After several rounds of contorted financial engineering proposals by all worthies, the first time one came across a discussion of the real issue in the euro zone—competitiveness, and internal real exchange rate misalignment—was in an article by Martin Wolf in the Financial Times last week (“Thinking through the unthinkable”, 8 November).
Smaller euro zone nations—let us include both Italy and Ireland in this—received a windfall in terms of cost of capital when they joined the euro zone. They got a stronger currency. One could have offset the other had the fall in the cost of capital led to productive investments. The productivity improvement would have offset the loss of exchange rate competitiveness. However, ultra-low interest rates never result in productive investments since they completely eliminate any incentive for savings. They only help boost asset prices through speculation. That is what happened in the euro zone.
Low interest rates led to credit and housing bubbles. The rise in leverage kept their economies humming. Governments—some and not all—did not bother to cut deficit and debt since they assumed that low interest rates were there for ever. Debt boosts growth, but countries do need growth to achieve a sustainable decline in debt. Cutting debt burdens now would only result in reaccumulation of the same if no sustainable avenues for growth are found. The strong euro, without any economic restructuring and productivity gains, precluded foreign investment in these countries and eroded their competitiveness. Competitiveness can be restored, in theory, through painful austerity, as it ushers in deflation and squeezes nominal wages. But it is politically impossible as it is socially disruptive. Further, even if such austerity were essential, it needs offsets. The offset for crisis-ridden euro zone countries has to come through a massive depreciation of their currency to go along with restructuring and fiscal austerity.
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However, the euro zone, particularly Germany, is ambivalent about a substantially weaker euro and it is not clear if it would meet with the approval of the friendly ally across the Atlantic that has the monopoly on fiat money debasement. Cutting these countries off the monetary union and allowing their re-established national currencies to depreciate is fraught with many unknowns. We do not know where depreciation would stop. Iceland appears to have gotten away with it so far, but these are early days. It cannot be experimented with bigger nations like Italy and Spain.
The better thing is to create two euro-currency areas. One is the Euro-mark and the other is the Euro-II. “Euro-peso” will have image issues. It Is best to allow these countries—Spain, Portugal, Italy, Greece and Ireland—to adopt the?Euro-II.?France should think deeply about joining this. It might be better off doing so.
The Euro-II would weaken. But, at the formation, a wide band can be announced for the exchange rate of the Euro-II vs Euro-mark. It would be credible if all the world’s leading central banks pledge to use their resources to defend the Euro-II. Further, “moral suasion” (= midnight phone calls) on the part of euro zone authorities on speculative forces—investment banks and hedge funds—would be needed and should be applied. It might make them lose their sleep, but most of them deserve to lose their sleep. Enhanced regulatory scrutiny can take care of those who refuse to cooperate. The hedge fund industry needs to consolidate, in any case.
This would allow the Euro-mark to appreciate against the dollar. That is what the US needs in more ways than one. The world gets back a credible reserve currency competitor. China exports would be uncompetitive in Euro-II countries and these countries would be able to boost exports and attract direct investment and technology from Euro-mark and other nations. China can safely diversify away from its dollar holdings into Euro-mark without jeopardizing the entire euro zone as it is doing now, with its euro purchases. The Euro-mark would appreciate, but the countries behind the currency are used to strong currencies and disinflationary environments. They believe in productivity and they can and will adjust.
The solidity of the bonds between the Euro-mark and the Euro-II can be enhanced over the years, depending on the progress of economic restructuring in Euro-II countries and strengthening of European institutions. Discussions on fiscal union that includes surrender of fiscal sovereignty and fiscal transfers between European countries can take place without an acrimonious backdrop. There need not be a timetable for the reintegration of the two currency areas. Haste did not help the last time around.
It is important to come up with this new arrangement at the earliest, but without announcing a time frame (speculators would push up the euro if a date was fixed for announcing the conversion rate between the Euro-mark and the Euro-II), for it would demonstrate to the world that policymakers have grasped the nettle of rebalancing and restoring competitiveness and abandoned the reflexive embrace of liquidity and financial engineering—the twin legacies of American financial capitalism of the last three decades.
V. Anantha Nageswaran is a senior economist with Asianomics. These are his personal views. Your comments are welcome at firstname.lastname@example.org