Article / 28 November 2014 at 14:14 GMT

Sorry Mario, the euro area is doomed

Blogger / MoreLiver's Daily
  • 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

By Juhani Huopainen

Yesterday, the European Central Bank’s president, Mario Draghi, gave a speech in Helsinki titled "Stability and prosperity in monetary union".

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. 

I’ve always thought that Draghi is a relatively sane, honest and pragmatic central banker. This speech is thus particularly hard for me to swallow.

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.

The eurozone is still mired in low growth and high unemployment. 
Photo: Jasper Juinen \

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. 

I’ve argued for a long time that if UK would have been in the euro, it would be in a worse shape than Spain. No one, including the International Monetary Fund, has a strong view on how such flexibility should be done without it being too costly in economic terms.

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.


Juhani Huopainen is a blogger and a macro analyst at More Liver’s Daily. Follow Juhani or post your comment below to engage with Saxo Bank's social trading platform.
Mickette Mickette
Juhani, you are a great analyst.
Juhani Huopainen Juhani Huopainen
I kind of think the above text is obvious. Perhaps one ingredient of the socalled greatness is speaking one's opinion. Half of success is showing up?
LeTaulier_Lmi LeTaulier_Lmi
It is strange that nobody speaks any more about the sword of Damocles hanging over the Q.E. of the E.C.B. I mean the awaited decision of the German constitutional court.
What will happens if the 8 judges of Karlsruhe consider that the Q.E. is in breach of primary EU law and forbid the Deutsche Bundesbank to participate to this operation.
Juhani Huopainen Juhani Huopainen
The ECJ discusses the legality of OMT, not the current or planned bond purchases. The ECB could do QE without the participation of Germany, if it would come to that at some point. Or there would be strong conditionality and limited amonts, or clearing the decisions beforehand with the German parliament. So while it might make things more difficult, it would not make them impossible.

Two old articles on ECJ / GCC: and
Juhani Huopainen Juhani Huopainen
And yes, one scenario is that Germany is forced to leave the euro area. While it would probably kill the euro, it would make a lot of sense for Germany to exit, if done properly.

Remember the Plaza accord in 1985? It was easier for the US to devalue instead of all the other major countries to revalue. Similar effects in many other FX regimes in the past. Instead of trying to make everyone adjust, let the one in most need of adjustment adjust. Would be whole lot easier than letting half of the euro area go.
LeTaulier_Lmi LeTaulier_Lmi
Hi Juhani,

Of course legally and technically ECB could do QE without the participation of Germany. But this scenario would imply that the financial weight of this operation would be supported by France and Italy..."the two the sick men of Europe".

If Germany would leave the euro area, no doubt that it would kill the euro. But the great fear is wouldn't it kill the U.E.?
Juhani Huopainen Juhani Huopainen
I think there is a danger in the European rhetoric that "euro is irreversible" and "euro is the same as the EU". It would make much more sense to highlight that not all EU-countries are in the euro. Killing the euro would make sense for economic reasons. I would argue that keeping the dysfunctional euro in place and associating it strongly with the EU is an existential threat to the EU.
LeTaulier_Lmi LeTaulier_Lmi
I don't think that "euro is the same as the EU" which is a point of view especially for the people leaving in a eurozone country. But "euro is irreversible". It is not an opinion but a fact. To leave Euro is an impossible mission. As you know there is only two exit ways. Leave the U.E. or 28 countries to agree!

I am a French but I should admit that French politicians are the main responsibles of the euro problems. They were so afraid to stand alone facing Germany and others Germans countries that they did impose the participation of "our Latin little brothers" and Greece which were not ready for a common currency (sometime I even think that France itself was not ready).
Juhani Huopainen Juhani Huopainen
I disagree on the EU/euro linkage and the irreversibility. ECB promotes your view: 2009 "Withdrawal and expulsion from the EU and EMU – some reflections" 2009
Juhani Huopainen Juhani Huopainen
1) I'd like to remind you that Italy and Netherlands have previously threatened to leave the euro area - thus, such unilateral action is clearly possible, as threats would not be made nor taken seriously unless they were realistic. 2) Agreements are made to be broken or amended later. 3) Should, say, Germany decide to leave the euro area, do you think they really could not remain in the EU, or if for legal reasons they would have to resign first from the EU, it could not be solved by resigning and joining back within a weekend?
LeTaulier_Lmi LeTaulier_Lmi
1/ Lot of politicians did threaten to leave the euro area. The specialist was Berlusconi but he never made his actions correspond to his words. In fact the opposite did happen, he was removed from his functions. Even Marine Le Pen never said that France should leave unilaterally the euro.
2/ Of course "Agreements are made to be broken or amended later" but the agreements we are speaking about need the unanimity to be changed . I don't say it is impossible but very difficult. The only agreement which need no unanimity is to leave E.U.
3/ I don't say Germany could not remain in the EU if they decide to leave the euro area. Maybe the 27 others countries would agree with it. I just say that E.U. is not a Hotel you can leave or enter at your convenience.


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