Can the euro survive? A new paper by Paolo Canofari, Giancarlo Marini and Giovanni Piersanti, three Italian economists, provides a nice framework for thinking about this question.
They start from the reasonable perspective that a country will leave the euro if the costs of doing so are less than the costs of staying in. They derive an equation in which this depends upon just four factors:
1. The shadow exchange rate, the exchange rate that the country would have if it were to leave. The lower this is, the stronger the case for leaving; there’s no point exiting the euro if your currency would only fall five per cent, but a stronger case for doing so if it were to fall 50 per cent.
2. The sensitivity of output to exchange rates. The more a devaluation boosts net exports, the greater is the case for exiting.
3. The output gap necessary to stay in the euro. The larger this is, the more chance of leaving.
4. Inflation aversion. The more a country’s rulers hate inflation (or the loss of “credibility” in leaving), the less likely it is to exit.
I find this framework illuminating. For example, it tells us why the Greek government wants to stick with the euro – it’s because of point (2), as well as (4). Between the 70s and the 90s, falls in the drachma led to inflation and rising wage costs which offset the benefits of a cheap currency. If a devaluation doesn’t boost the economy in the long-run, the case for leaving the euro is weak.
Equally, though, it draws attention to the case for a break-up. It lies in factor (3). The output gaps created by staying in the euro are large and growing. The strongest evidence for this is unemployment. In Spain and Greece, over half of under-25s are unemployed; in Portugal, one-third are.
This framework also tells us why Greece and Italy have technocrats in government. It’s that, being less populist, it is hoped that they have greater aversion to inflation and hence a stronger desire to stay in the euro. And this, in turn – it is hoped – has positive feedback effects. A government which has anti-exit credibility is less likely to suffer speculative selling of its bonds, and so has less need of fiscal austerity and so can stay in their euro with a lower output gap.
Herein, though, lies the danger – that of self-fulfilling speculative attacks. If a country has to impose huge fiscal austerity in order to placate bond markets, the resulting output gap – unemployment – adds to the case for it ultimately leaving the euro. Conversely, if markets are willing to hold a country’s bonds, it won’t need so much austerity and so the costs of staying in the euro are lower.
This draws attention to the two weaknesses of the euro. One is that policy-makers are not doing enough to reduce factor (3). The ECB’s LTROs do bear upon this. Giving banks cheap money, it was hoped, would encourage them to hold peripheral economies’ bonds, thus diminishing the need for austerity there - though the recent rise in Spanish bond yields suggests this effect is already fading. And there are two things the euro area could do to diminish factor (3) more. One would be fiscal transfers to indebted regions – a fuller fiscal union. The other would be fiscal expansion in Germany, to boost the exports of peripheral nations.
There is, though, another problem – factor (1), the shadow exchange rate. If a country continues to lose competitiveness within the euro, this rate will decline. This means that even if the euro stays intact through the present debt crisis, the long-term pressures for some to leave could intensify.
For now, the solutions to this seem to be the old-fashioned ones of hoping that mass unemployment and labour market “reforms” – reducing workers’ rights – will cut wage costs and improve competitiveness. Whether this proves sufficient is, however, another question.
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Chris blogs at http://stumblingandmumbling.typepad.com