In recent months bonds issued by some “peripheral” countries in the Eurozone have fallen sharply in price, and have thus borne much higher yields than the bonds of the benchmark country in Europe, Germany. Does this have any implications for the future of the Euro? The answer of course depends on why it has happened. Was it the result of irrationality on the part of the private sector – irrational pessimism? Was it caused by idiosyncratic factors, specific to each country? Or does it reflect flaws in the design of the Euro itself?
Mass irrationality is always possible, and should not be dismissed out of hand. There was, after all, quite a lot of irrationality in the boom preceding the recent banking crisis. But this time is different. In the boom while many in the private sector were indeed irrational, some were not. And as for the public sector, by and large it too was fooled. But this time the private sector is of one view – there is something wrong in the peripheral economies that was largely produced by the design of the euro – and the public sector, while accepting that some of these economies have problems, does not concede that for them all, and defends the design of the euro as requiring at most a little tinkering.
Mass irrationality is unusual, so it is set aside for the moment, to consider whether there may be fundamental problems with the euro.
But these countries are all different
A perfectly valid objection to those who say there are problems with the design of the euro is to reply that the problems in the countries under threat are not all the same. But every person with a particular illness does not exhibit exactly identical symptoms. The problems in these countries’ bond markets, although produced by different proximate causes, may have common roots.
What are the proximate causes? These are summarised briefly, recognising that this does not do full justice to their complexity so as to allow rapid progress to the main arguments.
Greece has a lavishly financed public sector and low tax collections. Expenditure exceeded revenue, and there was no sign that revenue was going to catch up. Ireland’s banking sector had expanded rapidly, made terrible loans in the process, and these loans, when the government took them on to protect the country’s banks, nearly overwhelmed the government’s finances. Portugal experienced a tremendous private sector credit boom in consequence of low interest rates and relaxation in lending criteria, so that the private sector collectively seemed unlikely to be able to pay its debts. This threatened the banking system, and in combination with a downturn this threatened the government’s finances. And Spain was similar to Portugal, except that the private sector bad debts were particularly concentrated on property, both residential and commercial.
Despite these differences, there were also common factors. Joining the Euro enabled every one of these countries to borrow at interest rates almost as low as those for the core. And many of them had much slower rates of productivity growth in the private sector than did the core members of the Eurozone.
A Common Cause?
In thinking about whether there was a common cause behind these similar but far from identical problems it is useful to look back at the beginnings of the Euro. No doubt some saw it as a political project, a step towards Europe’s becoming a single country. For those, no economic discussion seemed necessary. But many others wanted to consider economic factors, either because they saw the project as an economic one purely, or because while they shared the goal of Europe’s becoming a single country they wanted to see if the separate countries were as yet ready to have a single currency.
The body of analysis brought to bear was Optimum Currency Area theory. This theory, first enunciated by Robert Mundell in 1961, can be neatly summarised as follows.
“The crucial tradeoff identified by Mundell is, according to my own textbook (McCallum, 1996, p 258) that ‘an extension of the area over which a single currency prevails enhances microeconomic efficiency but reduces the possibility of monetary policy responses to shocks (or conditions) that affect various sub-areas differently. The wider the area, that is, the greater are the efficiency benefits of possessing a single medium of exchange and medium of account, but the smaller the area, the greater are the possibilities of tailoring monetary policy to (temporary) local needs. Somewhere between one currency for the entire world and one for each country (or for each city, or neighbourhood…) lies the optimum.” (McCallum, 2003, p8)
Now, as McCallum goes on to remark, although stating the optimisation problem is certainly the first step to solving it, it is not the same thing as solving it. Indeed, he points out that a long list of distinguished scholars has had no success in making the theory operational. The theory produces a list of factors which are possibly relevant to the optimality (or otherwise) of any proposed currency area, but many of these factors are not quantifiable and none of the tradeoffs between them can be specified, other than (at best) as to sign. The same goes for a less often mentioned benefit of a common currency – increased capital market integration, and its associated increased capital mobility.
This body of theory’s failure to be operational has much in common with another, and older, body of work – that on the optimal size of firm. This was neglected completely at the time the Euro was created, but in fact has much to say on the matter.
The Optimal Size of Firm
Work on the optimal size of firm was always inconclusive, whatever industrial sector was being investigated. George Stigler, writing in 1958, observed that “the theory of economies of scale has never achieved scientific prosperity”. (1958, p4) In the same paper he went on as follows: “A large cause of its poverty is that the central concept of the theory – the firm of optimum size – has eluded confident measurement.” (1958, p14) He then argued that we should judge the optimum size by whether firms survive or not. To quote Stigler again, “The basic definition of a firm of optimum size is that it can maintain itself indefinitely in competition with firms of other sizes.” (Stigler, 1987)
We see the same when we look at currency areas which are free of exchange controls. Many different sizes of area survive. What can we do with this observation? We can borrow from Stigler again, and look at various factors popularly said to contribute to currency area size, as he did when considering firm size. We could look at labour mobility; at price stability; at composition of output, and so forth. And, when considering the Euro, we could look for a long- lasting currency area of similar size, and ask if the Eurozone has all or most of the same attributes.
