A Euro Summit To The Death

Kevin O'Rourke Project Syndicate December 12, 2011

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A Summit to the Death

OXFORD "“ As many feared and most expected, the just-concluded European summit left much to be desired. Once again, Europe's national leaders showed themselves to be in denial about what underlies the eurozone's economic, banking, and sovereign-debt crises, and thus hopelessly unable to resolve them.

One lesson that the world has learned since the financial crisis of 2008 is that a contractionary fiscal policy means what it says: contraction. Since 2010, a Europe-wide experiment has conclusively falsified the idea that fiscal contractions are expansionary. August 2011 saw the largest monthly decrease in eurozone industrial production since September 2009, German exports fell sharply in October, and now-casting.com is predicting declines in eurozone GDP for late 2011 and early 2012.

A second, related lesson is that it is difficult to cut nominal wages, and that they are certainly not flexible enough to eliminate unemployment. That is true even in a country as flexible, small, and open as Ireland, where unemployment increased last month to 14.5%, emigration notwithstanding, and where tax revenues in November ran 1.6% below target as a result. If the nineteenth-century "internal devaluation" strategy to promote growth by cutting domestic wages and prices is proving so difficult in Ireland, how does the EU expect it to work across the entire eurozone periphery?

The world nowadays looks very much like the theoretical world that economists have traditionally used to examine the costs and benefits of monetary unions. The eurozone members' loss of ability to devalue their exchange rates is a major cost. Governments' efforts to promote wage cuts, or to engineer them by driving their countries into recession, cannot substitute for exchange-rate devaluation. Placing the entire burden of adjustment on deficit countries is a recipe for disaster.

In such a world, fiscal union is an essential counterpart to monetary union. If the gumbo industry goes into decline, driving the US state of Louisiana into a recession, residents will pay fewer federal taxes and receive more fiscal transfers. These financial flows are a natural counter-cyclical mechanism that helps local and regional economies to weather bad times. In a hypothetical European fiscal union, there would certainly be transfers from Germany to the periphery in 2011, but a properly designed setup would have ensured flows to Germany in the 1990's, as it struggled to cope with the costs of reunification with East Germany.

With this in mind, the most obvious point about the recent summit is that the "fiscal stability union" that it proposed is nothing of the sort. Rather than creating an inter-regional insurance mechanism involving counter-cyclical transfers, the version on offer would constitutionalize pro-cyclical adjustment in recession-hit countries, with no countervailing measures to boost demand elsewhere in the eurozone. Describing this as a "fiscal union," as some have done, constitutes a near-Orwellian abuse of language.

Many will argue that such arrangements are needed to save the eurozone, but what is needed to save the eurozone in the immediate future is a European Central Bank that acts like a proper monetary authority. True, Germany is insisting on a "fiscal stability union" as a condition of allowing the ECB to do even the minimum needed to keep the euro afloat; but this is a political argument, not an economic one. Economically, the proposal would make an already terrible institutional design worse.

What is needed to save the eurozone in the medium term is a central bank mandated to target more than just inflation "“ for example, unemployment, financial stability, and the survival of the single currency. A common framework for regulating the financial system is also required, as is a common banking-resolution framework that serves the interests of taxpayers and government bondholders, rather than those of banks and their creditors. This will require a minimal fiscal union; a full-scale fiscal union would be better still. Yet none of this was on the summit's agenda.

An immediate breakup of the eurozone would be a catastrophe, which is why the European Council agreed to a "fiscal stability union" in exchange for some movement by the ECB. This may indeed prevent collapse in the short run "“ though that is far from certain. Treaty negotiations outside the EU framework, and the ratification procedures that will follow, are a recipe for even more uncertainty when Europe needs it least.

In the slightly longer run, such a deal, assuming that it goes ahead, will mean continued austerity on the eurozone periphery, without the offsetting impact of devaluation or stimulus at the core. Unemployment will continue to rise, placing pressure on households, governments, and banks. We will hear much more about the relative merits of technocracy and democracy. Anti-European sentiment will continue to grow, and populist parties will prosper. Violence is not out of the question.

This summit should have proposed institutional changes to avert such a scenario. But if such changes are politically impossible, and the euro is doomed, then a speedy death is preferable to a prolonged and painful demise. A eurozone collapse in the immediate future would be widely perceived as a catastrophe, which should at least serve as a source of hope for the future. But if it collapses after several years of perverse macroeconomic policies required by countries' treaty obligations, the end, when it comes, will be regarded not as a calamity, but as a liberation.

And that really would be worse.

Kevin O'Rourke is Chichele Professor of Economic History at the University of Oxford, and a fellow of All Souls College.

