Poland and the Eurozone

J. Hölscher

• Publisher: Palgrave Macmillan
• Year: 2014
• ISBN:
  9781137426413
• Topic: Economics
• Subtopic: Development Economics
• Index: Economics

Poland is one of Europe's economic out-performers. The country's history and geography encourage it to be in favour of deeper European integration. This book aims to contribute to discussions on the future shape of EMU and the next steps ahead.

Part I

The Euro: General Reflections

1

Euro: The Main Problems and Solutions

Leszek Balcerowicz

Two main objections are raised against the euro. The first is expressed in a popular statement: ‘One monetary policy can’t fit all’, which implies that countries, especially larger ones, should have their own currencies, and – as a result – floating rates of exchange. The second objection is contained in another popular saying: ‘Monetary union requires fiscal (political) union’. I will discuss these two objections and present my own view as to what are the main weaknesses of the euro architecture in its present form and what should be done to improve it.

In its general form, the first criticism harks back to the old discussion: ‘Fixed (hard) pegs versus free float’. The views of the main protagonists in this debate: Milton Friedman and Robert Mundell (2001) were much more nuanced than most of the proponents of monetary nationalism and free floats. And there is no shortage of criticism of the deficiencies of the floating regime (see: e.g. Dornbush, 2001). National monetary policy can be very bad as was the case in some future members of the eurozone before they started their transition to the euro (e.g. Italy, Greece, France). It produced high and unstable inflation which called for the successive devaluation. Therefore, while criticising the deficiencies of the actual architecture of the eurozone should not take it for granted that the counterfactual was bound to have been much better. Most importantly, a general comparison: hard-peg versus free float, is not very useful in addressing the specific problems of the eurozone. In addition, one does not start from scratch but from a situation when the euro already exists. Therefore, an assessment of any proposed radical change would have to include the cost of transition from this situation to the proposed new monetary regime in the present eurozone (for more on these costs see: Eurozone Meltdown, 2009; Åslund, 2012; Blejer and Ortiz, 2012).

Nominal devaluation as an adjustment device is certainly no panacea, even though it is usually politically easier than an internal adjustment that is reducing the rate of growth of wages and prices relative to those in other countries of the hard-peg area. But this fact must have been obvious before the euro was launched. What was not considered to a sufficient extent were the reforms necessary to remove the rigidities of wages and prices in the eurozone countries, and to make internal devaluation quicker and less costly. Finally, however, internal devaluation has been advanced in Portugal, Ireland, Italy, Greece and Spain (PIIGS). And a comparison of their external adjustment with that with BELL countries (Bulgaria, Estonia, Latvia, Lithuania) highlights the importance of wage and price flexibility and of making the adjustment quickly (see: Balcerowicz and Łaszek, 2013).

Greece, Spain, Portugal, and to some extent, Italy, have introduced reforms which have made their labour and product markets more flexible (Balcerowicz et al., 2013). Such reforms would have been less likely if they had stuck to their own currencies and floating rate of exchange. Therefore, the assessment of the euro so far, should not be limited to deploring the crises in some euro-area countries but should also consider the longer term consequences of these crises, that is improved policies.

Let me now turn to the second criticism of the EMU: that it is a monetary union without fiscal (or political) union. This implies that to save the eurozone must turn the eurozone into fiscal (political) union. In commenting on this criticism let me first note that the crucial terms: ‘fiscal union’ and ‘political union’ are not clearly defined, and they mean different things to different people. Take the term ‘fiscal union’ which can mean:

•the existence of effective fiscal constraints in the members of the monetary union, or

•large cross-regional fiscal transfers, or

•both.

Or take ‘political union’: is it synonymous with fiscal union and if yes, then in which of the meanings of this term? Or does it, by definition, include the fiscal union plus something else. In which case, what is this addition?

It appears to me that behind the described rhetoric there are two different propositions. In the first case fiscal or political union are code words for some centralistic arrangements that would ensure the fiscal discipline in all member states in a eurozone. This was the original intention of the Stability and Growth Pact – with deplorable results. This is also the intention of newly introduced initiatives, like the Six Pack and the Fiscal Treaty. However, can these top-down fiscal constraints be much more effective than the Stability and Growth Pact, especially after the non-bail out clause has been violated? I doubt it, and I believe that nothing can substitute for increased monitoring of governments by the financial markets and for increased civic pressure coming from fiscally conservative voters in the respective euro-area countries. Even in the US, where the position of the federal government vis a vis the states is much stronger that of the ‘centre’ of the eurozone with respect to its member states, certain states are persistently fiscally ill-disciplined, and the non-bailout clause allows pressure coming from the financial markets to bear upon them. The same has recently been true of Australia (Ergas, 2011).

