The Economist

June 2, 2010

Will the Eurozone Fragment -- A Debate

MARTIN FELDSTEIN

Opening Statements Defending the Motion :

A single currency denies countries the ability to adjust monetary policy to local conditions, leading to excess unemployment and to the kind of bubbles in real-estate prices that have recently hurt Ireland and Spain. The political leaders who proposed the single currency did not understand nor care about these economic effects.
Although the European Monetary Union has survived for 11 years, the current strains within the euro zone show why it may not last for another decade without at least some of its members leaving.

Opening Remarks :

Although the European Monetary Union has now survived for 11 years, the current strains within the euro zone show why it may not last for another decade without at least some of its members leaving. If that happens, the remaining euro zone could be stronger and more cohesive and the countries that leave would be able to avoid the problems that they face in the current crisis.

Consider Greece's present situation. In exchange for temporary liquidity assistance from the European Union and the International Monetary Fund, Greece has agreed to reduce its budget deficit by 10% of GDP, from 14% to 4%, over the next four years. The reductions in government spending and increases in tax collections needed to achieve that deficit reduction would have to exceed 10% of GDP because the process of deficit reduction would cause GDP to decline, implying less tax revenue and more transfer payments. The required decline in GDP would be a very painful loss of income and employment lasting for at least five years.

Leaving the euro zone would be an attractive alternative for Greece because it would allow Greece to devalue its currency. That would boost Greece's exports and reduce its imports. The resulting increase in production would offset the decline in GDP caused by the tax rise and the cuts in government spending. As a result, the necessary reduction in the fiscal deficit could be done with less pain and less of an increase in unemployment.

The currency devaluation would also shrink Greece's enormous trade deficit without the extra pain that would be caused by using years of high unemployment to achieve large reductions in the nominal level of Greek wages and prices. Experts say that eliminating the Greek trade deficit without a devaluation would require Greek private-sector wages to fall by about 25%.

Leaving the euro zone and allowing its currency to respond to market pressures would also have long-term benefits. When Greece joined the euro zone, the euro:drachma exchange rate was set so that Greece could have an initial trade balance. But over time Greece failed to have the productivity gains of other euro zone countries and the external demand for Greek goods and services did not grow as fast as that of other countries. As a result, Greece now has a current-account deficit of 7% of its GDP while Germany now has a current-account surplus of 5%. Even if Greece suffered the pain necessary to reduce wages to a level that eliminated its present trade imbalance, the problem would recur in the future unless Greece continued to have a lower rate of price and wage inflation than other countries in the euro zone. With a separate currency that can respond to market pressures, Greece would adjust to keep trade in balance without the ongoing declines in relative nominal wages.

The decision to leave the euro would of course be a political one with ramifications that go beyond the rational calculation of economic costs and benefits. Some Greek politicians and voters may value euro-zone membership so much that they are willing to accept the pain of adjustment without devaluation. But others may be so angry with the conditions imposed on Greece by the other euro-zone members that they would prefer to leave even if doing so did not bring economic relief.

The political decision to leave the euro zone could be more accidental than deliberate. A candidate for prime minister might campaign on the promise that, if elected, he would threaten the European Commission that Greece would leave the euro zone if its external debts were not dramatically reduced. If he were then elected and the Commission refused to reduce the debts, he would have to choose between admitting that his bluff had failed and carrying through on his threat to leave.

Even if Greece does not want to leave the euro zone, it might be forced to do so by an angry German electorate that does not want to provide permanent financial assistance to a country with persistent fiscal and current-account deficits. Although there is no mechanism in the Maastricht treaty for expelling a member of the euro zone, the recent threats by Germany to deny financial assistance and infrastructure funds to any country that is not financially responsible shows the kind of threats that could lead Greece to choose to leave "voluntarily".

Although I have focused these comments on Greece, similar conditions apply to some of the other peripheral euro-zone countries. It is possible, therefore, that one or more of them could leave or that the euro zone could split with a group of countries choosing to leave or being forced out.

It is also possible that Germany could decide that the euro zone is not viable in its current form. If forced to choose between accepting a much more centralised political system in which the European Commission had control over each country's budget, as the Commission recently proposed, and leaving the euro zone, the German people might decide to leave.

Rebuttal - Defending the Motion :

While Mr Wyplosz refers to the single currency as "protecting" Greece from a currency crisis, I see it as preventing Greece from achieving a helpful increase in net exports by a natural currency depreciation.

