The Eurozone Political Crisis in One Picture

Some, like Krugman, have argued that the European crisis is a technocratic failure, the result of quasi-religious beliefs in mythical creatures ("the Confidence Fairy") held by Very Serious People in government and the commentariat. If only they would just abandon their heresies and follow the One True Keynesian path, everything would be fine. The optimal policy is obvious and Pareto-improving -- more monetary stimulus, possibly combined with debt rescheduling and the end of fiscal austerity -- so all that is required is the fortitude to implement it.

Others, like me, have argued that the European crisis is a political crisis, the result of a disjunction between the interests of the Eurocore (esp Germany) and the Europeriphery. Rather than postulate cognitive dissonance or willful ignorance (or something more sinister), I focus on distributional issues: either the Europeriphery's creditors are re-paid or they are not; either the Eurozone's macroeconomic imbalances are addressed by adjustment in Eurocore or by adjustment in the Europeriphery. Ultimately these are political questions, and political questions are generally decided by those with the most political power. In the case of the EZ crisis, any resolution must involve the European Central Bank, and the ECB has traditionally been influenced by Germany more than other member nations. There is no Pareto-improving policy -- what helps some countries hurts others -- so this is not a technocratic problem.

Look at this picture (via Niklas Blanchard) and tell me which view best explains the European Central Bank's policy calculus, and thus outcomes in Europe:

Germany is running above its nominal GDP trend; everyone else is below it. That means that further monetary stimulus will increase real GDP growth everywhere but Germany, which will instead experience higher inflation*. Germany does not want that to happen, because Germany does not like inflation. Germany has disproportionate control over the monetary authority of Europe. Therefore, the Europeriphery does not receive the monetary support which they want, because it would cause inflation in Germany.

No parsing of myths necessary; it works without them. Also no moral lesson. Just normal distributional politics.

UPDATE: Fixed some typos and poor wordings, which were both more common than usual (I think) and more egregious, and thus more likely to lead to misunderstanding.

*Added at the same time as typo-fixing: Arguably an increase in German inflation would not facilitate the sort of adjustment which is needed anyway. Higher German inflation would depreciate the real exchange rate of Germany vis-a-vis the other members of the eurozone, thus increasing Germany's competitiveness in export markets relative to, say, Spain. Movement in the opposite direction is needed. Because Spain cannot devalue externally through a fall in its currency, it will have to adjust to a rising real interest rate with an even larger internal devaluation. That means even lower wages, and probably more fiscal austerity.

If I'm right about that it's a potentially very interesting point which I've seen no one else mention.

Adjustment in the Eurozone

Martin Wolf says rough times are ahead for the eurozone:

What would have happened during the financial crisis if the euro had not existed? The short answer is that there would have been currency crises among its members. The currencies of Greece, Ireland, Italy, Portugal and Spain would surely have fallen sharply against the old D-Mark. That is the outcome the creators of the eurozone wished to avoid. They have been successful. But, if the exchange rate cannot adjust, something else must instead. That "something else" is the economies of peripheral eurozone member countries. They are locked into competitive disinflation against Germany, the world's foremost exporter of very high-quality manufactures. I wish them luck. ...

The late Charles Kindleberger of MIT argued that an open economy required a hegemon. One of its roles is to be spender and borrower of last resort in a crisis. The hegemon, then, is the country with the best credit. In the eurozone, it is Germany. But Germany is a lender, not a borrower, and is sure to remain so. This being so, weaker borrowers must fulfil the role, with dire results for their credit ratings. ...

A wave of defaults - private and even public - threaten.

The crisis in the eurozone's periphery is not an accident: it is inherent in the system. The weaker members have to find an escape from the trap they are in. They will receive little help: the zone has no willing spender of last resort; and the euro itself is also very strong. But they must succeed. When the eurozone was created, a huge literature emerged on whether it was an optimal currency union. We know now it was not. We are about to find out whether this matters.

Well, many economists (esp. American economists) thought it wasn't an optimal curency zone. But then again, neither is the United States. Right now California should be practicing different fiscal and monetary policies than Minnesota, but it can't. But these problems are exacerbated in the eurozone.

Interestingly, the European Commission recently published a sneering paper titled "The euro: It can’t happen, It’s a bad idea, It won’t last. US economists on the EMU, 1989-2002." It takes a look at pessimism among American economists on the prospects for the euro, and concludes that they were universally wrong: the euro has been a big success, they say, so neener neener.

But is it that simple? The last sentence of Wolf's op-ed is key... the American economists were absolutely right that the eurozone is not an optimal currency union, but does that really matter? P. O. Neill comments at A Fistful of Euros:

And whether that matters is ultimately a political decision. To dig into the pop culture well, the US-based economists who form the sample in the Jonung-Drea paper were giving the Star Trek answer: “Damn it Jim I’m an economist not a politician.” Looking at the predicament of Ireland, Greece, Spain, Portugal, and Italy, they may still be right.

One of my favorite IPE books is Beth Simmons' Who Adjusts? It's about economic policies in the interwar period, specifically about the determinants of states' policies when faced with a choice between devaluing their currency (i.e. abandoning the gold standard) in an attempt to maintain full employment or maintaining the strength of the currency while accepting the misery of deflation. In other words, it's about whether states adjust internally or externally. The modern analogue is whether troubled states will make domestic structural adjustments or whether they will flout the ECB's authority and try to pass on the costs of adjustment to other states in the eurozone. And if they choose the latter, what the ECB will do: allow it, or play hardball.

If I manage to find any spare time in the coming weeks I hope to re-read it. I expect this to be one of the most intriguing (and important) issues in the global economy in the coming year.

Angela Merkel seems not to understand what it means for the central bank to be independent. She said, "Unconventional monetary policies being pursued by the world’s main central banks could aggravate rather than ease the economic crisis...We must return to independent and sensible monetary policies, otherwise we will be back to where we are now in 10 years’ time.” She then continued, “Even the European Central Bank has somewhat bowed to international pressure with its purchase of covered bonds.”

The implication of course, is that she wishes the ECB would adopt a different policy and is willing to speak publicly to pressure it to do so (and thereby subordinate ECB independence to her more immediate concern). This is atypical: "Ms Merkel’s decision to ignore one of the cardinal rules of German politics – an unwritten ban on commenting on monetary policy out of respect for central bank independence – suggested Berlin is far more concerned about the ECB’s approach than has so far been apparent."

Which suggests that Merkel (and other German elite, perhaps) is happy to have an independent ECB as long as it follows her ideal monetary policy. Once the ECB's commitment to that policy appears less secure, she, like her French counterparts, is less keen on the idea of letting the ECB make its decisions independently. This isn't really a commitment to central bank independence, and it hints at the deeper underlying problem in EMU. It is nice to see, however, that the French and Germans aren't that different after all.