In the second case, fiscal or political union are code words for a federal state, with more emphasis on increased cross-country fiscal transfers and less focus on fiscal discipline. This position arises from a belief that the only model for the eurozone is that of ‘one currency, one state’ (and/or from the ideological attachment to ‘more Europe’ in Europe). There are two critical objections to this model:

•It is not necessary to solve the euro’s problems; and

•To solve the euro’s problems is politically not feasible.

One can add that the existence of a single federal state does not guarantee a good currency – witness the monetary history of Argentina, or – as already mentioned – the pre-euro monetary history of such countries as Italy or Greece.

Not only is the model of a federal state (in the sense of large cross-country transfers) in the eurozone not a proper solution to the euro’s problems but also it is not politically feasible (see: Issing, 2013). An attempt to rush it would be politically very risky – see the heated debate about the EU budget (which hovers around 1% of EU GDP) or political tensions, generated by inter-regional fiscal transfers in some EU countries (Italy, Belgium, Spain).

Even a brief look at developments in the eurozone after the introduction of the EMU demonstrates that it is not the lack of larger fiscal transfers that has caused the problems in the PIIGS; the true reasons are completely different:

1.Some elements of the original euro architecture have enabled –via easy money – the growth of financial booms and the financing of bad structural and/or fiscal policies;

2.After the consequences of those accumulated problems came to the surface, certain policies, including those of the ECB, have delayed adjustment, making it more costly in terms of the cumulative decline in GDP.

Let me start with the first issue, that of the easy money in the eurozone until the crisis in 2008.

There is one feature which deserves special attention in this respect: an extreme suppression of credit spreads between eurozone members with very different fundamentals. Until 2008 this had been widely welcomed as a sign of success indicating the euro to be a ‘true’ monetary union. Only few authors regarded this extreme suppression of spreads as a reason to worry. The main beneficiaries of the ensuing inflows of cheap money were countries which experienced credit booms and then busts (Greece, Ireland, Spain) or slowdowns (Italy, Portugal). These inflows either produced accelerated spending with resulting imbalances or they allowed the accumulation of policy-related distortions that tended to reduce economic growth.

There is much more controversy and much less research regarding the question: why credit spreads have been, until recently, so drastically suppressed across the eurozone countries. Some observers regard this as just another instance of market failure. However, the behaviour of market participants (including behaviour that one may consider to be erroneous) is shaped by many factors, and in the case of the financial markets these factors include the actual and/or expected actions of public policy makers. True, lenders in the financial markets were late in recognising the looming boom-bust problems in the eurozone but they were still quicker than the official monitoring agencies, including the IMF (Tran, 2013). Lenders in the financial markets may have underestimated the risks that the booms they had financed would turn into busts; or they may simply have been sceptical about the realism of a no-bail out clause, which constituted an important part of the euro’s institutional framework. If the latter is the case, the later developments in the eurozone have largely proven them right, the Greek exception notwithstanding. The assistance given to the problem countries, especially to Ireland, was in fact a bail-out by creditors from the assisting countries, especially from Germany and France (and, in the case of Ireland, from the US).

Two other factors are mentioned in the literature as having contributed to an extreme suppression of credit spreads across the eurozone and the resulting boom in some member countries. The first one clearly constitutes a feature of the euro design – and of practice; it is the modus operandi of the European Central Bank (ECB). Harold James (2013) notes: ‘When the EC Committee of Central Bank Governors began to draft the ECB statue, it took the principle of invisibility and centralization of monetary policy as given. But this was not really justified either historically or in terms of economic fundamentals’. George Soros (2011) is more specific: ‘The European Central Bank treated the sovereign debt of all members as riskless and accepted them of its discount window on equal terms. Banks that were obligated to hold lees risk assets to meet the liquidity requirements were induced to load up on the sovereign debt of the weaker countries to earn a few extra points. This lowered interest rates in Portugal, Ireland, Greece, Italy and Spain and generated housing bubbles ... ’. A similar point was made by Steinmeier and Steinbrück (2010). Gill and de Souza (2013) pointedly remark that ‘ ... by treating all sovereign debt equally, the ECB sent markets the wrong signal’.

