In a new NBER working paper, Barry Eichengreen presents an in-depth analysis of the odds and possible consequences of a break-up of the euro area. (Unfortunately, the full-text is only available to subscribing institutions, but you can find a draft version on Barry Eichengreens’s personal website.) The paper is the most comprehensive and coherent analysis of the political economy of a possible EMU break-up so far, even if one concludes studies distributed by investment banks such as HSCB, Société Générale, Morgan Stanley or Deutsche Bank to their clients only.
Eichengreen first draws a distinction between the different motivations behind a possible exit from EMU: First, there might be an incentive that stability-oriented countries like Germany might leave EMU as the inflation rate achieved for EMU as a whole is too high for their taste (a scenario which was first invented by Deutsche Bank’s Thomas Mayer and marked the first post on Eurozone Watch a little more than a year ago). Second, there might be countries like Italy and Portugal which have lost competitiveness to such a degree that they have an incentive to use a depreciation to gain competitiveness and get themselves back to full employment.
Eichengreen sees large technical problems (even larger than what has been argued on Eurozone Watch), but more limited political problems with a country leaving EMU. According to him, the reintroduction of the national currency would need adequate time to prepare, a time in which one could expect large capital flights. On the other hand, he believes that politically, a country leaving EMU would be reduced to “second-class status” in negotiations over other EU issues. Different from some other commentators, however, he believes that the country leaving EMU could do so without leaving the EU completely.
Economically, he remarks that the literature answers the question whether the debt and/or competitiveness problem of a country leaving EMU could be solved by reintroducing the Euro. Without a change in the underlying wage-setting or fiscal structure, a depreciation is unlikely to resolve the issues. His own empirical analysis, however, points toward a possibility that the increase in financing costs for a country leaving EMU could be counteracted by fiscal reforms which guarantee a more responsible future fiscal policy.
When it comes to policy options to improve the stability of the euro area, Eichengreen recommends to lower hurdles for labour migration between euro area countries so that asymmetric shocks can be bolstered by workers moving to other countries. When it comes to fiscal federalism or a EU insurance mechanism with transfers to countries in economic dire straits, he questions the viability, given the “lack of national identity” and the “lack of political solidarity”.
While the Eichengreen paper thus presents a large amount of very stimulating material, in our view, he neglects some important aspects: First, his economic arguments against leaving EMU might have less weight in the real world: Policy processes are sometimes extremely messy, and political candidates might have higher discount rates and different utility functions than the electorate. As Charles Goodhart has argued, a surge in the poll numbers of some Italian candidate who is publicly toying with the idea of leaving EMU might be enough to lead to a capital outflow which might force the government in question to leave EMU (something similar happened in Brazil in the run-up of the 2002 Lula election, when only a record IMF loan rescued the country from default).
Second, if some politician has a very short time horizon (technically: a high discount rate), he/she might value the short-term stimulus from a strong depreciation and a depreciation of the public debt higher than future financing costs (see here for a paper with that argument), thus opting for an EMU exit even if it is not optimal for the country as a whole.
We therefore believe that the risk for a political crisis in EMU (with a renewed debate about some country leaving the monetay union) will continue to re-emerge over the coming decade and we would estimate this risk to be somewhat higher that Eichengreen believes (who concludes that the exit of a single or more countries from EMU cannot be “ruled out”).
We also differ from Eichengreen in his reform proposals and evaluation of their viability: First, while further increasing hurdles to migration might increase mobility somewhat, labour mobility for a long time will remain much below that in the US. Given different languages, different cultures, but also very different business customs in different EMU countries, migration for the middle class will always come with some destruction of their human capital. While a construction worker might easily move from Lisbon to Berlin without a loss of productivity and the same might be true for a fund manager moving from Frankfurt to Paris if she is working in an English-speaking environment, the same is definetly not true for a bank clerk becoming unemployed in Germany. In Spain, he would most likely not be reemployed in a position adequate to his qualification because he might not be fluent in Spanish and might not know the customs.
Second, we are more optimistic for further fiscal integration in Europe or at least for improvements of the EMU’s fiscal framework, among others by introducing more cyclically-sensitive elements into the budget and a EMU-wide unemployment insurance (see our posts here and our – more academic – working papers here and here). In our eyes (whis we believe is well supported by Eurobarometer surveys), citizens of EMU are much more inclined towards further European integration and a EMU-wide unemployment insurance than the national politicians want to make us believe.
That being said, everyone who is interested in the debate on a possible EMU break-up must not miss Eichengreens paper.
