Low-growth Europe: some of the challenges ahead

The frequently drawn historical parallels between post-2008 events in the eurozone and monetary developments during the Great Depression of the 1930s do not make for comfortable viewing for a neighbouring EU country with inextricable economic links to the eurozone and a strong interest in its state of health.

The principal monetary doctrine at the time of the Great Depression was to try to keep the currencies of crisis-hit advanced countries pegged to gold. In other words to maintain an extremely hard version of a fixed exchange rate. With virtually nothing else at their disposal, it is little wonder that policymakers took this as dogma. So even when the asset bubble burst in 1929, the prevailing economic intellectual paradigm ordained that monetary conditions should be held tight, or even tightened further, to keep the currency fixed to gold at all costs.

This policy led to countless economic casualties – unemployment lines, failed banks and businesses, ruined economies. Only subsequently, after the best economic brains had applied themselves to the problem, did humanity wake up and understand that when the economy is at risk of strong, demand-driven deflation you need to ease monetary policy to create and supply more money, whatever the cost, in order to mitigate the impact as much as possible. At a time of crisis, anything that is fixed in monetary terms is a hindrance. In short, after the ruinous experience of hyperinflation following World War I it took a while to realise that price instability can also have an opposite side and that plummeting prices can be just as disastrous as soaring ones, with similar or even worse economic and political consequences. This is something we now should accept as canonical.

Fast forward to Europe today. It has been clear since the eurozone was created that a currency union without a state is a unique experiment, one that cannot be compared with anything that has gone before in monetary theory or practice. It has also been clear that the true strength or weakness of this experiment will only be revealed in bad times. A group of sovereign nations is sharing a single currency, held together solely by the will to share it and by a set of rules designed to enable such sharing. It’s a very appealing idea, in line with many things that frame the post-war history of European integration.

However, the reality of the first crisis in the eurozone’s history points clearly to a number of problems that need to be solved. The solutions adopted will be of key importance not only for eurozone members, but also for countries that have yet to decide about euro adoption.

First, it is not clear whether or not the EMU countries are supposed to resemble each other in terms of nominal parameters. The entry criteria are formulated in nominal rather than real terms. It would seem, then, that the nominal similarity of countries and the convergence of their interest rates, bond yields and inflation rates are desirable properties of the system as a whole. These criteria have been in place since the start of the project and between 1999 and 2008, the individual – significantly different – countries of the new eurozone started to closely resemble each other in a number of parameters, especially interest rates and bond yields (including yields on government bonds). Not many (if any) policymakers criticised this convergence when it was going on. Anyone who did was dismissed as an anti-integrationist.

Suddenly it’s 2015, Europe has been languishing in the economic doldrums for seven years, and in February we read this in the Four Presidents’ report: “Last but not least, the crisis can also be said to be a crisis of markets in terms of their capacity to price country risk correctly … investors treated the euro area as one, without taking into account diverging economic and financial risks. The crisis made these divergences transparent.” So even nominal convergence wasn’t desirable in the end? It’s an interesting take on market failure. European policymakers were previously trying to convincethe markets that convergence and “uniformisation” were a good and desirable thing, even the whole point of the project.

By the same token, at a time of crisis, when the nominal differences between countries have again widened enormously (for example in the area of government bond yields), policymakers have started looking once again for ways to “uniformise” countries, such as by establishing a banking union so that interest rate conditions and yields do not differ too much from one country to the next. Here we have an unresolved dilemma and inconsistency in the very foundation of the monetary project.

The second, related, fact is that it is genuinely difficult to create monetary policy for a heterogeneous group of countries, a group in which an economic shock has highly asymmetric impacts on individual members with largely autonomous economic policies. Net debtor and net creditor countries, and net exporters and net importers, naturally find it difficult to find common monetary ground when times are hard. This is particularly true when the government and private sectors are supposed to be undergoing deleveraging, when the debt overhang effect is very strong and when the financial sector is being subjected to a huge wave of regulation, which is acting as an anti-growth rather than pro-growth stimulus.

Consequently, a heavy load is being placed on the shoulders of monetary policy, which is in danger of becoming overburdened. What is worse, since 2008 some people have been loudly voicing the same arguments that were made in the first half of the 20th century, namely that monetary policy is useless, ineffective and should not act even at times of impending or actual demand-driven deflation (an argument I’m all too familiar with from my own country). Instead, they say, the problems should all be tackled by implementing structural reforms. Sure, structural reforms are crucial, but electorates don’t want them in good times or in bad. On top of that, there’s always a time lag before structural reforms have any effect.

To sum up, when we add together the post-2008 pressure to cut spending in all sectors of the economy, the strong regulatory pressure on the financial intermediation sector, the low appetite for structural reforms, the constraints on monetary policy described above and the fact that in reality the eurozone member states are just 20% a single zone and 80% individual countries with individual “monetary preferences” (as demonstrated by the cost-sharing principle used in the ECB’s quantitative easing programme), there are almost inevitable consequences for growth.

Now we have to find a way of dealing with those consequences without further radicalisation of the whole of Europe. Any way forward requires at least: i) no further regulatory pressure on the financial sector, ii) ending the useless debate about the inefficiency of monetary policy and iii) debt reduction where appropriate.