless to say that I think the Merkel government has been a disaster for Germany and Europe. It is not in our interest to have stagnating economies all around us. I would encourage everybody to not vote for her in the next election because Germany desperately needs a change of face as well as a change of policy.
One interest rate to rule them all!!! Nonetheless, I have now calculated the Taylor rule for a set of Eurozone countries because it can be useful indicator of the stance of monetary policy. Mathematically, the Taylor rule can be expressed as follows:.
The Failure of the Euro
At the time of invention, John Taylor prescribed that the Central Bank should put equal emphasis on the output gap and on inflation deviations from the inflation target. Consequently, the coefficients h and b should both equal to 0. The real interest rate in the U. Similar to John Taylor, I have set the coefficients h and b to 0. Instead of determining the output gap myself, I have simply used output gap data from the IMF. According to a paper published by the IMF, the average global real interest rate has been around 3.
It subsequently fell to about 2. With the outbreak of the financial crisis, the global real interest rate has averaged about 0. For the year , I have simply assumed the same real interest rate 0f 0. The graph below depicts the Taylor for the set of Eurozone countries mentioned above. I also inserted the nominal interest set by the ECB for comparison. Obviously, the ECB interest rate only starts in when the euro was introduced. So if the ECB had an interest rate of 1. One should be aware that in some years the ECB changed its interest rate more frequently whereas in other years it did not change it at all.
The decision to calculate a yearly average is somewhat arbitrary. It is nonetheless very useful since for all countries I also calculated the difference between the interest rate prescribed by the Taylor rule and the rate set by the ECB. This suggests that the business cycle for the Eurozone countries is to some extent synchronized. Output gaps and inflation deviations seem to be somewhat correlated. The Eurozone countries are so diverse that monetary policy is highly inappropriate for some member countries at any point in time. In , for example, the Taylor rule prescribed an interest rate of about 9.
This means that monetary policy was highly expansionary for Ireland, causing an enormous economic boom and a gigantic housing bubble. At the same time, monetary policy was somewhat contractionary for Germany, leading to unnecessary unemployment and slower economic growth. This is indicative of the fact that the introduction of the euro led to a substantial economic boom in the European periphery countries. Indeed, the stance of monetary policy for Ireland and Spain was highly inappropriate, in their case far too expansionary, during the entire time period from up to It is very plausible that easy money was a strong contributor to the housing bubble that developed in these countries.
If one were to do a similar analysis for Greece and Portugal, one would certainly find similar results. Indeed, the Taylor rule prescribed mostly large negative nominal interest rates, especially for the crisis countries Spain and Ireland. This is of course not possible because of the zero lower bound. However, one should note that the ECB has only reduced its interest rate to 0 in , 4 years after the outbreak of the crisis. Indeed, the ECB even raised interest rates twice prematurely, thus being one the main culprits of the current economic stagnation in the Eurozone, which by now is worse than the economic performance during the Great Depression in the s!
Ireland than for others e. Below I have calculated this difference for each country from onwards. According to the rule, a positive deviation means that monetary policy was too easy whereas a negative deviation indicates that monetary policy was too tight in a given year.
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Taylor rule deviations, table 1. Taylor rule deviations, table 2. It is meaningless to take an average of the deviations since some of them are positive while others are negative. I have then taken then average of all absolute values from to see last column in table 2. The result is quite striking. One can see that the stance of monetary policy was the most appropriate for France, closely followed by Germany and Austria whereas it was highly inappropriate for Spain and even more so for Ireland.
Indeed, the interest rate prescribed by the Taylor rule for Ireland deviated, on average, by about 3. Meanwhile, the average deviation of absolute values for Germany was only 1. Monetary policy was thus highly inappropriate for countries like Spain and Ireland ever since the creation of the Eurozone. Before the crisis, money was too easy leading to unsustainable economic booms and housing bubbles. Ever since , money has been far too tight, leading to economic depression in Southern Europe. This is, of course, highly problematic. Economic stagnation in the Eurozone will last if the ECB continues to implement the tight monetary policy that is requested by the German government and the Bundesbank.
I recently found a striking paper issued by the European Commission, which summarizes the opinion of many leading U. First, it describes how basically all leading U. However, the European authors of the paper, just as many European politicians at the time, are surprised by the American scepticism, even though it is based on rigorous economic analysis.
Second, the timing of the paper is abysmally bad. It was published in , just before the shit hit the fen, so to speak. Shortly after, the Eurozone plunged into an economic contraction similar in magnitude to the Great Depression of the s, making the pessimistic forecasts of the U. Robert Mundell was one of the first economists who analysed which factors are the most important in determining the optimum economic area for a single currency.
In what follows, I will briefly summarize the most important criteria, which determine whether it is optimal for a region to share a currency and adopt a common monetary policy. This ensures that factors production, i. Factor mobility is thus crucial for an efficient allocation of resources within the currency area. It turns out that labor mobility within the Eurozone is significantly lower than within the U.
This is obviously due to large cultural differences, different languages, and other barriers many of them institutional , which prevent people from moving to another country within the Eurozone and look for work elsewhere when faced with poor job opportunities at home. In comparison, the economic costs associated with moving from one state to another are much lower in the U. For that reason, the difference in unemployment rates in between most states is relatively small: As of August , Georgia has the highest unemployment rate with 8.
