18 May 2020

Germany’s ECB battle exposes the central problem with the Eurozone

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As is well known, economists only make predictions to make astrologers look good. Yet those who foresaw the inherent contradictions of the Euro were in fact correct.

Those contradictions still have not been resolved, and doing so will require the creation of a common European treasury, not just a common fiscal policy but a mutualised flow of funds. It’s this imperative that underlines the current battle between the German constitutional court and the EU and ECB, described by the Telegraph‘s Ambrose Evans-Pritchard here.

The reason the prediction from the 1990s has worked is because this is about markets and how they work, which is what neoclassical economics does normally get right.  The particular area in question is Robert Mundell’s theory of optimal currency areas. 

In colloquial terms, the problem with the single currency as currently constituted is that either Germany pays for everything or the Euro fails – not necessarily fails as in disappears, but fails to increase the incomes and wealth of Europeans, which ought to be the point of having economic policies or structures in the first place.

The central fact is that a common money requires common interest rates – everything else flows from that. It’s obvious enough that groups of people do better when they’ve a common money. However, a common means of exchange must also mean a common interest rate.

Over a small area, a town or county, the benefits of that outweigh the problems. But as the geographic area increases, the system starts to incorporate wildly different economic areas, which require different monetary policy – different interest rates – to deal with their local economic conditions. By this measure, the eurozone is simply too large. European economies differ too much to usefully all have the same interest rate.

We have empirical proof too. In the 2000s interest rates were set nice and low as the economic weighted average – largely driven by Germany needing them before the Hartz IV reforms kicked in – required them. This meant that peripheral economies like Ireland and Spain, facing entirely different needs, got interest rates much too low for them. That in turn spawned those massive property booms with all the attendant problems when the financial crisis arrived. Indeed, the proof of the euro area being too large to be optimal is not the crash itself, but the localised booms that preceded it.  

The Euro, as is, just isn’t going to work. Not for another 50 to 100 years of economic convergence at least. Empirical proof exists again, for this is the usual estimate of how long it took the United States to become such an optimal area.

Theory also tells us that we can expand this area that a single currency works in by not relying entirely upon monetary policy. If fiscal policy is also coordinated over the area then it can be larger. Fiscal means tax and spending.

More specifically, as Paul Krugman has pointed out, centralised tax and spending. An area suffering difficulties pays less tax as a result of them, gains more in welfare and other payments from the centre at the same time. Thus these “automatic stabilisers” provide fiscal stimulus to hard hit areas while draining the exuberance out of the better off. Monetary policy doesn’t have to carry all the weight and the area over which the single currency will work expands.

This is where the current contretemps starts. All of the above is well known to those arguing on either side, even if less well known to the wider public. Fiscal union means that economies will have to pay into the central pot in taxes then gain varieties of public spending out of that central pot. A useful estimate of how much being necessary, to provide those automatic stabilisers is the 15-20% of GDP at the command of the US Federal Government. Given that Germany is much richer than many other Eurozone economies, that means its citizens will pay in rather more than they get out – not a proposition they are all entirely happy with, to put it mildly.

That’s also why there are strict rules on what the ECB can do in terms of quantitative easing and monetary policy. For there’s no firm dividing line between doing QE as monetary policy and what is known as monetisation of fiscal policy. For instance, if the ECB buys up,all the Italian bonds on the market then that’s not just lowering long term interest rates, but effectively funding Italian government spending. Monetary policy is being used to finance spending, that’s the monetisation of that fiscal policy.     

Which is why Germany’s constitutional court is saying that the ECB can’t do what it has been doing, even before we get to what it proposes to do in the future. 

The problem here is that there is no way out of this. The Euro will not work – in the sense of making the people better off – without fiscal union, given that it’s too large to be an optimal currency area without it. Yet fiscal union means the richer places – again, largely Germany – pay for the poorer ones. We have a circle that cannot be squared.

The correct solution, of course, was to not have the Euro in the first place, but then I would say that given I used to work for Ukip. Though it’s worth pointing out that my own political views were driven by this economic analysis, not the other way around.

This is the central European political question – Brexit is an amusing side show in the larger scheme of things. If fiscal union doesn’t happen then the current economic dispensation isn’t viable in the long term. Messieurs, faites vos jeux

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Tim Worstall works for the Continental Telegraph and the Adam Smith Institute.

Columns are the author's own opinion and do not necessarily reflect the views of CapX.