By Patrick Artus
The crisis in the euro zone has taught us a lot about the functioning of currency areas, which is markedly different to that which is most often expected. First of all, monetary unification creates increasing heterogeneity in the countries and regions that form the currency area, because it enables production specialisation; the heterogeneity is not caused solely by bad economic policies implemented in some countries.
Second, as is well known, if the currency is common then the necessary changes in real exchange rates between the regions can only be achieved via changes in wage costs; but in reality these do not eventuate and, moreover, would have very destabilising short-term effects.
Lastly, having multiple sovereign issuers inevitably opens the door to speculation, with investors able to arbitrage between issuers.
The euro will therefore only be sustainable, beyond the short-term bailout plans, if the euro zone’s institutions enable this heterogeneity to be countered, if federalism makes it possible for the regional adjustments in wages to be bearable and if the financing of euro-zone countries is ensured in ways that discourage speculation, which is still far from being the case.
When the euro was created, the dominant argument was that monetary unification would bring about a convergence in the economies of the euro-zone countries, since these countries would trade on a large scale and would have the same monetary policy and the same currency.
Monetary unification indeed brought about convergence between inflation rates, since there is just the one money supply. It also brought economic cycles closer together since trade effectively intensified, but it led to a structural divergence in the real economies. The reason was that the elimination of currency risk enabled productive specialisation in the countries based on their comparative advantages. We saw the Northern euro-zone countries, namely Germany, the Netherlands, Finland, Austria and Belgium, concentrating the euro-zone’s industry, while the Southern countries, namely France, Spain, Italy, Greece and Portugal, specialised in services. Manufacturing employment accounts for 20 per cent of total employment in the Northern countries and 12 per cent in the Southern countries. So there is increasing structural heterogeneity within the euro zone, and therefore divergence between the countries’ growth rates, per capita income and foreign trade situations, with the Northern countries currently enjoying robust growth and massive foreign trade surpluses while the Southern countries bear the opposite fate.
If a country with a flexible exchange rate sustains a shock unique to itself, which could be a more rapid rise in wages or a crisis in the most important sector of its economy, the adjustment consists in a real depreciation of its exchange rate achieved via a depreciation in the nominal exchange rate, thereby improving competitiveness and boosting growth, as we saw in Europe in the early 1990s.
In a currency area, however, a real depreciation in the exchange rate can only be achieved via a fall in that country’s wage costs.
Yet the decrease in wages is, on the one hand, very difficult and very slow to achieve; on the other hand, it can trigger a harmful dynamics. When a country requires a real depreciation, achieving it via the depreciation of its exchange rate normally stimulates demand; if it achieves it via a fall in wages, a permanent depression in demand sets in, as we can currently see in Greece: gross domestic product fell five per cent in one year, because the real depreciation came via a 10 per cent fall in real wages.
If there were only one sovereign issuer in the euro zone, it would raise financing without difficulty due to the solid economic and financial situation of the euro zone as a whole, which has a small fiscal deficit and balanced foreign trade.
But a situation of multiple sovereign issuers enables institutional investors to invest only in a few countries and speculative funds to arbitrage one country against another, which explains the public debt crisis and the divergence of financing conditions between the countries.
The above has not been consensually granted for European institutions, yet it has nevertheless been demonstrated by the recent crisis. It follows that there are clear conditions in order for the long-term survival of the euro zone to be ensured.
First, it is impossible to imagine the survival of the euro zone if there is, on the one hand, increasing heterogeneity of income levels throughout the regions, due to the diversity of productive specialisations, and, on the other hand, the need to carry out significant downward adjustments in wages in certain countries, in order to achieve the necessary real depreciation of the exchange rate, in addition to the resulting risks of a depressive spiral and divergence between countries.
To make these changes bearable, the only solution is federalism, i.e. income transfers from high-income countries to low-income countries. Unfortunately, we know this is being increasingly rejected by the euro zone’s Northern countries.
Second, financial crises need to be avoided. Either, we retain multiple sovereign issuers but, to discourage speculation, introduce an intervention fund that buys the public debts whose prices have become abnormally low. Given the required amounts, this could only be a fund financed by monetary creation, i.e. by the ECB, yet we know that the central bank refuses to play such a role.
Or, there is a switch to a situation in which there is a single sovereign issuer for the euro zone countries as a whole, which issues euro-zone bonds; this scenario has also been rejected by the Northern countries.
On 21 July 2011, the euro-zone countries agreed to a bailout plan for Greece under emergency, but it only enables Greece to obtain funding at acceptable interest rates. This plan entails nothing that offsets the structural heterogeneity of the countries and the divergence in wages, nor will it prevent, over time, fresh speculation on the zone’s public debts due to the fact that there are multiple issuers.