This difference of about 5 percentage points, however, is quite insignificant compared to what one can observe nowadays within the Eurozone: Germany and Austria have an unemployment rate of about 4. While in the U. Similarly, a high degree of capital mobility within a currency union is necessary so that capital can be allocated to the region where its marginal productivity is highest. In comparison to labor, capital is very mobile within the Eurozone.
Unfortunately, instead of leading to an efficient allocation of resources, capital flows from the North to South created enormous housing bubbles in the European periphery, thus exacerbating boom and bust cycles within the currency area. One can thus conclude that labor flows within the Eurozone were largely insufficient to create an efficient allocation of labor from taking place while capital flows were directed to unproductive activities, i.
This misallocation of resources created the aforementioned bubble and thus led to an amplification of the business cycle. Basically, both supply shocks e. The synchronization of boom and bust cycles throughout a currency area is crucial since monetary policy has to respond to these shocks.
It is fairly obvious that the Eurozone does not fulfill this criterion. Using a standard Taylor rule, it is easy to see that monetary policy by the ECB was already inappropriate for most countries before the crisis. The nominal interest rate set in Frankfurt was too high for Germany, which suffered from low growth rates and elevated unemployment in the early s after the Dot-Com bubble.
Conversely, monetary policy was too loose for the European periphery. Low interest rates led to an economic boom creating large housing bubbles in countries like Ireland and Spain. The Eurozone is far too diverse and economic shocks across member countries are highly asymmetric, which means that the stance of monetary policy is likely to be inappropriate for at least some of the member countries at any point in time. Fiscal policy coordination and fiscal transfers The smooth functioning of a currency union also relies on the amount of fiscal transfers from one region to the other.
Nevertheless, unemployment in Florida leveled out at about This large difference can be attributed to fiscal transfers and automatic stabilizers. Unemployment benefits, food stamps and health care benefits are all programs that are paid by the federal government. Aside from fiscal transfers, the institutional setup of the Eurozone requires the national states to use countercyclical fiscal policy as a stabilization tool. That is because monetary policy will be often inappropriate either too loose or too tight for many member countries. In the case of a boom, a government should thus reduce its expenditures to cool off the economy while in the case of an economic slump it must increase its expenditures.
Unfortunately, exactly the opposite occurred. Governments usually spent too much in good times while unnecessarily engaging in harsh austerity in recent years. Pro-cyclical fiscal policy thus exacerbated the boom and bust cycle in the Eurozone. Instead of smoothening the business cycle, governments were thus largely responsible for amplifying it!
Lender of last resort for government and banks The recent crisis also made it abundantly clear that Central Banks have to assume their role as lender of last resort, both for the banking sector as well as for the government. This role is obviously necessary for the financial industry. The business model of banks is to borrow short banking deposits and to lend long credit to consumers and firms. This so-called maturity mismatch can get even healthy banks in trouble. In normal times, banks are protected by the law of large numbers.
Usually, only a fraction of bank customers decide to withdraw some cash at any given day while at the same time other customers will increase their deposits. During a crisis, however, it frequently happens that a large number of people suddenly decide to withdraw cash out of fear that their bank might fail. In that case, even healthy banks can easily get into trouble because they only have a certain amount of capital at hand.
Governments usually have several tools at their disposal to prevent this kind of self-fulfilling prophecy from happening. Deposit insurance, for example, eliminates or at least reduces the incentive for bank customers to withdraw their money in times of crisis. Similarly, the Central Bank can always inject money into the banking system if required. The Eurozone crisis painfully revealed that there is a fundamental difference between countries that can borrow in their own currency e. Spain, Portugal, etc.
Governments that can print their own currency can never run out of cash, which makes them fundamentally different from Eurozone countries. In that respect, Eurozone countries are more similar to U. For that reason, American or Japanese government debt was regarded as much safer than debt issued by Eurozone countries. While the U. The crucial difference was that the ECB did not assume its role as lender of last resort. Of course once it did, it led to a significant improvement for the member countries, which were suffering from the speculation in the bond markets.
This supports the theory that bond yields at that time really did not accurately reflect economic fundamentals. Instead, speculation in the bond market followed a self-fulfilling prophecy, which was put to an end once the ECB de facto assumed its role as lender of last resort. Using the four criteria mentioned above, it becomes obvious that the Eurozone really does not represent an optimal currency area. Labor mobility is minimal in between countries, economic shocks are highly asymmetric across the currency area, fiscal transfers and fiscal coordination between member countries is largely absent.
Last but not least, the ECB has only very reluctantly assumed its role as lender of last resort, and this far too late after as a lot of economic damage was already inflicted. Briefly after the introduction of the euro, Mundell thought that the common currency would be a success story. This is insofar surprising as his own criteria suggest that the Eurozone does not represent an optimal currency area. Other American economists, however, were much more critical.
