September 13, 2006
Stir in the blogosphere over EMU exit options
My last post on exit options for EMU has caused quite some stir in the blogosphere. Not only the new blog on Roubini’s RGE Monitor, “Economonitor” by Felix Salmon, but also Edward Hugh on “a fistful of euros” and Claus Vistesen on “alpha.sources” as well as a good dozen on readers in the comment sections of these sites have reacted to my – obviously provocative – post.
Reactions have been mixed. While Felix seems to believe I am some madman, just by proposing that Argentina could be a role model in the eyes of anyone, even in those of Italian populists, Edward and Claus have been much more sympathetic. Some commentators have even proposed that there is an anglo-saxon conspiracy to derail the EMU project (hi Paris Ib).
Maybe I should first make again clear that I am not at all arguing Italy should leave EMU. I honestly believe that this would be catastrophic for the rest of the euro-zone as well as Italy, though I am not quite sure who would suffer most. Europe is very integrated tradewise and a heavy devaluation of a new lira would take heavy tolls on the rest of EMU (maybe even more than on the Italian economy as Italy might profit from the boost in competitiveness and only in the long run feel the pinch of higher interest rates). Felix is completely right that an Italian default-cum-devaluation might even cause systemic problems for the global financial system.
However, there are populist politicians in Italy arguing for leaving the Euro and they might at some point resort to the Argentine example. And even though some readers on “Economonitor” have argued that Italy cannot have any incentive to leave EMU given that it has benefited so much from lower interest rates in EMU, I believe there are realistic scenarios in which the incentive structure might fundamentally change. The problem is the trends in both Italian competitiveness and its debt level.
Italy has lost competitiveness
Italy over the past years has lost competitiveness to a shocking degree, mainly because wages kept rising with a trend of roughly three percent while productivity was flat while in Germany and other parts of EMU unit labour costs have risen much more slowly.
Gaining back competitiveness, as also EU commission officials admit behind closed doors, would require a number of years of domestic deflation in Italy. However, domestic deflation would almost suddenly worsen the debt burden: First, with low price increases, nominal GDP growth would be lower than otherwise, making the (nominally fixed) debt level increasingly burdensome. Second, as we have seen in Germany in the past years, a strategy of competitive devaluation by low domestic rates of wage increases puts heavy burdens on social security and tax systems which are all designed for an environment of an increasing nominal wage sum, depleting governing revenue. Given the already high debt burden and high budget deficit in Italy, it is not at all clear whether Italy could manage to keep the debt level within sustainable limits.
The main danger, however, might be political: During the time of adjustment, unemployment would surely rise (as it did in Germany and Argentina during their attempts to devalue in real terms). Populists might use exactly this development to crusade against the euro.
Default-cum-devaluation
As some commentators on the other blogs have pointed out, the result would have to be a default on Italy’s debt (maybe only to the foreign part of it) and an exit of EMU, combined with a strong devaluation. This, of course would be a very messy outcome. However, there might be a point at which the Italian debt burden cannot be serviced anymore and this appears to be the least terrible solution in the eyes of Italian voters.
There would be a number of parallels to Argentina in this scenario: Argentina had also lost competitiveness in the 1990s, due to wage increases above those in its anchor country, the United States, but also due to the Brazilian devaluation in the late 1990s. Gaining back competitiveness by a policy of domestic deflation proved very hard, as it added to the budget problems. Argentina in the 1990s did have problems with extensive government spending. At least in the last years of the currency board, however, rising borrowing requirements were not mainly results of profligate spending, but also of the results of dismal business cycle developments. The government of Fernando de la Rua tried very seriously to limit spending and borrowing in 2001, but due to the rapidly deteriorating economic situation, tax revenue repeatedly came in worse than expected, leaving de la Rua’s team not much space to manoeuvre. In the end, it was the rising unemployment, a bank run and the following riots in the street which triggered the exit of the currency board and the default.
