Martin Feldstein, a professor of economics at Harvard, was Chairman of President Ronald Reagan's Council of Economic Advisors and President of the National Bureau for Economic Research.
The economic recovery that the euro zone anticipates in 2010 could bring with it new tensions. Indeed, in the extreme, some countries could find themselves considering whether to leave the single currency altogether.
Although the euro simplifies trade, it creates significant problems for monetary policy. Even before it was born, some economists (such as myself) asked whether a single currency would be desirable for such a heterogeneous group of countries. A single currency means a single monetary policy and a single interest rate, even if economic conditions – particularly cyclical conditions – differ substantially among the member countries of the European Economic and Monetary Union (EMU).
A single currency also means a common exchange rate relative to other currencies, which, for any country within the euro zone, precludes a natural market response to a chronic trade deficit. If that country had its own currency, the exchange rate would decline, benefiting exports and impeding imports. Without its own currency, the only cure for a chronic trade deficit is real wage reductions or relative productivity increases.
The European Central Bank is now pursuing a very easy monetary policy. But, as the overall economy of the euro zone improves, the ECB will start to reduce liquidity and raise the short-term interest rate, which will be more appropriate for some countries than for others. Those countries whose economies remain relatively weak oppose tighter monetary policy.
The contrast between conditions in Germany and Spain illustrates the problem. The unemployment rate is now about 8% in Germany, but more than twice that – around 19% – in Spain. And Germany recorded a trade surplus of $175 billion in the 12 months through August, whereas Spain has run a trade deficit of $84 billion in the past 12 months.
If Spain and Germany still had the peseta and the D-mark as their respective currencies, the differences in trade balances would cause the mark to appreciate and the peseta to decline. The weaker peseta would stimulate demand for Spanish exports and reduce Spain’s imports, which would boost domestic demand and reduce unemployment.
Since the interest rate set by the ECB is now less than 1%, there is little difference between its current monetary policy and what the Bank of Spain would do if it could set its own interest rate. But when the euro zone starts to recover, the ECB might choose to raise the interest rate before a higher rate would be appropriate for Spain, which could exacerbate Spanish unemployment. Spain and other high-unemployment euro-zone countries might oppose this policy but face monetary tightening nonetheless, because the ECB deems the overall state of the euro zone to warrant higher interest rates.
Spain is not the only country that would have an incentive to leave the EMU. Greece, Ireland, Portugal, and even Italy are often cited as countries that might benefit from being able to pursue an independent monetary policy and allow their currencies to adjust to more competitive levels.
The widening spreads between the interest rate on German eurobonds and some of the other countries’ euro bonds show that global bond markets take this risk seriously. For example, while the current yield on 10-year German government eurobonds is 3.33%, the corresponding yield on Greek eurobonds is 4.7% and 4.77% for Ireland’s eurobonds. These divergent yields reflect the market’s perception of the risk of default or of effective devaluation associated with leaving the euro.
Leaving the EMU would, of course, involve both technical and political issues. A government that wants to replace the euro with, say, the “new franc” (which is not to suggest that France or Belgium would be likely to abandon the euro) would have to reverse the process by which its currency was originally swapped for euros. But, having learned to do that once would make it easier to do it again in the opposite direction.
How would the exchange rate be set for the new currency? The obvious choice would be to start by exchanging one “new franc” for one euro and then leave it to the global currency markets to re-price the new currency. A country with a large initial trade deficit would expect to see its currency decline relative to the euro, say, to 1.2 “new francs” per euro, which would make its products 20% cheaper than products in other euro countries and would make imports more expensive. If that causes a rise in the departing country’s price level, the nominal exchange rate would have to decline further to achieve the same real adjustment.
Because individuals from the departing country could continue to hold euros, leaving the EMU would not cause a loss of existing wealth. But such a country would have to worry about more substantial economic consequences. Global capital markets would recognize that a country with high unemployment might choose to pursue an inflationary policy or a policy or exchange-rate depreciation. That could lead international investors to withhold funds from a departing country and raise substantially the interest rate on its national debt.