Rebuttal Remarks:

Charles Wyplosz is candid in his admission that the euro is "an ongoing bet" that may or may not survive. I believe that it will survive but not in its current form and not with all of its current members.

More specifically, I think that one or more of the 16 countries that are now members of the euro system may leave during the next ten years. But I am not predicting the end of the monetary union. As I explained in my first statement in this debate, while the single currency and the single monetary policy will be a cause of continuing problems for the euro-zone countries, the political leaders of the major euro-zone countries are likely to accept those economic costs in order to achieve what they see as the political advantages of a more unified and politically centralised Europe.

But Greece would now benefit by leaving the euro zone. In order to get financial help from the other euro-zone countries and from the International Monetary Fund, the Greek government has agreed to very large increases in taxes and cuts in government spending over the next three years. That fiscal contraction will reduce domestic demand in Greece, causing a collapse of economic activity and personal incomes. In contrast, the countries in Asia and Latin America that have accepted such large IMF-imposed fiscal contractions have avoided sustained devastating reductions in economic activity because they have been able to devalue their currencies at the same time, leading to increases in exports and reductions in imports. The single currency prevents that offsetting adjustment. While Mr Wyplosz refers to the single currency as "protecting" Greece from a currency crisis, I see it as preventing Greece from achieving a helpful increase in net exports by a natural currency depreciation.

If Greece reverts to the drachma and floats the currency, it would probably achieve a devaluation of about 30%. That would make its products and services much more competitive, boosting economic activity and employment. Although the value of its external euro-denominated debts would rise by a similar percentage when stated in drachma, that would be largely offset in the debt restructuring that is virtually inevitable in Greece. There would not be the doubling up in local currency terms of its debt that Wyplosz asserted.

I agree with Wyplosz that there would be administrative issues in reverting from the euro to the drachma. But these administrative problems would not be a major burden. Many countries introduced new currencies when they achieved political independence. The drachma would be familiar to the Greek public and therefore would have ready acceptance. Going back from the euro to the drachma would be easier than the initial shift from the drachma to the euro.

Mr Wyplosz cites an article by Barry Eichengreen on the problems that a country would face in leaving the euro. In a later version of that same article (Barry Eichengreen, "The Breakup of the Euro Area", in Alberto Alesina and Francesco Giavazzi, Europe and the Euro, University of Chicago Press, 2010), Mr Eichengreen concluded that it would be possible for a euro-zone member to leave but that, acting rationally, none would chose to do so. That article was written in 2008, before the current fiscal crisis and the imposition of the IMF's fiscal squeeze on Greece. The case for leaving is clearly stronger now than it was then.

In my comment on Mr Eichengreen's article in that same volume I disagreed with his implicit benefit-cost evaluation and also emphasised that the decision to leave would be political rather than just economic. I cited extensive survey evidence collected by the European Commission in which Europeans indicated much greater identification with and loyalty to their own currencies than to the euro and the euro zone. A politician seeking election or re-election could disregard what some see as the economic risks of leaving the euro zone in order to get broader popular support.

Mr Wyplosz emphasised that it is a "political necessity" that fiscal policies "remain in the national sovereignty domain". That is why the Stability and Growth Pact, imposed at the level of the euro zone, failed to limit fiscal deficits. It is also why the recent proposal of the European Commission to require that that each country's annual budget be subject to review by all other euro-zone countries would never be accepted.

But making a commitment to future fiscal discipline would be important, especially for any country that leaves the euro zone. Greece would be well advised to enact a constitutional amendment similar to the one adopted recently by Germany and proposed for France by President Sarkozy that would require a cyclically adjusted balanced budget. The experience of the individual states in the United States with such constitutional amendments shows that they can be very effective in limiting fiscal deficits. As it became clear over time that Greece was respecting its own constitutional amendment, the interest rate on its debt would gradually decrease.

The economic conditions in Greece are now a disaster. Greece would do well to begin planning how it will eventually leave the euro.

Closing Statement Defending the Motion:

Closing Remarks :

The euro is more than just a currency. For many Europeans, it is also the symbol of a nascent European government and an instrument for unifying the population of the euro-zone countries. This "European project" goes back 60 years to when in 1950 the French Foreign Minister, Robert Schuman, proposed the European Coal and Steel Community as a way of bringing France and Germany closer together in order to prevent yet another German-French war. The Coal and Steel Community was also seen by its proponents as the first step towards the development of a European political union, starting with the free-trade arrangement (the Common Market) and leading eventually to the creation of the European Economic and Monetary Union that embodies the euro.