To Italy’s defence, one has to say that Mr. Prodi has understood the problems and is pushing both for measures to improve competitiveness and for measures to limit budget deficit to limit public debt (see Daniela’s post). However, it is far from clear whether he will succeed. He needs all the support he can get from other European leaders, including an end of the German devaluation-by-wage-restraint policy (see on this topic my previous post). As David Milleker has pointed out in his comment to my previous post on EMU exit options, a regional stabilisation fund to bolster divergent regional business cycles as the European unemployment insurance proposed by Daniela and me might be an option to make EMU working smoother.
After all, it would not only be Italians who were hurt by the worst-case-scenario pictured above: It would be other Europeans who lose their money invested in Italian bonds and it would be manufacturing workers in other European countries who lose their jobs both because Italy would not be able to afford their products anymore and because it would be a much stronger competitor. In the end, if a new lira devalued by 70 percent as the peso did in 2002, this would not only deplete Italian purchasing power, but also cut Italian labour cost by two thirds.
Comments(22)
Another very interesting post Sebastian. And now welcome to the blogsphere in the full sense!. Here in Europe this is a kind of small world phenomenon in the most literal sense of the term. I look forward to some intersting debates. Another blogger who takes some interest in European economic issues (apart from Brad S who you already have in the blogroll) is Dave Altig at MacroBlog. He is also worth reading for his take on the US economy, and an important datapoint for triangulation purposes.
I won’t comment much more on the substantive issues, since I am sure you have more or less gathered what I think. I would just mention that my take is very much influenced by the importance that I give to demographic factors in economic theory. This, I know, means that I look at a lot of processes in a different light from the way many other theoretical economists see things. Greg Mankiw recently suggested that the idea that low fertility was an important economic question was extermely wrong headed. Well, I suppose it takes all sorts to make a world, but I think this view is easier to sustain in the US than it is in Europe or Asia.
On the euro, I am, of course, a convinced European. That, in part, is why I am in Barcelona. But I think really political unification should have preceded the single currency, and this is now one of the difficulties that we face.
But on a more general level, it has always been accepted that Mundell’s idea was vulnerable to the presence of asymmetric shocks. Now actually I would argue that the low fertility and the increased life expectancy we are seeing isn’t exactly a ‘shock’ since I think it forms part of an ongoing process called the demographic transition (and is involved in economic feedback processes at all sorts of levels), but still, since this transition effectively happens at different rates in different countries, then de facto, the impact could be considered in ‘shock’ terms, and anyway this makes it easier for everyone to talk the same language.
This ‘differential’ demography couldn’t be clearer in the case of France and Germany. Many have been banging their heads against the wall trying to figure out why, since Germany has had many reforms which France hasn’t, France still consistently continues to grow more rapidly than Germany. Paraphrasing Clinton I would say, it’s the demography, silly!
France is much younger than Germany (fully 6 years in median age terms 39 to 44). France won’t be where Germany is now for another twenty years, and maybe not even then if they attract immigrants.
Same goes for Spain and Italy. The difference in ages is more or less like Germany and France. Spain was about to age very rapidly indeed, but thanks to very cheap (in theory excessively cheap, this could tturn into another example of the law of unintended consequences) finance from the ECB the working population has grown by nearly 5 million in 6 years, and the whole shape of the population pyramid has changed beyond recognition. Of course this has associated sustainability issues. We will see.
“The government of Fernando de la Rua tried very seriously to limit spending and borrowing in 2001, but due to the rapidly deteriorating economic situation, tax revenue repeatedly came in worse than expected, leaving de la Rua’s team not much space to manoeuvre.”
I think you have understood what happened in Argentina admirably. And you understand that Prodi could become the de la Rua of Italy. It is important to bear in mind that many people inside Argentina were big winners from what happened, and there is no shortage of people knocking around who could profit from chaos in Italy.
Such interests hedge their bets, but animate hostility to the de la Rua/Prodi character. This is why they publicly blame Prodi for Italy’s entry into the euro, or make speeches saying ‘the euro has been a disaster for Italy’ (Berlusconi himself, remember).
Also remember that Maroni claimed all along that Berlusconi was fully informed about what he was doing. The Lega was, of course, a coalition partner, and coalition partners can sometimes be used to say things that the main party finds it inconvenient to say directly, but at the same time doesn’t disagree with in principle. Politics in Southern Europe isn’t quite the same as in the North.
