Friday, June 20, 2014

Whither the Euro?

An excellent paper by Kevin O’Rourke (All Souls College, Oxford) in Finance and Development (IMF, March 2014).


“Historians may wonder how it came to be introduced in the first place.
The euro area economy is in a terrible mess.”

Indeed, the eurozone GDP still 3 percent lower in 2013 than in the first quarter of 2008 while in the United States it was 6 percent higher, and the zone unemployment exceeding 12 percent, “are not minor details, blemishing an otherwise impeccable record, but evidence of a dismal policy failure.
The euro is a bad idea, which was pointed out two decades ago when the currency was being devised. The currency area is too large and diverse – and given the need for periodic real exchange rate adjustments, the anti-inflation mandate of the European Central Bank (ECB) is too restrictive. Labor mobility between member countries is too limited to make migration from bust to boom regions a viable adjustment option. And there are virtually no fiscal mechanisms to transfer resources across regions in the event of shocks that hit part of the currency area harder than others.
 Problems foretold
All these difficulties were properly pinpointed by traditional optimal currency area theory.

Readers please note: it was “the theory” that predicted these difficulties before the fact, not individual economists! So judgment and clear understanding of theory and facts count for nothing … What about the (majority of) economists who neglected the teachings of OCA theory?

Maybe this curious conception of economic analysis has something to do with the author’s confession, later in the paper, that:

“I and many others have made such arguments (for “more Europe” rather than less) over the past five years. But as time goes on, it becomes more and more difficult to do so with conviction.”

His confession of guilt is welcome. But he could add the few names (there weren’t many!) of the economists who were right from the start, Martin Feldstein for example. And one that, spectacularly, had his theory right from the start but his analysis dead wrong, Robert Mundell!

Fortunately O’Rourke has some interesting things to add:

“ is becoming increasingly clear that a meaningful banking union, let alone a fiscal union or a safe euro area asset, is not coming anytime soon. For years economists have argued that Europe must make up its mind: move in a more federal direction, as seems required by the logic of a single currency, or move backward? It is now 2014: at what stage do we conclude that Europe has indeed made up its mind, and that a deeper union is off the table? The longer this crisis continues, the greater the anti-European political backlash will be, and understandably so: waiting will not help the federalists. We should give the new German government a few months to surprise us all, and when it doesn’t, draw the logical conclusion. With forward movement excluded, retreat from the EMU may become both inevitable and desirable.”

O’Rourke however relapses in “eurospeak” when he concludes that the demise of the euro “would be a major crisis” and would require “capital controls, default in several countries, (and) measures to deal with the ensuing financial crisis.”

This standard pessimistic outlook has been repeatedly made by euro sectarians, including Barry Eichengreen who has even claimed that while it was possible to become a member of the Eurozone, it was radically impossible to get out (despite abundant contrary evidence on a number of exits from fixed exchange rates arrangements, as well as currency zone dissolutions) because it would create “the mother of all financial crises” – whatever that means!

Common sense, on the contrary, tells us that if the real exchange rates are deeply misaligned within the shared currency (because of implied nominal exchange rates fixed “forever”) and since the misaligned exchange rates are the cause of deep structural imbalances in the national economies of the area, a return to equilibrium exchange rates should favor a resumption of growth an prosperity. Once this burdensome handicap is removed, the economy should return to a “natural rate of growth”, especially so because of the accumulated slowdowns of the past two decades.

A final interesting consideration. Since our techno-monetaro-economists are so deeply ignorant of political realities and public choice theory, they should read the following sentence of O’Rourke:

“During the interwar period, voters flocked to political parties that promised to tame the market and make it serve the interests of ordinary people rather tha the other way around. Where Democratic parties, such as Sweden’s Social Democrats, offered these policies, they reaped the electoral reward. Where Democrats allowed themselves to be constrained by golden fetters and an ideology of austerity, as in Germany, voters eventually abandoned them.”

Politicians beware ...