Escaping from the Golden Fetters

An intermediate to currency disunion

The prospects for the Eurozone look bleak.  CDS spreads are going up, large countries have downgraded debt, politics is turning against fiscal consolidation, and the central bank still feels trying to save the Euro would jeopardize (what's left of) its credibility.  This has led to widespread pessimism about the long-run sustainability of the Euro, including from my fellow soon-to-be-undergraduate blogger Evan.  But, we must remember that "The long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is past the ocean is flat again."  Our goal for the endgame of the European economy is irrelevant if sovereign debt crises interrupt our theorizing.  Especially given the precipitous state of several other key economic powerhouses, such as India and China, adding a large scale currency adjustment hardly seems like a credible option.  The sheer physical demands of such a transition would make it nigh impossible to create an orderly transition.

Thus, even if all the nations are bound by the "golden fetters" of the Euro, simply abandoning the fetters is not a sufficient answer.To begin this walk away from the abyss, there needs to be more room for national policy in a continent that is otherwise deeply integrated.  The apparent struggles of the Eurozone are a particularly interesting case of what Dani Rodrik calls for in a path to a saner globalization.  We cannot let the perfect become the enemy of the good, and therefore let a potentially destabilizing deep integration get int the way of the many beneficial forms of shallower integration. Nations are different; why shouldn't their laws be the same?  In the words of Rodrik:

We have to think of these differences not as aberrations from the norm of international harmonization, but as the natural consequences of varying national circumstances.  In a world where national interests, perceived or real, differ, the desire to coordinate regulations can do more harm than good.  Even when successful, it produces either weak agreements based on the lowest common denominator or tougher standards that may not be appropriate to all.  It is far better to recognize these differences than to presume that they can be papered over given sufficient time, negotiation, and political pressure (The Globalization Paradox, 262).

Too often, attempts at harmonization result in policies that are "one size fits none."  Interest rates or macroprudential requirements may be too high in one polity, too lower in another, thereby aggravating the procyclical tendencies for both.  Stricter fiscal pacts and banking unification won't help; if anything, they would likely worsen the situation.

So if the Euro isn't going away in the short run, then there needs to be a way to introduce frictions to give national governments "policy space" to adjust.  This is where national macroprudential policies and potentially capital controls come into play.  Even if Eurobonds and enhanced lender of last resort capabilities are necessary, they need to be paired with policies that can ensure that the question of liquidity does not evolve into a question of later solvency.  Without national policy space, differing unit costs of capital and labor can evolve into serious financial issues, replicating the current European debt crisis.

This kind of financial segmentation would be even more appropriate given the dangerous roles of private capital flows in promoting the current crisis.  Private capital, freed from exchange rate risk and in search for higher yields, would flow from core banks to the periphery.  However, due to the poor institutional underpinnings of the periphery, there was no proper way to organize that capital (interfluidity).  In the time of adjustment, the common currency then prevents any kind of external devaluation that otherwise might have blunted the highly procyclical capital flows.  Since the currency cannot self adjust the capital flows, the governments may have to take a stronger role in ensuring that destructive capital flows don't distort national economies.

Eventually, when things have stabilized, the Euro can be steadily phased out  But with the current uncertainty and chaos, that option hardly seems viable.

Update 4/29/12:


New article from the economist that discusses the prospects for financial integration:

Breaking that interrelationship requires a number of things, Lord Turner argues. He would like to see Eurobonds that can, among other things, act as a risk-free asset that liberates banks from the “wrong-way risk” of holding their own sovereign’s debt; and he argues, too, for a pan-euro-zone approach to bank resolution, deposit insurance and supervision. National authorities should, he thinks, have responsibility for pulling “macroprudential” levers designed to prick booms before they get out of hand.

A much more integrated euro-zone banking system is a logical response to the euro crisis, but boy will it be difficult. Just imagine the implications. A big European supervisory authority that excludes Britain, the continent’s biggest financial centre; a system that would see taxpayers in creditor countries backing the banks of debtor countries; a process that could end up with supervisors in Frankfurt telling the Spanish, say, they cannot have more credit. Thorny stuff, but still better than the direction in which the euro zone is now travelling.

 But why are we trying for force all European countries into the same financial straitjacket if they're, quite obviously, Not The Same?