So some are watching and waiting, if things go well they may hope to take advantage of any improvements in the economy to get back into power, and if things go badly, well they have all their arguments prepared.
“It would be other Europeans who lose their money invested in Italian bonds”
Oh, I think it could even become much bigger than this. You have to remember that the eurobond market is enormous, and that the global bond markets are tightly interconnected. This would send reverberations round the globe. Also you have to think about Japan (and Greece, obviously, but Greece is comparatively small beer). Anything which made clear that what has been happening in Italy was unsustainable would probably produce a long hard look at what is going on in Japan.
If what I fear will happen in Italy does actually happen then this will mark a major turning point in something.
Maybe my memory faults my other comment actually referred to the (thought it had been yours) proposal for regional stabilization to centralise the corporate tax take on the European level rather than just having some type of regional transfer system – though unemployment insurance is certainly the right thing on the payout side.
@David F. Milleker:
No, your memory does not fault you. Daniela and me proposed both: An unemployment fund and a centralised corporate tax. See the SWP paper link above.
Maybe it is not only Italy facing the conflict of the internal and external anchor. If you take a look at Portugal, for example, you will find a tricky macro situaion, too. Since Portugal’s output gap performs below EMU average and aggregate (core) price level is higher than EMU average, the appropriate policy coordination seems not to be clear. Moreover, inflation dynamics are not due to convergence processes or due to national demand growth. Inadequate wage growth pushed inflation. Thus, regaining competitiveness needs -like in Italy- a deflation.
@Felix Geiger:
Thanks for pointing to Portugal. I’ve been arguing in several presentations that this is the prime example for things to turn sour with EMU. Especially since Spain seems to be heading in much the same direction as can, for example, be seen from the sector financial accounts.
@all
However, I’d also like to stress that deflation in Italy or Spain is only the first order condition if we assume continued wage deflation in Germany as a given. That is not necessarily the case. In this respect, I do favour Heiner Flassbeck’s suggestion that Germany has to reflate wages thus making the adjustments in affected countries easier. That, however, would make it of prime importance to see more strike activity as suggested by Robert von Heusinger in the Herdentrieb blog.
I don’t know if anyone has pointed this out (just emerging from a very busy summer), but this whole thing was covered by Joachim Fels way back in January 2004: Euro Wreckage, a piece he wrote for investors warning them not to get too bullish on the euro. It’s all there, including problems with contracts denominated in euros. (No preview button here?)
@pantom: Yes, I remember Joachim Fels’ piece. However, his argument was quite different from what has been discussed here: Fels used to argue that the Southern Europeans might push for higher inflation and Germany and other “stability-oriented” countries might then decide to leave – a scenario that I believe is highly unlikely. Germany has a current account surplus of more than 4 percent of GDP. A new mark would surely appreciate sharply – something no German politician could want…
This is a very interesting discussion. With the Italian option of exiting EMU, the weak points that have been apparent since EMU’s beginning are now becoming manifest: the union is no optimal currency area and there are no sufficient instruments to counter asymmetric shocks.
In this week’s editorial, the Economist wrote that adjustment in Italy was only politically feasible when no-adjustment had immediate effects like during the 1992 crisis. With the entry into EMU, the economic cost of no-adjustment are getting higher, but the political costs even more so because simple nominal devaluation is no longer an option.
So, what policy options are available?
First, adjustment seems highly unlikely politically. The coalition is too weak and cuts in the budget deficit will be vetoed by some parties in the coalition. Thus, outright real devaluation – which is even costlier in political terms will hardly be an option (Remember, German real devaluation relative to other EMU-members with its cuts in welfare programmes and stagnant wages did lead to new elections). The more so as real exchange rates would not only have to grow at a slower pace but would have to sink in absolute terms. Such a policy has not been applied in Europe since the 30s in Great Britain (correct me if I’m wrong here) – you know the consequences.
Second, if Italy really exited EMU, devalued and then defaulted, financial contagion would be likely to affect Portugal and Greece, but also the new EU member states of which some already have real problems with their budgets and face capital flight (Hungary is a case in point). Given strong trade and financial links to the richer countries in EMU, this would have grave consequences for the whole union.