There would also be political problems. Would a country that leaves the EMU be given a diminished role in EcoFin, the European Economic and Financial Affairs Council? Would its voice be diminished in European discussions about foreign and defense policy? In the extreme, would it be forced out of the European Union altogether, thereby losing its trade advantages?
These economic and political risks may be enough to deter current EMU members from deciding to leave. But remaining in the euro zone could impose significant costs on some of them. At some point, the inability to deal with domestic economic problems within the EMU framework may lead one or more countries to conclude that those costs are simply too high to bear.
Copyright: Project Syndicate, 2009. Used with permission.
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Richard Baldwin is Professor of International Economics, Graduate Institute, Geneva; CEPR Policy Director, and VoxEU.org Editor-in-Chief
27th November 2009
World trade experienced a sudden, severe and synchronised collapse in late 2008 – the sharpest in recorded history and deepest since WWII. VoxEU today posts a new Ebook – written for the world's trade ministers gathering for the WTO's Trade Ministerial in Geneva – that presents the economics profession's received wisdom on the collapse. Two dozen chapters, written by leading economists from across the planet, summarise the latest research on the causes of the collapse as well as the consequences and prospects for recovery.
The world’s trade ministers gather at the WTO next week just as the world’s trade is starting to recover from the “great trade collapse” – the sharpest drop in recorded history and deepest since WWII.
Vox has today posted an Ebook “The Great Trade Collapse: Causes, Consequences and Prospects” that aims to tell the world’s trade ministers what economists’ know about the trade collapse.
The Ebook can be downloaded for free from http://www.voxeu.org/index.php?q=node/4297
The two dozen chapters establish a consensus on what caused the collapse. In a nutshell, it was caused by the sudden postponement of purchases, especially of durable consumer and investment goods. Trade fell far more than GDP, since the demand shock was amplified by “compositional” and “synchronicity” effects.
“Compositional effect”: In the 4th quarter of 2008 and 1st quarter of 2009, the Lehman-induced ‘fear factor’ caused consumers and firms around the world – but especially in the US and EU – to freeze; expenditures were postponed until things became clearer. The sales/production of “postponeables” plummeted, dragging down GDP growth rates. However, since the composition of GDP places much lower weight on postponeables than the composition of trade, the same shock had a substantially larger impact on trade than it did on GDP; the lion’s share of trade takes place in manufactures, mostly final durable consumer and investment goods, and related parts and components.
“Synchronicity effect”: National drops in trade were large – many attaining post-war records – but the world trade drop was much larger than previous episodes, since almost every nation’s trade dropped sharply; there was no averaging out this time. The synchronisation was probably due to the global and instantaneous transmission of the ‘fear factor’, and partly due to the development of international supply chains that reacted “just in time” to the collapse in demand for postponeables.
Some of the chapters find evidence for supply-side factors, but other do not. The supply shocks considered include: the impact of the credit crunch on the specialised financial instruments that grease the gears of international trade (e.g. letters of credit), bankruptcy-induced disruptions of international supply chains, and protectionism.
The best available evidence suggests that declines in global trade finance have not had a major impact on trade flows. Policy responses aimed at shoring up trade credit were early and massive; these may have prevented credit from being more of a problem than it was.
There is no evidence that protectionism played a direct role so far; there has been plenty of new protection, but is has been applied to small trade flows.
Finally, there is almost no evidence that supply chains have collapsed. Direct evidence from firm-level data shows that the exits of firms from trade relationships (i.e. the extensive margin) has not played an important role in this crisis.
If the global economy recovers, the recovery of global trade – which seems to have started in mid-2009 – is likely to be rapid, with pre-crisis growth rates being reached next year. This could foster growing imbalances.
Several authors warn that the global imbalances are a problem for the trade system as well as for the macro and financial system. As unemployment in many nations is projected to rise, or at least remain high, pressures for a protectionist backlash could grow over the coming year or two. To avoid this, and to prevent laying the foundations for another global crisis down the road, the US, China and other nations with large trade imbalances should undertake the necessary macroeconomic adjustments, such as exchange rate realignments, and designing credible plans for long term fiscal sustainability.
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