The obvious comparator is the USA. The Euro area does not have the same amount of labour mobility. In principle labour is free to move anywhere in the EU, but of course lack of a common language greatly restricts such movement. The Euro area does not have a central fiscal authority which can help smooth shocks which hit one area but not others. There is not the ready mobility of firms to take up the advantages that one area offers over another in terms of unemployed labour. And of course, it does not have the political cohesion which comes from having been a nation state, and one still proud to have fought for its independence, for over two hundred years.
What if anything can compensate for these missing characteristics? If there are no such compensating factors, we must be driven to conclude that there are design flaws in the Euro, and the latest problems are a symptom of these flaws.
Looking at the recent, and very grave, problems of Ireland reveals whether there are compensating factors, or whether a Euro redesign is needed.
Back around the time when Britain’s Northern Rock and then Iceland’s banks got into severe difficulties, a run started on the Irish banking system. The Irish government stopped this by guaranteeing all funds deposited with Irish banks. Not just retail deposits, but everything. Not surprisingly, the run stopped. But recently fresh problems appeared. The problems in Ireland’s banks were much greater than had been thought. The already considerable fiscal tightening needed to repay the borrowings the Irish government had made to prop up their banks seemed likely not to be enough.
But more fiscal tightening was perhaps not politically feasible, and indeed, it seemed possible that the Irish economy, however hard it was willing to try, might actually not be able to repay the debts. A further run on the banks developed. This run has triggered a loan from the EU and the IMF to the Irish government.
Now, if the problem was too much debt, how can taking on more debt help? There is only one answer – the loan must be on terms so generous that the new, bigger, loan is much easier to pay than the old one, and must also initially be used to repay the earlier debts. So if, for example, the earlier debts needed to be repaid over five years, if the new loan is bigger than the old ones (so as not just to repay them but also capitalise the Irish banks more securely), needs to be repaid over a much longer period, and bears a lower rate of interest, then the new loan will bail out Ireland.
But what will that mean for Ireland, for those who have lent the money, and for the Euro?
For Ireland it will mean years, maybe decades, of high taxes. Even if the most obvious source of damage, a higher corporation tax rate, is avoided, there will be problems. Ireland has a well educated work force, and one which if not accustomed itself to going abroad at times of economic difficulty has certainly, and recently, seen earlier generations do so. Will any skilled workers be left in Ireland after the bail out? Who will pay these higher taxes? Ireland’s problems have not been solved. They have simply been changed to a different kind of problem.
For those who have lent the money – and remember this loan has to be on very generous terms if it is to solve even Ireland’s immediate problem – budget strains have increased. Maybe Germany can cope – but what about Greece, Spain, Portugal, and perhaps others? In any event, the nature of the Irish loan, as described above, makes clear the kind of loan terms that will have to be offered to any other EU country that gets into difficulties. Low in cost, and long in term.
Who can offer such loans? More such loans will be needed, for the current loan has not solved the Irish and thus the Euro problem, but just postponed it. For the adjustment mechanisms are not there. Counter-cyclical capital flows do not smooth out regional differences. Persistent sluggish productivity growth is not offset by labour mobility. One country after another, when stress comes, will need a loan. And with one loan after another the burden on the Eurozone’s big and robust economy, Germany, will increase. How long will it be able to bear it? And how long willing?
The Structure of the Eurozone
At some point doubts will develop about the stability of the whole Euro project. These doubts can be eliminated in one of four ways. The union will end; or contract to a core with the peripheral members reverting to national currencies; or there will be a core Euro and a peripheral Euro; or there will be sudden political and fiscal centralisation. Which is most likely? To answer that we have to move into the area of political discussion. The answer is not for an economist to produce. But it is clear that the answer involves responding to two questions. Will Germany want to be in a union with some slow growing, fiscally irresponsible, members? And will some countries want to be in a united Europe in which they are no more than poor, subservient, and unimportant provinces?
The Euro may survive, but it will not survive in its current form.
I am indebted to Alessandro Roselli for discussions on EMU, and to Professor Forrest Capie, Paul Reid, and Dr. A.L. Wood for comments on a draft of this paper.
McCallum, B.T. (1996) International Monetary Economics, Oxford University Press, New York
McCallum, B.T. (2003) “Theoretical Issues Pertaining to Monetary Unions”, in Monetary Unions: Theory, History, Public Choice, ed. Forrest Capie and Geoffrey Wood, Routledge, London
Stigler, George J. (1958) “The Economies of Scale”, Journal of Law and Economics, 1
Stigler, George J. (1987) The Theory of Price, Macmillan, London