June 24, 2012, 3:22 PM
Paul Krugman
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The euro crisis
As I just suggested, the architects of the euro, to the extent that they took optimum currency area theory at all seriously, chose to believe that asymmetric shocks would be a relatively minor problem. What happened instead was the mother of all asymmetric shocks – a shock that was, in a bitter irony, caused by the creation of the euro itself.
In essence, the creation of the euro led to a perception on the part of many investors that the big risks associated with cross-border investment within Europe had been eliminated. In the 1990s, despite the absence of formal capital controls, capital movements and hence current-account imbalances within Europe were limited. After the creation of the euro, however, there was massive capital movement from Europe’s core – mainly Germany, but also the Netherlands – to its periphery, leading to an economic boom in the periphery and significantly higher inflation rates in Spain, Greece, etc. than in Germany.
This movement was itself a large asymmetric shock, but a relatively gradual one, and one that the European Central Bank was willing to accommodate with slightly above-target inflation. Matters were quite different, however, when private capital flows from the core to the periphery came to a sudden stop, leaving the peripheral economies with prices and unit labor costs that were well out of line with those in the core. Suddenly the euro faced a major adjustment problem.
This was the kind of problem optimum currency area theory warned would be very difficult to handle without currency devaluation; euro optimists had believed that reforms would make labor markets sufficiently flexible to deal with such situations. Unfortunately, the pessimists were right. “Internal devaluation” – restoring competitiveness through wage cuts as opposed to devaluation – has proved extremely hard. Table 3 shows hourly labor costs in the business sectors of several peripheral economies that, by common account, entered the crisis with very flexible labor markets; even so, and despite very high unemployment, they have achieved at best small declines.
So optimum currency area theory was right to assert that creating a single currency would bring significant costs, which in turn meant that Europe’s lack of mitigating factors in the form of high labor mobility and/or fiscal integration became a very significant issue. In this sense, the story of the euro is one of a crisis foretold.
Yet there have been some surprises – unfortunately, none of them favorable.
First, as far as I know nobody or almost nobody foresaw that countries hit by adverse asymmetric shocks would face fiscal burdens so large as to call government solvency into question. As it turned out, the adjustment problems of the euro area quickly turned into a series of fiscal emergencies as well. In this sense, Kenen has turned out to dominate Mundell: lack of labor mobility has not played a major role in euro’s difficulties, at least so far, but lack of fiscal integration has had an enormous impact, arguably making the difference between the merely bad condition of America’s “sand states”, where the housing bubble was concentrated, and the acute crises facing Europe’s periphery.
Second, traditional optimum currency area theory paid little attention to banking issues; little thought was given to the importance of national as opposed to regional bank guarantees in the United States. In retrospect, however, we can see just how crucial such guarantees have actually been. Deposits in U.S. banks are guaranteed at the federal level, so that bank bailouts have not been a burden on state governments; in Europe, bank bailouts have helped cause sudden jumps in government debt, most notably in Ireland, where the government’s assumption of bank debts abruptly added 40 points to the ratio of public debt to GDP.
The combination of concerns about sovereign debt and the absence of federal bank backing have produced the now-famous phenomenon of “doom loops”, in which fears of sovereign default undermine confidence in the private banks that hold much sovereign debt, forcing these banks to contract their balance sheets, driving the price of sovereign debt still lower.
Then there’s the lender of last resort issue, which turns out to be broader than even those who knew their Bagehot realized. Credit for focusing on this issue goes to Paul DeGrauwe, who pointed out that national central banks are potentially crucial lenders of last resort to governments as well as private financial institutions. The British government basically can’t face a “rollover” crisis in which bond buyers refuse to purchase its debt, because the Bank of England can always step in as financier of last resort. The government of Spain, however, can face such a crisis – and there is always the risk that fears of such a crisis, leading to default, could become a self-fulfilling prophecy.
As DeGrauwe has pointed out, Britain’s fiscal outlook does not look notably better than Spain’s. Yet the interest rate on British 10-year bonds was 1.7% at the time of writing, whereas the rate on Spanish 10-years was 6.6%; presumably this liquidity risk was playing an important role in the difference.
An even more striking comparison is between euro area countries and those nations that have pegged to the euro but not actually adopted the currency. Denmark, Austria, and Finland are all, by common agreement, in pretty good fiscal shape. But where Austria and Finland are euro nations, Denmark is merely pegged to the euro. You might have thought that this lack of full commitment on Denmark’s part would exact a price in the form of higher interest rates — after all, someday Denmark might choose to devalue. In fact, however, Danish borrowing costs are significantly lower than those in Finland and Austria. To be fair, this could reflect fears that all euro countries will end up being contaminated by the problems of the periphery – say, by suffering large losses on loans between central banks. But a more likely explanation is that Denmark is seen as a safer bet because it could, in a liquidity squeeze, turn to its own central bank for financing, ruling out the self-fulfilling crises that pose risks even to relatively strong euro area governments.
The bottom line here would seem to be that concerns about the euro based on optimum currency area theory were actually understated. Members of a currency area, it turns out, should have high integration of bank guarantees and a system of lender of last resort provisions for governments as well as the traditional Mundell criterion of high labor mobility and the Kenen criterion of fiscal integration. The euro area has none of these.
Making the euro workable
I won’t try here to project the likely outcome of the euro crisis, since any such discussion will surely be overtaken by events. Instead, let me ask what it might take to make the euro workable even if it isn’t optimal.
One answer would be full integration, American-style – a United States of Europe, or at least a “transfer union” with much more in the way of automatic compensation for troubled regions. This does not, however, seem like a reasonable possibility for decades if not generations to come.
What about more limited fixes? I would suggest that the euro might be made workable if European leaders agreed on the following:
1. Europe-wide backing of banks. This would involve both some kind of federalized deposit insurance and a willingness to do TARP-type rescues at a European level – that is, if, say, a Spanish bank is in trouble in a way that threatens systemic stability, there should be an injection of capital in return for equity stakes by all European governments, rather than a loan to the Spanish government for the purpose of providing the capital injection. The point is that the bank rescues have to be severed from the question of sovereign solvency.
2. The ECB as a lender of last resort to governments, in the same way that national central banks already are. Yes, there will be complaints about moral hazard, which will have to be addressed somehow. But it’s now painfully obvious that removing the option of emergency liquidity provision from the central bank just makes the system too vulnerable to self-fulfilling panic.
3. Finally, a higher inflation target. Why? As I showed in Table 3, euro experience strongly suggests that downward nominal wage rigidity is a big issue. This means that “internal devaluation” via deflation is extremely difficult, and likely to fail politically if not economically. But it also means that the burden of adjustment might be substantially less if the overall Eurozone inflation rate were higher, so that Spain and other peripheral nations could restore competitiveness simply by lagging inflation in the core countries.
So maybe, maybe, the euro could be made workable. This still leaves the question of whether the euro even should be saved. After all, given everything I said, it looks increasingly as if the whole project was a mistake. Why not let it break up?
The answer, I think, is mainly political. Not entirely so – a euro breakup would be hugely disruptive, and exact high “transition” costs. Still, the enduring cost of a euro breakup would be that it would amount to a huge defeat for the broader European project I described at the start of this talk – a project that has done the world a vast amount of good, and one that no citizen of the world should want to see fail.
That said, it’s going to be an uphill struggle. The creation of the euro involved, in effect, a decision to ignore everything economists had said about optimum currency areas. Unfortunately, it turned out that optimum currency area theory was essentially right, erring only in understating the problems with a shared currency. And now that theory is taking its revenge.
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Revenge of the Optimum Currency Area - NYTimes.com
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