Tuesday, December 27, 2011

Feldstein, the Euro, and Optimal Currency Areas

Martin Feldstein has an essay in the January/February 2012 issue of Foreign Affairs on "The Failure of the Euro"  (it's not available free on-line). I found it especially interesting because Feldstein is a long-term skeptic on the euro and explained his skepticism the Fall 1997 issue of my own Journal of Economic Perspectives,
in   "The Political Economy of the European Economic and Monetary Union: Political Sources of an Economic Liability."  (Like all JEP articles from the current issue back to 1994, it is freely available on-line courtesy of the American Economic Association.) But while Feldstein is a long-time skeptic on the euro, his argument has shifted slightly over the last 14 years.  

Here's Feldstein's critique from the 2012 article: "The euro should now be recognized as an experiment that failed. This failure, which has come after just over a dozen years since the euro was introduced, in 1999, was not an accident or the result of bureaucratic mismanagement but rather the inevitable consequence of imposing a single currency on a very heterogeneous group of countries."

Feldstein has long argued that the euro is best understood not as an economic policy, but as a step toward an attempted political unification of Europe. In both the 2012 and 1997 articles, he quotes a comment from German Chancellor in 1956, after the U.S. forced England and France to abandon their attack on the Suez Canal. As quoted in the JEP article, Adenauer said: "France and England will never be powers comparable to the United States and the Soviet Union. Nor Germany, either. There remains to them only one way of playing a decisive role in the world; that is to unite to make Europe. England is not ripe for it but the affair of Suez will help to prepare her spirits for it. We have no time to waste: Europe will be your revenge."

The Treaty of Rome launched the European Common Market a year later. But it wasn't until the Maastricht treaty in 1992 that a common currency became part of the project. In retrospect, it's obvious to point out that lots of countries have extensive trade with low trade barriers--say, the U.S. and Canada, or the countries of Europe circa 1995--without any particular need for a common currency to facilitate such trade.

The potential difficulties with a common currency have been widely discussed among economists at least since the work on "optimal currency areas" by Robert Mundell and others back in the 1960s. When countries share a currency, they also share a one-size-fits-all monetary policy. Some countries might prefer lower interest rates to stimulate their economy, some might prefer higher interest rates to hold down inflation; but with a single currency, the countries all get the same monetary policy. Thus, countries must find other ways to adjust.

This theory suggests four key factors: if a group of nations has these four factors that affect economic adjustment, a single currency may work well; if it lacks these factors, the single currency may turn out badly. The four factors are: 1) fiscal transfers to and from a central government, overall moving funds to where the economy is doing less well; 2) geographic movement of families and companies away from areas where the economy is doing poorly to where it is doing better; 3) flexibility in prices and wages so that areas doing poorly see prices fall and become more attractive locations for business, and vice versa; and finally 4) that the economies of these different geographic areas move more-or-less in unison, so that economic differences across the regions don't require these other adjustments to do too much.

The United States, for example, scores pretty well on these four categories, which is part of what makes a single currency workable and beneficial. Europe doesn't score especially well on any of these four categories. Thus, the euro was an attempt to put the cart before the horse: instead of first creating a European economic and political structure where a single currency would work, the idea was to first create the single currency, and then follow up later with the needed economic and political structure. As a result, the euro created a situation in which national economies suffering difficult times, like Greece, no longer had an independent monetary policy to help, and also didn't have many other methods of adjustment. Perhaps not surprisingly, they turned to another short-term method of soothing their economic pain: large domestic budget deficits.

However, the euro's troubles in the last year or so did not arrive in the way Feldstein envisioned back in 1997. Back then, he was concerned that the new European Central Bank might not be very independent of political pressure,and thus would allow a higher rate of inflation to emerge along with an ongoing depreciation of the euro as a way of stimulating European exports. Back in 1997, Feldstein discussed the rules that as part of belonging to the euro, countries would have to limit their budget deficits. While he discussed the likelihood that these rules would not be strictly enforced (and that arguments over the deficit limit rules might even derail the euro negotiations), he did not seem to envision that the runaway levels of government debt in Greece and elsewhere would cause the euro to tremble. At that time, Feldstein was relying on another part of the treaty--the part which banned the European Central Bank from bailing out member states. That provision is being bent, although not yet totally abandoned, in the present crisis.

What actually happened, as Feldstein explains in the 2012 article, is that the European Central Bank did stay tough on inflation. As a result, countries around the periphery of Europe that had long experienced high interest rates--from fear of future inflation and instability--now found that they could borrow at low interest rates. Households borrowed and poured much of the money into housing; governments borrowed more and poured the money into everything. But bond-buyers seemed to ignore the provision in the euro treaty that there would be no bail-outs.  In the U.S. economy, it is accepted as a fact of life that some U.S. states and cities will need to pay higher interest rates when they borrow, because their finances are in dodgier shape. But
debt levels rose in Greece, Ireland, Italy, and Spain, they treated debt issued by these countries as if it had the same risk level and thus the same interest as debt issued by, say, Germany or France. When investors finally took notice of the greater risks, and started jacking up the interest rates they demanded on additional borrowing, severe overborrowing had already occurred.

At this point, there's no good way out of the euro tangle.  For example, one set of proposals are that Europe should now take steps toward a meaningful fiscal union, where countries like Greece would get funding from the rest of Europe in exchange for tight oversight of their future government borrowing. But ordinary Germans don't want to send money to Greece, and ordinary Greeks don't want Germany controlling their country's budget. Having the European Central Bank print euros to buy all the dodgy debt would flatly contradict the euro treaty provisions against bailing out countries, and would leave the ECB holding a bunch of financial securities that are unlikely to pay off.

Meanwhile, European banks hold large amounts of the bonds issued by governments, so any agreement for the governments to default on a substantial portion of their debts means that Europe's banks will be badly underwater. (In a way, this is similar to how U.S. banks were underwater when they thought they were holding safe mortgage-backed financial securities, but then those securities turned out not to be safe.) In facing the risk of these losses, European banks are trying to build up their capital ratios by holding down on lending, which slows Europe's economy more.

But more fundamentally, the euro has linked together quite disparate economies--like Germany and Greece--with a common exchange rate. In a post last November 18, I called this "The "Chermany" Problem of Unsustainable Exchange Rates." Just as China's long-term refusal to let its exchange rate relative to the U.S dollar move (much) has contributed to enormous ongoing trade surpluses for China and corresponding trade deficits for the U.S. economy, the locked-in common currency (in effect, a fixed exchange rate) between Germany and Greece has locked in large trade surpluses for Germany and large trade deficits for Greece.

Feldstein concludes his 2012 essay: "Looking ahead, the eurozone is likely to continue with almost all its current members. The challenge now will be to change the economic behavior of those countries. Formal constitutionally mandated balanced-budget rules of the type recently adopted by Germany, Italy, and Spain would, if actually implemented, put each country’s national debt on a path to a sustainable level. New policies must avoid current account deficits in the future by limiting the volume of national imports to amounts that can be financed with export earnings and direct foreign investment. Such measures should make it possible to
sustain the euro without future crises and without the fiscal transfers that are now creating tensions within Europe."

Back in the 1990s, I was dubious as to how the euro would actually work long-term. As a practical matter, I find it hard to believe that the EU will be able to enforce limits on government fiscal policies or on total volumes of trade across countries. I find it hard to believe that the needed economic adjustments when a country has slow productivity growth, like Greece, will happen through changes in wages and prices, or geographic mobility of people, or fiscal transfers. The euro will probably hobble on for awhile, because breaking up is hard to do. But it will probably hobble from one economic crisis to another until its underlying economic and political context has been fundamentally changed.