The State Of The European Monetary Union
4. Redrawing the EU’s geography: Core EMU within a diverse EU
Last but not least, the Mundell-Kenen criteria for a common currency could be achieved by reducing the number of EMU member countries to those closest to meeting the criteria. This would leave us probably with a small EMU around the French-German couple (which for historical reasons would be determined to keep the euro). Most likely, such a union would also include the Netherlands, Luxembourg, Austria, Finland, and Belgium, the latter possibly in its two separate parts. Any shortfall in meeting the real economy criteria for the currency union would be covered by the fast-track creation of closer political union. We would regard such a small EMU more likely than a complete break-up into national currencies because of France’s insistence on the continuation of at least a core-EMU, a demand Germany cannot refuse for historical reasons. Of course, France has never liked the idea of a core-EMU in view of its strong commercial and financial relations with Southern Europe and concerns about German economic dominance. It would therefore insist that the economies of the participants in the core-EMU be managed via a tight regulatory system, a pro-active industrial policy, and perhaps a nationalized banking sector. Industrial policy and a nationalized banking industry would be used to arrange permanent fiscal transfers from stronger to weaker EMU members. The countries outside of EMU would form a large group with economies and currencies of vastly different strength and quality, held together by the common market of goods, services, capital and labour.
Replacement of private credit by central bank credit through Target 2
If cheap private credit was necessary to sustain EMU during the first decade of its existence and cheap private credit has disappeared, why has EMU then not already collapsed into one of the above described states? The answer is that with the decision of the ECB to provide unlimited funds to banks at a fixed rate against a wide range of collateral in its weekly refinancing operations cheap private credit has been replaced by cheap central bank credit to sustain the system. Commercial banks no longer able to fund themselves in the private markets, mostly in southern European countries, turn to the ECB as their primary or only source of funding. Thus, the banking sector of a country unable to fund net payments abroad arising from the country’s current account and / or private capital account deficit—in other words a country with a balance of payments deficit—turns to the ECB as the lender of last resort.
The reserve money provided by the ECB to the banks of this country then flows through the euro area’s inter-bank payment system “Target 2” to the banks in countries with current and / or capital account, i.e., balance-of-payments, surpluses.5 Since the beginning of the financial crisis the ECB has replaced more than EUR670bn in private credit from a few balance of payments surplus countries to the deficit countries (Chart 3). As the reserve money accumulates in the balance-of-payments surplus countries and banks at present are reluctant to increase private sector credit, the banks in these countries have turned into net lenders to the Eurosystem (Chart 4). If continued, the replacement of cheap private credit by central bank credit will create an excess supply of reserve money that will eventually lead to inflation.
Hard or core EMU?
The GIIPS group has embarked upon efforts to come closer to the Mundell critera for currency union. Although the prospects for achieving this goal are very doubtful in the case of Greece and still uncertain in the case of Portugal they look good for Ireland and perhaps fair for Italy and Spain. Since public support schemes at the EU and international level (provided by the EFSF and the IMF) are probably insufficient for the funding needs of the latter two countries, help by the ECB in accessing the private capital market—in other words a “start-up funding” of the adjustment efforts—will probably be needed. Of course, involvement of the ECB raises the risk of moving to an “inflation” union and will happen only as a measure of last resort.
What could pave the way for ECB intervention? First, the countries in financial difficulties, notably Italy and Spain, would have to implement credible economic and fiscal adjustment programmes. Second, there would have to be agreement on a new fiscal governance structure for EMU which ensures that economic and fiscal adjustment presently under way continues until all countries are fit for a hard EMU and remain so in the future. To this end, the European Council is likely to agree on changes or additions to the EU Treaties at its December 9 meeting. When both conditions are fulfilled, more forceful ECB intervention (e.g. by imposing a cap on bond yields at, say, 5%) would seem plausible in the face of a further increase of market tensions. Intervention could be rationalized by the need to create monetary conditions in Italy and Spain allowing the adjustment programmes to succeed. Although the German members in the ECB’s Governing Council rejected ECB intervention in government bond markets in the past and may well do so in the future, there will most likely be a large majority in the Council in favour of such intervention when the time is ripe. A drop in capital market rates in Italy and Spain would give the new governments there at least a fighting chance for successful economic adjustment and fiscal consolidation.
Whether the efforts will eventually be successful or fail will probably be decided in early 2013, when Italy prepares for the next regular elections. First positive results of the Monti government would set the stage for the election of a new government with the mandate to continue the adjustment effort. Against this, dire economic conditions at that time could lead to the election of a government hostile to reform. In the first case, chances for the creation of a “hard EMU” would rise significantly, in the latter the risk of continuous monetization of southern European government deficits and debt by the ECB would rise sharply. The ECB could then stop intervening and trigger a move towards a core- EMU as described above. On the other hand, ongoing monetary funding of government deficits and debt would raise inflation expectations and trigger efforts in inflation- averse countries to leave EMU and create a new, more stable common currency. Most likely, these efforts would be led by Germany. However, as in our above described fourth scenario, we would expect France to stick to Germany in case the latter left EMU, followed by the Benelux countries, Austria and Finland. In this case the final state would again be a new core-EMU, surrounded by the old (Latin) EMU and the remaining EU countries with their national currencies.
With the disappearance of cheap credit EMU 1.0 lacked an essential element compensating for its deficiencies as an optimal currency area. In principle, cheap credit from the markets could be replaced by government transfers from stronger to weaker EMU countries or ample central bank credit. However, we would consider a “transfer union” or an “inflation union” not as stable states of EMU. This leaves in our view only two options for EMU 2.0: A hardening of EMU or a redrawing of the boundaries of EMU such that only countries meeting the real economy criteria for a currency union are members. We expect EU governments and institutions to do everything possible to retain an EMU with a large group of countries. This requires credible and irreversible adjustment in the countries in financial difficulties and an improved economic governance structure in EMU. Most likely, it also requires start-up funding from the EU level, including from the ECB as other facilities (e.g. IMF and EFSF) lack the necessary financial fire-power.
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 Robert A. Mundell, A Theory of Optimum Currency Areas, American Economic Review No. 51 (1961), pp. 657-665.
 Peter B. Kenen, The Theroy of Optimum Currency Areas: An Eclectic View, in Mundell and Swoboda (eds.), Monetary Policy Problems of the International Economy, Chicago 1969, pp.41-60.
 There is an interesting parallel to the role of cheap credit for fulfilling the economic aspirations of low income private households in the US. As Raghuram Rajan has argued, cheap credit made up for the limited earnings capacity of these households due to insufficient education (see. R. Rajan, Fault Lines, Princeton 2010). Similarly, cheap credit allowed low income economies in EMU to narrow the consumption gap to more dynamic or richer economies.
 See T. Mayer, “The Case for a European Monetary Fund”, Intereconomics, May/June 2009, pp. 138-141, and Daniel Gros and Thomas Mayer, “How to deal with sovereign default in Europe: Towards a Euro(pean) Monetary Fund”, CEPS Policy Brief No. 202 / February 2010.
 For a more detailed discussion see “Euroland’s hidden balance of payments crisis”, GEP from 25 October 2011.
Copyright © 2011 • Deutsche Bank AG, DB Research
Published by kind permission of Thomas Mayer.