Sorry Mario, the euro area is doomed
- Creating fiscal space by prudent fiscal policy in the good times is unrealistic
- The quest for flexibility is too hard and too expensive
- Draghi’s recipe will only work if some can cut debt levels – this won't happen
Like most commentators, I usually do not read the central banker speeches in full, but instead rely on key points in the financial media. This time was different, as I used the rare opportunity to attend the live event, and ended up reading the whole paper.
Adjusting without monetary policy
Draghi begun by pointing out that within a currency union a single member facing asymmetrical economic shocks cannot rely on monetary policy, but must instead be able to use other adjustment channels that are at least as effective as monetary policy would be.
If these other channels would be less effective than sovereign monetary policy would have been, the member country would be better off outside the monetary union. These other channels include fiscal transfers between the member countries, counter-cyclical fiscal policy and flexible labour markets that can adjust to changes in a rapid manner.
Adjusting without a fiscal transfer union
Draghi noted that all currency areas rely heavily on permanent fiscal transfers between the richer and poorer regions – with the exception the euro area. As such transfers are not foreseen within the euro area, a different approach with two minimum requirements is needed: the ability of member countries to thrive and survive independently by being flexible enough, and some sort of communal method to alleviate the effects of asymmetrical shocks.
Draghi admits limitations of flexibility
“Economies will never be so flexible that adjustment happens as quickly as if they had their own exchange rate. There will always be short-term costs”, Draghi said. This is why, according to Draghi, communal methods would be needed, and countries would have to have sound fiscal policies and sustainable debt levels at normal times so that during difficult times they would be able to counter the asymmetric shocks with counter-cyclical fiscal policy.
The idea of creating fiscal space by prudent fiscal policy during the good times is a beautiful idea, but is really not helpful in the current situation. With large debts and legally binding limits on debt and deficit, most of the member countries do not have the opportunity to do that. But that is not everything that is wrong with Draghi's dogma.
Is the euro worth saving?
These ideas that further integration and flexibility are mandatory are founded in the assumption that the euro in itself would be worthy of all the efforts and sacrifices. This implies that monetary policy is not really that important, and a world where maximal flexibility of the labour markets and also other contractual obligations would be preferable to what we have had until now.
This view would accept large variations in nominal wages, employment of uncertain length and in general increased entrepreneurial risk for the labour force. If we assume that the euro is not necessarily such a good idea after all, the need for such highly radical flexibility is decreased – adjustment could be made via monetary policy and flexible exchange rates. Draghi’s dogma faces several real-world problems:
Flexibility is hard
Creating and maintaining flexible labour markets is hard, and has not been extensively and successfully done in any developed country. As an example, the United Kingdom let the GBP devalue by 30% against the euro at the onset of the financial crisis. If labour markets would have been the only adjustment channel left, trying to quickly lower wages in a similar fashion would have been a recipe for a disaster.
Flexibility is expensive
There is little if any economic research to suggest that highly flexible labour markets are actually good for the economy. Facing uncertainty about employment and wages, households would decrease their spending and have lower debt levels – if they would be able to get credit at all. “Flexiworkers” do not get mortgages, or if they do, they would end up paying very high risk premiums. Such changes in private spending would hurt economic activity and government tax revenues, which would worsen the debt sustainability of countries.
Is this just public relations?
In my opinion the euro area is doomed. We are not getting the transfer union, as Draghi admits. There will be attempts to create more flexibility, but the attempts will fail. Even if such attempts would succeed, their negative effects are grossly underestimated. Draghi’s recipe would work only if certain countries’ government and private debts would be cut in order to create more fiscal space. Such debt cuts are not in vogue at the moment, and the systemic risk that they would bring is enormous, as financial markets in the euro area are currently more fragmented than ever before.
Perhaps Draghi was talking to German voters by demanding that structural reforms should be directed by the European Union. Perhaps this is a public relations campaign to get Germany on board a massive quantitative easing programme in the first quarter of 2015. But questionable advice and sloppy analysis always ruins my day, even if its purpose is noble.
Sure, there is political will behind the euro, which has been underestimated by the financial markets, as Draghi said. But the political will of the leaders will eventually lose to the political will of the voters. And any political will shall lose to economics.
Draghi's speech on Youtube
Summary of the speech
The Wall Street Journal: Draghi Highlights the Eurozone’s Unfinished Business
Reuters: ECB's Draghi warns countries to reform as clouds gather over euro zone
Bloomberg: Draghi Pledges Open Mind on Asset Buying as Price Pressures Wane
The Financial Times: Draghi steps up push for economic union
– Edited by Oliver Morrison