Not only were nominal interest rates radically suppressed in the future problem countries of the eurozone but real rates in these economies were suppressed even more; thus additionally fuelling the demand for credit in these countries. This was due to the fact that until 2008 the PIIGS displayed persistently higher inflation than the core members of the eurozone (Inflation Differentials, 2012), which resulted from the boom but also from the various distortions in the PIIGS which had hampered the single market and thus the tendency for the prices of tradables to be equalised across the members of the currency union. Therefore, in considering the question of how to reduce the risk of serious boom-bust episodes in the eurozone one must, on one hand, look at the causes of the extreme suppression of nominal credit spreads across the eurozone and, on the other hand, at the structural reforms, that are necessary to complete the Single Market. These reforms are also important for other reasons, especially for strengthening longer term growth in the eurozone countries.

What about the link between the euro and the fact that many members of the eurozone have made little progress on structural reforms, and some of them accumulated anti-market distortions and delayed the necessary institutional improvements of their economies (especially Greece, Portugal, Italy, France)? The pace of institutional change results from the interplay of many factors, among which political ones play a prominent role. The question is then: has the euro influenced these factors and, thus, the quality of the institutional systems in at least some members of the eurozone. The original expectations of the proponents of EMU were that as the euro would remove the easy way of coping with the economic problems, that is nominal devaluation, their governments would be forced to use a harder but more productive methods, such as structural reforms (see: Fernandez-Villaverde et al., 2013). This expectation has not been fulfilled; the pace of structural reforms in the member countries has turned out to be very disappointing, except perhaps in Germany (Whyte, 2010). The main reason for this state of affairs has been that the introduction of the euro did not remove all the easy ways of coping(or rather pretending to cope) with countries’ respective economic problems. True, the option of nominal devaluation was eliminated, but another easy way of tolerating distortions and delaying reforms were created: cheap credit and cheap capital inflows, especially to the future problems countries. These inflows not only fuelled the financial crises in some member countries but also made bad structural policies more financeable than otherwise.

Turning now to those policies pursued in the euro-area since the outbreak of the crisis, a huge amount of literature has emerged on this topic. Here I can deal only with a few selected issues. First, one should distinguish between crisis management, that is policies designed to cope with the crisis, and structural policies, that aim at lasting effects; such as reducing the risk of future financial crises, making eurozone countries better able to cope with future shocks, strengthening economic growth in these countries (and more broadly in the European Union). Both kinds of policies have been present at two levels: (1) that of the eurozone (or the EU), and (2) that of the respective countries. In this section, I will focus on crisis management, in the next I will discuss actual and proposed structural reforms in the eurozone.

The practice and the rhetoric with respect to policies at the eurozone level have been dominated by what I would call a bail-out bias. It is not specific to the eurozone; one can see it also in policy and policy debates in the US, UK, and Japan.

Much attention has been dedicated to the creation of the temporary and then, permanent official assistance fund in the eurozone, the European Stability Mechanism (ESM). However, here I will only note that the issues that have been raised with respect to the International Monetary Fund (IMF), also apply to ESM; and the larger the financial capacity of ESM, the more acute the problems of moral hazard, and the nature and extent of conditions demanded from borrowers and the capacity of the ESM to enforce them.

There have been two other related bail-out mechanisms in the Eurozone which have turned out to be more important than the ESM and more controversial: the policies of the ECB and the operation of the Target2 payments system since 2008. The first is a special case of a broader problem: the unconventional policies (UMP) of the central banks of major OECD economies, especially of the US Federal Reserve (the Fed).

The UMP pursued by the ECB have been very expansionary by historical standards, but not as expansionary as those of the Fed. (For more on this comparison see: Balcerowicz et al., 2013, pp. 50–52). However, UMP as implemented by the ECB produces some problems that are specific to the Eurozone. First, this policy, especially buying up the bonds of the distressed governments, is akin to regional policies. To justify such measures in terms of monetary policy, that is by claiming that its purpose is to repair the broken transmission channels of monetary policy, is not convincing, as one can justify in these terms any bail-out financed by the ECB. And, of course, it begs the question what formal and professional competence any central bank has to decide which risk spreads are u...

Table of contents

• Cover
• Title
• Part I  The Euro: General Reflections
• Part II  Income Developments
• Part III  Monetary Aspects
• Part IV  Firms’ Behaviour
• Authors Index
• Subject Index