The Euro Crisis and the Future of European Integration
Nobel laureate Milton Friedman summarized in two sentences why it is likely that the euro will turn out to be an economic disaster. For Paul Krugman, the collapse of the euro was already a fait accompli before its proper introduction. He thus wrote the following in The paper mentioned in the beginning includes numerous other examples on how American economists were rather sceptical about the euro.
The common currency was always a political project and European policy makers pushed economic considerations into the background. With the outbreak of the Eurozone crisis, it should have become clear that these American economists were right all along. But instead of following their advice on how to mitigate the economic crisis, European policy makers mostly did exactly the opposite of what economists recommended. The consequence is that the Eurozone member countries are now performing worse than during the Great Depression in the s, a remarkable accomplishment!!!
Below is a link to a very interesting video that features several presentations about monetary policy and the economic slump since Balance Sheet Recessions The great economic slump in Japan in the s, the recent recession in the U. I myself find the expression useful because it encourages us to think in terms of assets and liabilities. Specifically, it is of interest how an economic crisis affects the balance sheets of the private sector, that is, households and firms.
This was the case for Japanese corporations in the early 90s after the burst of the housing and stock market bubble. Similarly, the burst of the housing bubble in the U. This is exactly what happened to many households in the U. Ending up with negative equity, such households had a huge incentive to default on their loans.
Thanks to U. Obviously, this only shifted the problem to the banks, which now ended up with balance sheet problems on their own. This example hopefully makes clear why the huge fall in housing prices in in the U. A balance sheet recession is thus a situation in which the burst of a bubble leads to the collapse of asset prices while liabilities remain, leaving many private sector balance sheets underwater. As a consequence, the ultimate goal of the private sector, following the collapse of asset prices, is to repair its balance sheets.
Households and firms thus increase their savings drastically as they start to deleverage. That is because for the economy as a whole income is equal to expenditure. If everybody reduces their expenditures, incomes across the board will fall as well. This reduction in demand further depresses asset prices. This, in turn, induces a further fall in aggregate demand and the economy experiences a downward spiral of falling incomes and asset prices.
Monetary policy ineffective? Consumption as well as investment might be very inelastic with respect to changes in the real interest rate when the private sector deleverages. Central Bankers thus face enormous difficulties reviving the economy in a balance sheet recession.
Koo thus thinks that balance sheet recession can only be resolved with large fiscal stimulus programs in order to increase aggregate demand, which cannot be achieved by monetary policy for the reasons given above. This is the part where I strongly disagree with his analysis and where recent events have definitely proven that Koo is wrong on this particular point. Part of the problem lies with Central Bankers themselves. Historically, Central Banks have in fact regulated economic activity by buying and selling a variety of assets in the economy.
Only during the last decades, the Great Moderation, Central Bankers became accustomed to using the interest rate as the main tool of monetary policy. This is a problem insofar as Central Bankers did not know what to do once interest rates hit the ZLB in many industrialized countries after the crisis in and already in the 90s in Japan. Monetary policy mainly works through affecting expectations. The result is very promising and Japan has been one of the fastest growing industrialized countries in with an estimated real growth rate of 2.
For comparison: the Eurozone Similarly, the various QE programs in the U. QE has mainly worked by positively changing inflation expectations and expectations about future incomes. It also worked by affecting a variety of asset prices. Furthermore, QE provided markets a strong signal that the FED would be engaged in monetary stimulus for a long period. All the empirical evidence gathered over the last few years thus points towards the fact that countries with more expansionary monetary policy have fared much better since Monetary stimulus thus has been highly effective in stimulating aggregate demand in Japan and in the U.
The last years have shown that even in the U. In this case, fiscal policy and monetary policy should be complementary in addressing the demand shortfall.
To splurge is human
Unfortunately, fiscal policy has been highly contractionary in the U. Despite being wrong on the efficacy of monetary policy during a balance sheet recession, Richard Koo is definitely spot-on when analyzing the dilemma the Eurozone is facing. The ECB has been completely unable to offset the shortfall in demand that occurred as a result of the financial crisis and the Eurozone crisis.
Furthermore, it turns out that the institutional setup of the Eurozone makes member countries vulnerable to demand shocks and balance sheet recession, which I will explain below. The German economy fell into a deep recession after the burst of the Dot-Com Bubble in the early s. The chart below displays the DAX from to DAX blue vs. The private sector as a whole in Germany experienced a huge shock in confidence as the result of the burst of the bubble and the associated drop in asset prices in the early s.
Subsequently, both firms and consumers increased their savings and started to deleverage as asset prices fell significantly. As a result, aggregate demand decreased significantly as the German private sector sharply increased its savings in the early s. The fall in aggregate demand, the associated recession and the high unemployment rate could have been prevented, or at least mitigated, by expansionary monetary or fiscal policy, which could have prevented such a big shortfall in demand from occurring in the first place.
Unfortunately, the Eurozone system is particularly mal-equipped to address idiosyncratic country-specific demand shocks. Furthermore, recent times have shown that governments often are unwilling to step in and stimulate demand when the private sector is reducing its expenditures. Monetary policy, on the other hand, is made for the Eurozone as a whole. However, inflation rates differed significantly in between Eurozone member countries. The implications for policy makers in the Eurozone are severe.