Third, as these two scenarios are very unlikely to realise, then another option would be a real appreciation in Germany. I think this would be the option with the lowest costs for Italy and the union and give other members with problems in competitiveness some breathing space.
However, economic ideology and vested interests that favour wage restraint are still dominant in Germany’s public discourse. People like Heiner Flassbeck are laughed at in the political arena and in important parts of German academia. Plus, German exporters, who represent a big part of the German economy, are benefiting from real depreciation. But even if politics would agree to higher wages, it is not in their hand, but depends on industrial relations – the unions and the employers. Will European solidarity be high enough to change wage policy?
There is also an external constraint: In the short run, the ECB will see higher wages to cause higher inflation. So, given the Germna VAT raise next year, higher wages are no immediate option if one would like to keep interest rates low.
All things considered, what is the most probable scenario?
Best,
Kramladen
Hi Sebastian,
Wolfgand Munchau today has this:
“The long-term viability of the eurozone has become a hotly debated topic. The blogs are full of it. ”
I wonder who exactly he was reading
.
Incidentally I am convinced looking at the French industrial output data today that the Eurozone is now slowing. Basically nearly all the pundits are reading this wrong.
And don’t miss Germany’s (dis-)inflation figure today.
More rot. What is the proportion of Italian Government Debt held by foreigners? Facts and figures please. Italy has always funded its Government Debt domestically. High private sector savings rates and a high level of Government debt is how the Italians play the game. They don’t pay taxes where ever possible and they expect a lot of Government services (roads, free medical care, free education, large pensions etc.). They are not prepared to pay for this by passing the money to the Government in the form of taxes but they are prepared to LEND it by buying Government Debt. Hence the term: BoT People.
Italy is still competitive. It does not run a massive trade deficit with the rest of the world (unlike say the U.K. or the U.S.A.) and any recent deterioration in its balance of trade has largely been due to the rising price of OIL. Devaluation would go nowhere to solving its structural problems which revolve entirely around the reform of the public sector.
Populist politicians (care to name a few?) are mostly the type of ignorant lay-abouts that the Italian Public sector has absorbed – as a sop to high rates of domestic unemployment – for years and years. They are part of the problem. No, they are in fact THE problem. If Italy wants a quick fix it would do well to cut their benefits, reduce their pensions and give them proper jobs (not that they would be capable of holding one down). If you listen to these people it is because you enjoy their rantings, not because they actually say anything worth hearing.
Quoting Morgan Stanley:
“A euro that is at risk of falling apart one day is unlikely to rival the US dollar’s reserve currency status.” 22 January 04
Indeed, and that is what the U.S. fears: the emergence of an alternative reserve currency. With a massive external deficit to finance and a low domestic savings base the U.S. has a whole lot riding on its ability to MAINTAIN its reserve currency status, despite the obvious fact that economic fundamentals have eroded international confidence in the USD. So, as per usual, the strategy of choice is to try and undermine potential external threats (the Euro as a reserve currency) rather than address domestic economic problems.
@Paris ib
Well, yes you have a point about the US’ interest to maintain it’s status as the world’s reserve currency. But the funny thing is that the euro area seems not really inclined to take the status of a competitor. Just remember that respective members of the ECB council are not even lukewarm but even hostile to the idea. And think of all those close-to-Bundesbank analysts being strongly opposed to it. Just to give you an example: Thorsten Polleit of Barclays Capital stated a few weeks ago that the proper alternative to the USD would not be the euro but gold.
Why the reluctance: Well, a reserve currency country has just two options: Printing money or running current account deficits to provide sufficient money to the external users (Triffin dilemma). That’s hardly compatible with EMU’s institutional setup, is it?
I agree that the EEC did not set the Euro up in an attempt to challenge the USD’s status as a reserve currency. The Euro was set up in order to eliminate foreign exchange risk and to further promote trade in the EuroZone. THAT is not the point.
The point is that the USA obviously has concerns about any potential threat to the USD’s status as a reserve currency because of the USA’s enormous external funding requirement. The USA economy has become dependent on the inflow of basically risk-free foreign capital. Foreign debt is denominated in USDs and so the risk lies with the foreign holders of that debt in the case of USD devaluation. The world is currently looking for an alternative to the USD as an international reserve currency becasue the present situation is clearly unsustainable. And the USA looks vulnerable.
