It wasn't meant to be this way. When the architects of the euro met to put their vision of a unified, European-wide monetary union into practice, they didn't think that a decade and a half later the economic landscape would be clouded by Great Depression levels of unemployment in some countries and the prospect of a 1930s style deflation trap in the monetary union as a whole. But, sadly, that is the grim reality of the current economic conjuncture. Moreover, it is pretty safe to assume that they did not think that fringe parties, some of which ascribe to quite disturbing views, would be gaining support across Europe; yet, that is the result of recent European Parliament elections.
Go figure. Re-create the dysfunctional monetary arrangements of the asymmetric gold standard of the late 1920s – early 1930s, subject it to a financial shock at the core of the global financial system and get protracted economic stagnation and political polarization. Who could have seen that coming? After all, it’s not like we have seen that combination before — except of course that we did.
Meanwhile, on the other side of the Atlantic, who would have thought that premature fiscal tightening (for the sake of argument, call it sequestration) in 2013 would cause the green shoots of robust recovery to wither on the vine? That hasn't been experienced before — except that it has; it is pretty much the script from 1937.
What in heaven's name is going on?
I will address the U.S. situation in a follow-up post. For now, let's concentrate on Europe.
The architects of the Eurozone surely knew that Europe did not satisfy the conditions of an optimal currency area (OCA). But there was a project to complete; a vision to realize. Is it possible that they conceived of the euro as a commitment device to be used as a lever to get countries to adopt the structural reforms that would transform Europe into an OCA and end the Eurosclorosis that pushed Europe progressively behind the U.S.? Frankly, I don't know. But if that is indeed the case, as Paul Krugman would say, a funny thing happened on the way to monetary union.
The euro architects and their project became trapped in an expectations gap. Briefly, with the monetary union, exchange rate risks associated with investments in periphery countries were eliminated; interest rates converged to core country levels and, in the heady days before the global financial crisis, capital flowed from the core to the periphery. But, with interest rates down and in the context of robust growth throughout the Eurozone, the impetus for structural reforms was gone: such reforms, which are politically difficult, and economically and socially disruptive, are usually put off until there is no alternative. And, from the perspective of Eurozone countries, high growth was ample evidence that structural reforms were unnecessary.
However, the global financial crisis revealed the extent to which that growth had been fuelled by capital flows. When the flows stopped, so did growth. Worse still, the dysfunctional nature of the monetary union led to perverse policy responses which exacerbated the economic collapse. In these dire straits, default risk and “exit” risks were priced into bonds and interest rates within the Eurozone. By early 2012, the situation had devolved to the point that the whole project was viewed as at risk.
Mario Draghi, President of the European Central Bank, calmed markets with a dramatic commitment to “do whatever it takes” to save the Euro. His timely actions probably did save the Euro. But preventing the collapse of the Euro and restoring growth have proven to be two distinct challenges. For the past two years, growth in the Eurozone has been, well, abysmal. It is not just about recovering the potential output lost over the past half-decade or so, it is about reaching potential output.
In this environment, the threat of deflation haunts the Eurozone. So “Super Mario” has once again acted with resolve to save the day, by driving key ECB rates below zero and providing additional liquidity to Eurozone banks. The move to charge banks to hold reserves at the ECB is intended to force banks to lend, rather than lock up liquidity at the ECB. Will it work? I certainly hope so. But in the context of nagging questions about the solvency of Europe’s banks and whether the governance arrangements of the Eurozone would allow the ECB to actually “do whatever it takes,” losing a small amount of capital with certainty may be preferred to the uncertainty of losing a large amount of capital.
That is one cost of the New Age of Uncertainty.
Moreover, even if the ECB’s shock and awe campaign is successful in restoring growth and reducing the threat of deflation, it is unlikely to make up the output lost and the lives disrupted over the last five years. That legacy is the kindling that has ignited the rise of extreme parties across Europe; it is the solvent that weakens the bonds of economic and political cooperation that have been the objective of international relations for the past 70 years.
This is another cost of the New Age of Uncertainty.
As noted in an earlier post, here, the international architecture was created to provide the institutional support needed to sustain cooperation. It is needed today more than ever. There are huge adjustment challenges in the global economy that, if not managed well, could lead to a dystopian outcome. But we needn’t tread that path. The integration of China, India, Brazil and other emerging markets offers a huge opportunity for gains from trade — both temporal, in goods and services, and inter-temporal gains with savings of rich, ageing countries financing much needed infrastructure in emerging markets. We are in an age of potential prosperity. As Umair Haque argues:
The paradox of prosperity is this. Imagine a lush field that goes fallow. The tribes begin fighting over the last few dried, cracked stalks of wheat. They fight one another tooth and nail. Until, at last, one is victorious. The field is theirs; but there is no longer any wheat; just handfuls of dust. The others starve. They will do anything for the dust. Until one day, a man says: “Why, the dust! It is rightly ours! Let us take it from them!” And so they do. And the spiral of violence and impoverishment never ends.
One day, generations later, the starving tribes wonder: Why didn’t our grandfathers plant another field?
The paradox of prosperity is this. It is at times of little that we must plant the seeds of plenty; not fight another for handfuls of dust.