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Username Password New registration Forgotten password bkkopp 08:19 09 Dec 11

The ECB, the IMF and the ESM will prevent collaps in the short run. It has to be seen if and when today's agreement converts into practical policy.

However, national competitiveness is not a matter of fiscal austerity. The OECD has just completed a report on the structural conditions of Greece for near term change - devastating. Still, it will encourage Italy, Spain and Portugal to expedite structural reforms, and, they will most likely get ahead in a material way and indeed change their uncompetitive social contracts.

Nobody said that 'Europe' is going to be easy. But, what we had for the past 50 years is much better than what our ancestors had for centuries.

davidodonnell 11:20 09 Dec 11

@Kevin O'Rourke

Describing this as a “fiscal union,” as some have done, constitutes a near-Orwellian abuse of language.

Absolutely. We need a more realistic agenda.

http://www.irisheconomy.ie/index.php/2011/12/09/statement-by-euro-area-heads-of-state-december-9/#comment-207222

cohagan 11:49 09 Dec 11

The key proposal from Kevin O'Rourke’s article, more easing and liquidity provision by the ECB, could certainly help drag us out of the quagmire. Just it is far trickier to implement than many imagine. I’m not just thinking of the longer term dangers from inflation. Even the mechanics of it need careful design and implementation. I think the déboires we’ve had with the very limited SMP amply illustrate that. And if any further doubt, see here: http://www.tcd.ie/iiis/assets/doc/ciaranohagan-oct252011.pdf

Broadening out the objectives of the central bank also doesn’t necessarily help, if it is bedevilled with implementation problems. The ECB has arguably just one tool (maybe more if you were to segregate out regulation etc.). And as every economist who has read his Jan Tinbergen knows, one tool allows the pursuit of only one policy objective. Easy to paint an ideal central bank as all-singing, all-dancing; harder to do in practice. For a more practical, recent, hands on, analysis by *monetary* economists, see e.g. here ( Schoenmaker and Wierts http://www.dsf.nl/assets/cms/File/Research/DSF%20policy%20paper%20No%2013%20Macroprudential.pdf ).

Kevin O'Rourke says what is needed to save the eurozone in the medium term is a central bank mandated to target more. I’d say it is rather a set of policies that will help restore investor confidence in the ability of governments to honour their debts and ensure financial stability. The agreements by the EU governments this week are on the whole a few steps in the right direction . Not sufficient, clearly, but not to be dismissed from our armchairs either (just I’d be fearful – like the rating agencies - that the involvement of the IMF in new programmes of “loans assistance” would result in the subordination and crowding out of investors, like we saw in Ireland, Greece and Portugal).

Kevin O'Rourke is right of course to suggest an inter-regional insurance mechanism involving counter-cyclical transfers would significantly ease tensions. But the proposed “fiscal stability union” can still work, if spendthrift governments were to moderate substantially their still enormous budget deficits (starting with Ireland at some 10% to GNP in 2012 as current planning seems to indicate). When Maastricht was designed, already 3% of GDP seemed to be a ginormous budget deficit. Now we seem to have lost all sense of proportion.

Such a fiscal union – with moderate and coordinated budget deficits, and strong oversight – can work because massive “beggar thy neighbour” swings in fiscal policy are no longer tolerated. The burden of adjustment then falls elsewhere… with hits to living standards, as we live more within our means, and unless governments follow growth enhancing structural policies.

If leaving that conception of monetary union is a liberation, as Kevin says, for some nations that can’t respect the necessary discipline, then so be it. We saw in the late 1970s, as an historian like Kevin O'Rourke will be well aware, the arrival of Margaret Thatcher and austerity in the UK. Ireland under the erstwhile leadership of Fianna Fáil instead allowed its budget deficit balloon, and decided to pull out of the common sterling currency area, create the Irish punt, and hitch the punt’s wagon to the EMS. “Linking the currency with the mark did not impose an unsupportable discipline, largely because the option of depreciation was readily availed of" .. on ongoing budget largesse (if we can believe James Donnelly’s “Encyclopedia of Irish History and Culture). - I’m sure Kevin can confirm as this would be more his area of expertise.