Europe is not seeking to undermine the USA or of the USD as an international reserve currency. From where I stand the USA is perfectly capable of doing that all by itself. Bush just accelerated that trend so that it is now travelling at the speed of light.
@Paris ib
I don’t disagree that the USD’s international position is likely to erode over time and that the US is to some degree worried about that.
However, my point is that as long as EMU is not only unwilling but actively denying to take the position of an alternative, it is not going to happen that the USD is properly challenged.
Apart from that, there is no denying that the EMU’s internal problems with economies drifting precariously apart has to sort out how to stop Germany’s beggar thy neighbour policies.
Everyone has problems. Some are worse than others. And this idea that “economies” are “drifting precariously apart” is rot, quite frankly. What on earth do you mean? More and more trade is taking place within Europe, within the EuroZone and there is more integration, not less. And economic conditions are IMPROVING in Europe, despite all the nay saying in the press.
As for the USD losing its reserve status, let me remind you that Sterling lost that status with no help from anyone else. Economic decline and mismanagement were sufficient. That’s how it works. That’s how it has ALWAYS worked.
Excuse me. Just look at the case of Portugal to see what “drifting precariously apart” means. Since 2001 this country is moving in and out of recession, yet inflation and wage increases are continually above EMU average and the current account deficit is thus getting worse every year. That’s definitely not what the doctor ordered to get the economy moving again. For deteriorating competitiveness is certainly not getting the private sector consolidation process needed to gain traction again.
As for the pound sterling and its reserve currency status. Well, I suppose you are going to argue now that World War II and the raising of necessary funds was not anything external but “economic decline and mismanagement” on Britain’s part.
As for myself, I’d argue that many of the UK’s post-45 economic hickups were related to the flooding back of GBPs from the rest of the world AFTER Britain could not maintain its reserve currency status which in turn was the result of a) high levels of debt for financing the war and b) US pressure to dissolve the empire.
I don’t follow the ins and outs of the Portugese economy and I don’t think its particular relevant to this discussion. Portugal is not a major economic power in Europe and its problems are not central to the European project. Perhaps you wish to discuss the possibility of Portugal leaving the Euro? Or Spain? So whenever your argument appears weak just shift the terms of the debate. You never now, as a strategy it just might work. At any rate I would appreciate more facts and less blab.
War was part of the British decline. But British arrogance and over reach went further than that. The misadventures of the USA in Iraq and Afghanistan are part of the USA’s problems right now. Bravo for noticing. The cost of war in Iraq and Afghanistan has enormously increased the U.S.A.’s external funding requirement. But U.S. savings were dismally low even before these foreign misadventures. The U.S.A. has mismanaged both domestic economic policy and foreign policy and, as a direct result, it has undermined its own international standing. It did all that entirely on its own with no help from anyone else. This mismanagement has contributed to weakening of the USD and to increasing lack of international confidence in the USD as an international reserve currency. Hence the resurgence in GOLD.
As for “US pressure to dissolve the empire”. Please explain. This is just more vague blab. When a void is created it is filled. When Britain fell into decline, other powers emerged to take its place. It’s called history. As the success and importance of the USA declines its place will be taken by some other area. That’s how history works. It doesn’t mean that the emerging power has to conspire to global domination or some other conspiracy-type nonsense. The Euro could feasibly take the place of the USD as a global reserve currency without Europe necessarily pushing that agenda.
Now my dear “I don’t follow the ins and outs of the Portugese economy and I don’t think its particular relevant to this discussion”, perhaps it would not be too bad if you would try to digest those numbers:
Current account balances as percent of GDP in 2005 (from IMF Economic Outlook September 2005):
Portugal: -9.3
Spain: -7.4
Greece: -7.8 (o.k. that was of course before they included prostitution in the GDP figure)
USA: -6.4
Actually, I do disagree that it should be irrelevant to the future of EMU if you have CA balances that are a lot worse than the US’ especially since the easy way out (devaluation) is blocked and there is no other regional offsetting mechanism. This is “not shifting the debate” but pointing to different examples of the same kind.