Economists applauded the European Union's removal of trade barriers but warned that imposing a single currency on a very heterogeneous group of countries would create serious problems. A single currency denies countries the ability to adjust monetary policy to local conditions, leading to excess unemployment and to the kind of bubbles in real-estate prices that have recently hurt Ireland and Spain. A single currency also means that all euro-zone nations have the same exchange rate, eliminating the natural response of the currency to shifts in global demand and in productivity trends. Over time, the fixed exchange rate inevitably leads to chronic trade surpluses and deficits in different euro-zone nations. The common interest rate and exchange rate also encourage euro-zone countries to run large fiscal deficits because it eliminates the market feedback through the interest rate and exchange rate that would otherwise act as a warning to a country that had its own currency. And, when a country has to reduce a large fiscal deficit by cutting spending and raising taxes, the single currency means that it cannot soften the adverse effect on GDP by a currency devaluation.

The political leaders who proposed the single currency did not understand these economic effects and did not particularly care about them. They were much more interested in advancing the process of political union.

But after the euro had enjoyed a decade of favourable performance, the cumulative adverse effects of the single currency have led to the current euro-zone crisis. Greece is now the focus of this crisis. It has a fiscal deficit of 14% of its GDP and has been forced to accept onerous terms from its euro-zone partners and from the IMF in exchange for a liquidity package that will allow it to pay its external debts for the next two years. The required reduction in the fiscal deficit will plunge Greece into a deep recession that, as a member of the single currency, it cannot offset by a currency devaluation.

The high interest rates on Greek debt show that financial markets believe that Greece is likely to default on part of its obligations within the next two years. It is not unlikely that Greece will also choose to leave the euro zone and return to its own currency or be asked to leave by other euro-zone countries that do not want to continue to finance Greek deficits or suffer the costly results of Greek devaluations. For those seeking a European political union, it may seem better to eliminate a weak and troublesome country.

I don't know whether Greece will actually leave the euro zone during the next few years. But I believe that the euro zone will not continue with all of its current members for the next decade. The problem of the euro zone is not just a Greek problem and the pressure for a country to leave is not just a problem of 2010.

Charles Wyplosz raises the frightening spectre that leaving the euro zone would cause Greece to experience 50% devaluation and therefore a 50% fall in the value of Greek GDP when valued in euros. The 50% devaluation is almost certainly an exaggeration and the impact on the value of Greek GDP as measured in euros is basically irrelevant. The real volume of the goods and services that are produced in Greece and consumed by the Greek public does not fall just because there is a change in the Greek currency. The loss of real income is only the increased cost of those goods that Greece imports from the rest of the world, a much smaller effect.

Mr Wyplosz says that leaving the euro zone and devaluing is not a "panacea" for Greece. I agree. Greece needs to reduce its fiscal deficit by reducing spending and raising taxes. And it needs to reduce its trade deficit by reducing real wages relative to that of its competitors. Leaving the euro zone and devaluing the currency reduces the economic pain of deficit reduction and helps to shrink the trade deficit. So while leaving the euro may not be a panacea, it would help to make a bad situation better.

But this debate is not about what would be best for Greece. Nor is it about what might have happened if a different adjustment had been proposed by the IMF and the other euro-zone countries.

This debate is about whether Greece or some other member of the euro zone will leave the euro in the coming decade. That will not be determined by technical economic advice or by the desires of the European political leaders in France or elsewhere who want to move to a political union as rapidly as possible. It will be determined by the political process in Greece or in some other euro-zone countries during the decade ahead. I believe that one or more of those countries will choose to leave or will be forced out by its euro-zone partners.

Martin Feldstein is the George F. Baker Professor of Economics at Harvard University and President Emeritus of the National Bureau of Economic Research (NBER). He served as President and CEO of the NBER in 1977-82 and 1984-2008. He continues as a Research Associate of the NBER. From 1982 to 1984, Mr Feldstein was Chairman of the Council of Economic Advisers and President Reagan's chief economic adviser. He served as President of the American Economic Association in 2004, and was appointed in 2006 to the President's Foreign Intelligence Advisory Board and in 2009 to the President's Economic Recovery Advisory Board. Mr Feldstein is an economic adviser to several businesses and governmental organisations in America and other countries and is a director of Eli Lilly. He is the author of more than 300 research articles in economics and is a regular contributor to the Wall Street Journal and other publications.