Europe’s easy-money endgame

The euro has brought a balance-of-payments crisis to Europe, just as the gold standard did in the 1920s.

In fact, there is only one difference between the two episodes: During today’s crisis, huge international rescue packages have been available.

These rescue packages have relieved the eurozone’s financial distress, but at a high cost.

Not only have they enabled investors to avoid paying for their poor decisions; they have also given overpriced southern European countries the opportunity to defer real depreciation in the form of a reduction of relative prices of goods.

This is necessary to restore the competitiveness that was destroyed in the euro’s initial years, when it caused excessive inflation.

Indeed, for countries like Greece, Portugal or Spain, regaining competitiveness would require them to lower the prices of their own products relative to the rest of the eurozone by about 30 per cent, compared to the beginning of the crisis.

Italy probably needs to reduce its relative prices by 10-15 per cent. But Portugal and Italy have so far failed to deliver any such “real depreciation”, while relative prices in Greece and Spain have fallen by only 8 per cent and 6 per cent, respectively.

Revealingly, of all the crisis countries, only Ireland managed to turn the corner.

The reason is obvious: its bubble already burst at the end of 2006, before any rescue funds were available.

Ireland was on its own, so it had no option but to implement massive austerity measures, reducing its product prices relative to other eurozone countries by 13 per cent from peak to trough.

Today, Ireland’s unemployment rate is falling dramatically, and its manufacturing sector is booming.

In relative terms, Greece received most of Europe’s bailout money and showed the largest increase in unemployment. 

The official loans granted to the country by the European Central Bank (ECB) and the international community have increased more than sixfold during the past five years, from 53 billion euros ($58 billion) in February 2010 to 324 billion euros, or 181 per cent of GDP, now.

Nevertheless, the unemployment rate has more than doubled, from 11 per cent to 26 per cent.

There are four possible economic and policy responses to this state of affairs.

First, Europe could become a transfer union, with the north giving more and more credit to the south and later waiving it.

Second, the south can deflate. Third, the north can inflate.

And, fourth, countries that are no longer competitive can exit Europe’s monetary union and depreciate their new currency.

Each path is associated with serious complications.

The first creates a permanent dependence on transfers, which, by sustaining relative prices, prevents the economy from regaining competitiveness.

The second path drives many debtors in crisis countries into bankruptcy. The third expropriates the creditor countries of the north.

And the fourth may cause contagion effects via capital markets, possibly forcing policy makers to introduce capital controls, as in Cyprus in 2013.

European politics has focused so far on providing public credit to the crisis countries at near-zero interest rates, which eventually may morph into transfers.

But now the ECB is attempting to break the impasse through quantitative easing (QE). 

The ECB’s stated goal is to reflate the eurozone, thereby reducing the euro’s external value, by purchasing more than 1.1 trillion euros worth of assets.

According to ECB President Mario Draghi, the inflation rate, which currently stands at just below 0 per cent, is to be raised to an average of just below 2 per cent.

This would offer southern European countries a way out of their competitiveness trap, because if prices remained unchanged in the south, while the northern countries inflated, the southern countries could gradually reduce their goods’ relative prices without feeling too much pain.

Of course, in that case the north needs to inflate faster than by just 2 per cent.

If, say, southern Europe kept its inflation rate at 0 per cent and France inflated at a rate of 1 per cent, Germany would have to inflate by a good 4 per cent, and the rest of the eurozone at 2 per cent annually, to reach a eurozone average of slightly less than 2 per cent.

This pattern would have to continue for about 10 years to bring the eurozone back into balance. At that point, Germany’s price level would be about 50 per cent higher than it is today.

I do expect QE to bring about some inflation.

Given that an exchange rate is the relative price of a currency, as more euros come into circulation, their value has to fall substantially to establish a new equilibrium in the currency market. 

Experience with similar programmes in the United States, the United Kingdom and Japan has shown that QE unleashes powerful forces of depreciation.

QE in the eurozone will thus bring about the inflation that Draghi wants via higher import and export prices. Whether this effect will be sufficient to revitalise southern Europe remains to be seen.

There is a risk that Japan, China and the US will not sit on their hands while the euro loses value, with the world possibly even sliding into a currency war.

Moreover, the southern EU countries, instead of leaving prices unchanged, could abandon austerity and issue an ever-greater volume of new bonds to stimulate the economy. Competitiveness gains and rebalancing would fail to materialise, and, after an initial flash in the pan, the eurozone would return to permanent crisis.

The euro, finally and fully discredited, would then meet a very messy end.

One can only hope that this scenario does not come to pass, and that the southern countries stay the course of austerity. This is their last chance. 

The writer, professor of economics and public finance at the University of Munich, is president of the Ifo Institute for Economic Research and serves on the German economy ministry’s advisory council. He is the author, most recently, of “The Euro Trap: On Bursting Bubbles, Budgets, and Beliefs”. ©Project Syndicate, 2015. www.project-syndicate.org