Eurozone economy. Viability of monetary unions

Summary:

On 17 December 2020, the Rafael del Pino Foundation organised a dialogue entitled "The Eurozone Economy. Viability of Monetary Unions", with the participation of Luis de Guindos, Vice-President of the European Central Bank; Pedro Schwartz, Professor of Economics at Camilo José Cela University, and Juan Castañeda, Professor of Economics at the University of Buckingham and Director of the Institute of International Monetary Research (Buckingham), on the occasion of the publication of the work by Juan Castañeda, Alessandro Roselli and Geoffrey Wood entitled "The Economics of Monetary Unions. Past Experiences and the Eurozone", published by Routledge.

Pedro Schwartz began by commenting that the European Monetary Union has withstood great difficulties in its short life. It is still alive because it is transforming itself.

In a roundabout way, the gold standard is the model that the euro has tried to replicate to make a monetary union. The gold standard was a very successful monetary union.

Desirable convergences within a monetary union follow the rules of the 19th century, especially those of Bagehot, who wrote "Lombard Street" and defined how the gold standard worked. What policymakers have to look at, first of all, is what Bagehot called the hedging ratio, that is, how much international currency the different members have to have so that there is no danger of people fleeing the euro, both at home and in the rest of the world. Then there is the concern ratio, which reflects when things start to get so bad that action has to be taken.

The question of how to organise the euro arises as to whether to make it an automatic system like the gold standard, or whether for other reasons to change to a system in which none of the members of the monetary union is forced to leave the situation. The question must now be asked why the Maastricht rules on which the euro was founded no longer apply. They do not apply because it would have meant Greece's expulsion from the euro. And since the euro is new and is building its reputation, an exit by one of its members would have endangered the euro. In this context, the question is whether we should create a fiscal union to accompany monetary union.

Now, just as we were recovering from the 2008 crisis, the Covid-19 crisis has arrived, which has disrupted the ECB's monetary policy, prolonging interest rates towards zero. The money supply in Europe and the United States has grown to extraordinary levels. The obligation to reduce government deficits to below 31GDP Q3 of GDP has been suspended. The ECB has been allowed to buy government bonds indirectly, which is a change in the Maastricht conditions. Finally, it remains to be seen whether the European funds for recovery will be conditional, whether they are given blindly or whether a way of reorganising the economy is imposed. The question, therefore, is how to return to a normal monetary policy after the liquidity mess that the ECB has created in the euro zone.

Juan Castañeda discussed how optimal the euro area is compared to other economies. To do so, Castañeda and Schwartz calculate a macroeconomic convergence index based on twelve macroeconomic indicators for the euro area. They start by calculating the standard deviation to try to estimate how convergent or divergent the economies of the euro area countries have been in relation to these twelve indicators.

These twelve indicators are grouped into four sub-indices: those relating to a country's business cycle (GDP, GDP per capita and unemployment rate), those relating to competitiveness (CPI, labour costs and real exchange rate), public finances (rates of change of deficit and public debt, as a percentage of GDP) and monetary indicators (rates of change of money growth, credit to the private sector, current account balance and Target2 balances).

To calculate the index, the base year is 1999, the year of the creation of the euro, and the standard deviation is calculated for each year and for each of the countries that formed part of the euro area at that time.

Dispersion is calculated in two alternative ways. First, the standard deviation of the unweighted Eurozone average is calculated, as if the dispersion of each member state mattered the same. The second way is to calculate the standard deviation from a mean weighted by the economic weight of each member state in the Eurozone.

Both forms of calculation are relevant. With the first, the dispersion in economic growth and public finances is quite low. The lessons from the euro since 1998 are quite positive. The bad news comes from the monetary indicators because dispersion has increased, especially since the 2008 crisis. And dispersion in competitiveness indicators has grown even more. In this case, the differences in wages, in prices, in the real exchange rate, have been much greater, both before and after the crisis.

If the information on these four indicators is aggregated into an aggregate dispersion index, the unweighted dispersion shows that already before the crisis the dispersion had already increased a lot. Thus, the situation was already not good before the crisis. After the crisis, these differences between countries became more pronounced.

The weighted dispersion indices are then calculated. In this case, the evolution of the Eurozone has been much more symmetric, but after the crisis it returned to better values than before the crisis.

These results are then compared with other comparable currency areas, and the same method is applied to calculate the same indices in two other currency areas, the US dollar and the UK pound sterling. The comparison is not straightforward because in these areas there is a common budget and monetary union has been in place for many years. The results indicate that the worst performing economy in terms of dispersion has been the Eurozone, both before and after the crisis. The US economy has not performed well either, but it does not reach the dispersion levels of the Eurozone. The most symmetric has been the UK. With weighted indices, the dispersion of the euro area is similar to those of other economies.