As for the “US pressure to dissolve the empire” please look to the Atlantic charter or Roosevelt’s speech on the four freedoms, the diplomatic intervention during the Suez crisis 1956 or the US stance during the Falklands war of 1982.
Apart from that Henry Kissinger’s Diplomacy might be some good reading (and just to make sure you don’t have to point that out, I know that he is both American and a Jew).
In addition to that, I’d like to point out that I do not consider the euro to be part of an anti-American conspiracy but nonetheless it might help to get European institutions fit for the single currency before the example of Portugal repeats itself in Spain, Greece or Italy. I consider this blog to be exactly about that question.
So now we are not talking Italy out of the EEC (always a ludricous proposition) now we are talking: Spain, Greece, Portugal? Are you serious? No I guess not, just shifting around in the shallows of a spent argument.
We could argue the various external positions of a lot of countries in the EuroZone, hell we could even go into the current account positions of various regions. Is it relevant? No it is not. As a whole the EuroZone does not run a large external account deficit. That’s what counts as far as the Euro is concerned. Although, as you have pointed out:
“a reserve currency country has just two options: Printing money or running current account deficits to provide sufficient money to the external users”…..
so obviously running an external deficit is not necessarily incompatible with becoming a reserve currency. Although I think the “printing money” option you mentioned is debateable. What is incompatible with remaining a reserve currency is running the type of external deficit which the USA is running, and has been for so long, together with the totally clueless economic and foreign policy management of the current U.S. administration. The USD is going the way of the Pound Sterling. Why on earth would anyone want to hold it when it’s an accident waiting to happen? And as for GOLD, well obviously keeping your ear to the ground on that one. The move into Gold has only been going on for the past four years or so. Boy what an interesting new factoid. Not.
Fact is that this debate has run its course. Italy is not a candidate for Euro exit, does not run an external deficit (neither current account or trade) has not accumulated a large external debt position, does not rely on foreign savings and (despite the whinging from various Italian politicans during election campaigns) is not in a parlous economic position. That was my interest in this thread. Everything else can and should be somewhere else.
Could you please stop accusing me of something that is not my position. I have never proposed taking anyone out of EMU but pointing to the build up of disequilibria in a number of countries and I strongly agree with Sebastian that – given the lack of a regional offsetting mechanism -EMU might blow up under current institutional arrangements.
Just in order to help your memory here is again my posting of September 13 10:29 on the Italian exit: “I suppose that discussing options for EMU-exit cum default or sine default, really makes a lot less sense than putting resources into dicussing how a post crisis regime could or better should be like. Which is probably getting us to the design of either a fiscal transfer system and/or a stabilization fund. Apart from the more structural approach of removing migration barriers still build into the mostly not fully portable social security systems.”
As for the other arguments: Running an external deficit or having a built-up of excess liquidity is the result of being a reserve currency. And both are, as you have put it, accidents waiting to happen. I suppose that the 1970s inflation problem in the US was just the opposite side of the coin to today’s external deficit.
And just before you start misinterpreting me again: As a normative I personally would very much favour the euro to become the world’s main reserve currency. But that goes hand in hand with the acknowledgement that EMU is not working properly and therefore we need to change its institutions to make it fit for the future. Even if it were just for not denying 10 million EMU citizens (the Portugese) the necessary relevance to European society.
A single currency can not be micro-managed to suit all the countries which come under its umbrella. The advantages of the single currency, however, tend to outweigh the disadvantages. Hence the slight of hand used by countries like Greece to gain entry in the first place. All the Euro nay-sayers are basically complaining that the system is not perfect. Why they thought it should be or could be right at the get go is beyond me.
Italy is one country which has greatly benefitted from the introduction of the Euro. The United States, however, is likely to be less pleased about the emergence of the Euro as a potential rival to the USD’s reserve currency status.
[...] One of the hottest topics in the debate on Eurozone economics over the past months has been the question whether dangerous divergences are building between the 12 countries which share the euro. In fact, the fear that some countries might have lost competitiveness to a dangerous degree has been behind scenarios of countries leaving EMU (there has been a lively debate in the blogosphere and on Eurozone Watch – see here and here and here). [...]