Possible new states of EMU

Without cheap credit from the capital markets there are four new states that EMU could assume next: First, the real economy (Mundell) criteria could be met in a euro area with (most of) the present members. Second, the real economy and fiscal (Kenen) criteria could be met. Third, cheap credit from capital markets could be replaced by generous credit from the central bank. Fourth, membership of EMU could be reduced to countries meeting the Mundell-Kenen criteria. Since arrival at any one of these new states depends on the dynamics of the adjustment process some are more likely than others, and not all are stable in the long-run.

1. Meeting the Mundell criteria: The hard EMU

EMU was originally designed as a “hard currency union” of sovereign states. To achieve this, mutual financial “bail- outs“ and monetization of government debt were forbidden. Recall that the budget constraint of a government in its broadest form is given as the sum of its capital market borrowing capacity and seigniorage from issuing non interest-bearing central bank money to the general public. Seigniorage rises when inflation accelerates. Hence, in a “hard currency regime” the government must refrain from adding to its borrowing capacity in the capital markets by boosting seigniorage through inflation. But this is only possible, when the economy is flexible enough to adjust to the government’s capital market borrowing capacity without default under all circumstances.

For the GIIPS [Note that this is the polite reference to PIIGS.—Ed.] countries to restore their capital market borrowing capacity in the new environment of tight credit comprehensive measures to reduce public debt levels and improve growth prospects are essential. Greece has tried to achieve this since early 2010 but may yet fail. Portugal’s response has been more convincing but success is still highly uncertain. By contrast, adjustment seems to progress in Ireland. Yet, the battle to save EMU is likely to be won or lost in Spain and Italy. In the former, where public debt levels are relatively low and only a part of the banking sector is in trouble, a new government seems to have a decent chance within the coming four years to make the country fit for a hard currency union by de-regulating the labour market, recapitalising the weak savings banks, and bringing government budget deficits down. In the latter, the new government’s job is harder as public debt is higher, past economic performance poorer, and the available time for the government much shorter (i.e., only a bit more than a year until the next elections in May 2013). Without a significant reduction in capital market rates, the government is unlikely to overcome recession while at the same time cutting government spending, reforming the social security, tax and education systems, de-regulating the labour market, and increasing competition in goods and services markets.

In the event, a “hard currency” union in which participating countries meet the real economy (Mundell) criteria would represent a stable future state of EMU without cheap credit. The problem is how to get there. Achieving the necessary flexibility in most of EMU may well take more than 5 years and not all countries may succeed. Hence, a concerted effort of economic policy at the national and EU level would seem necessary to promote adjustment and avoid transition to another state. To obtain assistance for adjustment, a government in need will have to give up part of its budget sovereignty. Sovereignty is regularly ceded under IMF programmes, but the cessation is temporary and reversible. A country can always decide to break the programme, although this may lead to default and, in a fixed exchange rate system, currency depreciation. At present, however, EMU is ill- equipped to manage adjustment and deal with adjustment failure. EU Treaties will have to be changed to build institutions enforcing a hard budget constraint, managing and funding adjustment when this constraint has been violated, and dealing with default and EMU exit when adjustment fails. Two years ago we suggested the creation of a European Monetary Fund capable of carrying out these tasks.⁴ The European authorities decided to create a European Stability Mechanism (ESM). It remains to be see whether the latter can perform the tasks of a European Monetary Fund.

2. Meeting the Kenen criteria: EMU based on inter-country fiscal transfers (“transfer union”)

To some extent, deficiencies in the real economy criteria for an optimal currency area can be made up through fiscal transfers (outright or via joint debt issuance). However, to make permanent and sizeable fiscal transfers from stronger to weaker member countries politically sustainable monetary union would need to be complemented by much closer political union. Substantial parts of national sovereignty would have to be permanently surrendered to a central EU government, which would decide on the mix between economic flexibility and fiscal transfers in a democratically legitimate process. Such a political union would be inconsistent with a union of sovereign nation states and require a federal structure for European states. However, in view of existing language and cultural barriers among European nations, a political federation of European states seems hardly possible in the foreseeable future. Hence, policy makers most likely will shy away from creating what is commonly called a “transfer union”. In any event, it would in our view not represent a stable future state of EMU if it were tried.

3. Cheap central bank credit: The “inflation union”

In principle the effects of the disappearance of cheap capital market credit can be offset by a generous provision of cheap credit from the central bank. However, although this would avert default of illiquid and insolvent countries and hence an immediate collapse of EMU, it would most likely only create a transitory state. The use of central bank credit as a substitute for real economic and fiscal adjustment would eventually lead to rising inflation and trigger the exit of EMU member countries with lower inflation preferences. Indeed, monetization of government debt has induced the break-up of monetary unions among sovereign states before, notably that of the Latin Monetary Union (among a number of mostly southern European countries) before WWI.