Kevin often “conclusively falsifies the idea that fiscal contractions are expansionary”. It is of course patently obvious that fiscal contractions are deeply painful, especially at first (only crazies maintain otherwise, but can be useful paper tigers for the job at hand). That is of course why progress on deficit reduction is so painfully slow in some countries. The alternative though will be extensive financial dislocations. That in turn will introduce considerable uncertainties and sharp hits to confidence, which will further postpone any sound recovery. That fate might become history for Kevin O’Rourke to write about in the years to come. However I hope responsible and resolute policy makers can engineer us a better future.

skintnick 04:49 10 Dec 11

I'm not a trained economist so maybe missing the point, but what seems clear to me and must be a factor in all these financial upheavals, is what Richard Heinberg describes in his latest book "The End of Growth". Peak oil, resource depletion in general, climate change, a host of other factors are strongly suggestive of an end to economic growth until the transition to a sustainable resource base is (if ever) established. This is surely the elephant in the room.

skintnick 04:55 10 Dec 11

And, as Michael Hudson identifies, (perhaps a symptom of the end of growth) an almost total lack of profitable investment opportunities on which the capitalist system depends. The theory that the global economy cannot grow with oil at $100+ a barrel is apparently true. So perhaps it's an advantage not to be a trained economist - there is no intellectual baggage to throw overboard! Isn't it the case that the entire financial system is broken beyond repair and all minds should be focused on revolutionary strategies?

Tyranosopher 08:47 11 Dec 11

Professor O'Rourke suggests that much more federalization of Europe is needed. Sure. But it takes time.

He also suggest to follow the Quantitative Easing path of the USA promoted by, say, Krugman. That just enriches the banks, and they invest in derivatives (several hundred trillions of Credit Default Swaps, for example). Why would Europe strive to enrich Wall Street too?

Instead the ECB will lend to banks as needed, at 1%. That's much better; not a blank check to invest in yachts and derivatives, obviously.

Krugman made another ill informed, europhobic commentary on this article. Among other things, he neglected the fact that the 3% deficit rule could be overruled at a qualified majority (instead of the present qualified unanimity). Also miscreants will be referred to the European Court of Justice, meaning that only willful cheating will be punished.

The gumbo shrimp example is utopia. What is real is that the school system, from primary schools to universities is collapsing in the USA. For example it cost $31,000 to attend first year college at the University of California this year, a supposedly PUBLIC university. Stanford is more like $70,000 (although it does get plenty of public funds to support the hyper rich and the ideas that sustain their stranglehold on society). Primary schools are being closed all over the USA.

And what does the government of the USA do? Make sure General Electric pays no taxes. In other words it is impotent. So professor Krugman, from his rich private university, Princeton, compares favorably a country, the USA, which looks like the Titanic, an hour after the iceberg, with Europe. Well, Europe is not sinking, but thinking. And European federal debt is basically zero. The American federal one is more than USA GDP, and overall American debt levels, about four times GDP, are higher than Greece.

http://patriceayme.wordpress.com/

Ferdydurke 10:04 12 Dec 11

Professor you said "In a hypothetical European fiscal union, there would certainly be transfers from Germany to the periphery in 2011, but a properly designed setup would have ensured flows to Germany in the 1990’s, as it struggled to cope with the costs of reunification with East Germany". Wasn't it the case ? With both funds from the EU dev programm and the erasing of Germany debt to its european partner ?

AUTHOR INFO Kevin O'Rourke Kevin O'Rourke is Professor of Economic History at the University of Oxford, and a fellow of All Souls College. MOST READ MOST RECOMMENDED MOST COMMENTED The Neuroeconomics Revolution Robert J. Shiller Is Modern Capitalism Sustainable? Kenneth Rogoff The Anatomy of Global Economic Uncertainty Mohamed A. El-Erian What Can Save the Euro? Joseph E. Stiglitz The 70% Solution J. Bradford DeLong A New World Architecture George Soros America's Political Class Struggle Jeffrey D. Sachs Did the Poor Cause the Crisis? Simon Johnson The Second Great Contraction Kenneth Rogoff To Cure the Economy Joseph E. Stiglitz The 70% Solution J. Bradford DeLong Is Modern Capitalism Sustainable? Kenneth Rogoff Iran on the Warpath Joschka Fischer Europe's Last Best Chance Michael Boskin Europe is Not the United States Martin Feldstein ADVERTISEMENT PROJECT SYNDICATE

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The ECB, the IMF and the ESM will prevent collaps in the short run. It has to be seen if and when today's agreement converts into practical policy.

Nobody said that 'Europe' is going to be easy. But, what we had for the past 50 years is much better than what our ancestors had for centuries.

@Kevin O'Rourke

Describing this as a “fiscal union,” as some have done, constitutes a near-Orwellian abuse of language.

Absolutely. We need a more realistic agenda.

http://www.irisheconomy.ie/index.php/2011/12/09/statement-by-euro-area-heads-of-state-december-9/#comment-207222

Professor O'Rourke suggests that much more federalization of Europe is needed. Sure. But it takes time.

Instead the ECB will lend to banks as needed, at 1%. That's much better; not a blank check to invest in yachts and derivatives, obviously.

http://patriceayme.wordpress.com/

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A Euro Summit To The Death

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