It makes sense to do the calculations both ways, because if you are living in a small economy, such as Greece, Cyprus or Portugal, and you see that your unemployment rates are very different from those in the Eurozone, and that monetary policy is not really helping you to solve those problems, it matters a lot economically and politically. The euro would not facilitate the convergence of its members and hampers the ECB's role as the maker of a single monetary policy for all member countries.

So, which way to go? There are two models. One is the Eurozone as a centralised state, in which macroeconomic policies are more harmonised. This would imply a mutualisation of debt, a fiscal union and the issuance of European bonds. This would turn the ECB into a modern central bank, i.e. a central bank willing to help its state. This seems to be the way forward.

The other way is a Maastricht-style decentralisation, in which fiscal policy would be a fully national competence, with each state responsible for paying its debt, in which there would be no bailouts. There would be the possibility of suspending a member state, even expelling it. This option has not been tested.

Luis de Guindos recalled that the ECB is the central bank of a monetary union made up of nineteen countries, which is a monetary union that is not complete. The Banking Union lacks the existence of a single deposit guarantee fund. Nor do we have a single capital union. We have a dispersion of rules, for example, on the taxation of savings or on insolvency situations, which makes it very difficult to have a single capital market.

Then there is the issue of fiscal union, which is the most important. The recovery fund that was approved in July to deal with the pandemic is certainly a very important step in the right direction: for the first time there is a joint debt issue, part of the transfers are no longer refundable and the distribution of the money is done according to what the damage has been in each of the countries.

It is very important that the possibility of a Member State leaving the euro area was never accepted. The tail risk, which would have had devastating consequences for the monetary union, was eliminated. This shows the enormous political capital behind the euro, which should never be underestimated.

In the current situation we are faced with an exogenous shock, which has produced a health shock and a fall in GDP of an intensity and with a speed unprecedented since the end of the Second World War. Between March and May, GDP in the euro area fell by almost 12 points. The financial impact of this is important because, unlike other crises where the financial squeeze comes from the banking sector or from monetary policy tightening, in this case it comes through companies, with a very sharp fall in turnover in a very short period of time. Then, as de-financing takes place, activity levels recover.

It is a shock that has been common, but whose consequences have not been identical. There were economies that were more exposed to the tourism sector, or that had less fiscal leeway, which are those that have suffered the most from the impact of the pandemic. This leads to a first consideration: to deal with this dispersion, the appropriate instrument is fiscal policy. In the first instance, fiscal policy has to be national. But, given the different fiscal space in the different countries, it could not be homogeneous and could not lead to fragmentation from the point of view of fiscal policy. That is why the approval of the recovery fund has been fundamental. Here we can differentiate between the comparative situations of the different countries from the point of view of impact and recovery.

The contribution of monetary policy has also been very different from that of the previous crisis. In this case, monetary policy reacted quickly, through three pillars: making very large amounts of liquidity available to banks on very favourable terms, the targeted debt purchase programme and macroprudential measures to make it easier for banks to use available capital to extend credit.

From the point of view of the impact of financial conditions, the ECB has been successful. There has been no fragmentation of the sovereign debt market, which would have been tremendous. Financing conditions have even remained more favourable than they were before the pandemic. This has prevented the health crisis from being superimposed on a debt crisis. The ECB's action is allowing governments very moderate financing costs to carry out the first line of action, which is fiscal policy.

The future necessarily lies in further integration. It is essential to complete the institutional structure of the euro. We still have national banks, there are still very few international transactions within the euro area in processes of bank consolidation, which shows that there is still something that prevents us from having truly European banks. It is essential to have a single capital market in the euro area, especially after Brexit. London and the City are the capital union of the Eurozone and with Brexit this will change. This requires measures to be taken at national level for harmonisation purposes, especially of tax regulations and insolvency regulations, which are not always straightforward, to achieve capital market scales that allow us to compete with the world's major capital markets and to provide financing to European companies and families on the best possible terms.

Finally, the creation of a pan-European institution to conduct a common fiscal policy is not a simple matter, where a parallel process between risk reduction and risk sharing still needs to take place. Sooner or later it will happen because, if one looks back over the twenty years since the launch of the euro, one can see that the integration process has always been moving forward.

The Rafael del Pino Foundation is not responsible for the comments, opinions or statements made by the people who participate in its activities and which are expressed as a result of their inalienable right to freedom of expression and under their sole responsibility. The contents included in the summary of this conference are the result of the debates held at the meeting held for this purpose at the Foundation and are the responsibility of their authors.

The Rafael del Pino Foundation is not responsible for any comments, opinions or statements made by third parties. In this respect, the FRP is not obliged to monitor the views expressed by such third parties who participate in its activities and which are expressed as a result of their inalienable right to freedom of expression and under their own responsibility. The contents included in the summary of this conference are the result of the discussions that took place during the conference organised for this purpose at the Foundation and are the sole responsibility of its authors.

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