Euro imbalances and adjustment: a comparative analysis.

• Author: Balcerowicz, Leszek
• Position: Column

This article deals with the main problems and proposed solutions with respect to the euro. I start with what I perceive to be confusion in the debate on the euro. The next section shows a large variation in the growth performance in the eurozone, and more broadly in the European Union (EU). This should make us skeptical when hearing about the crisis of the euro, or of Europe. I then proceed to discuss what the problem countries in the eurozone suffer from. The next section deals with a more difficult question: What are the links between the euro architecture and the accumulation of these problems--that is, the imbalances and structural barriers to economic growth in some members of the eurozone? I then proceed to discuss the adjustment under the euro after 2008, focusing on the weaknesses of the policies of the crisis management. The article ends with a critical discussion of the problems and solutions put forward in the debate on the euro.

Against this background and based on the previous diagnosis, I sketch what I consider to be the right approach to solving the problems of the eurozone. Throughout the article I discuss the euro as a monetary arrangement, the weaknesses of which have to be identified by taking a comparative perspective--namely, that of other currency unions.

Confusion in the Debate on the Euro

There is a lot of confusion in the debate on the euro. First, problems that have appeared in the eurozone are often confused with those caused by the euro. As a result, the euro is blamed for almost everything bad that emerged after the introduction of the Economic and Monetary Union (EMU). In discussing the impact on the euro, little effort is usually dedicated to spelling out what would have been the developments in the eurozone under alternative monetary arrangements--that is, if EMU had not been introduced.

Second, more general issues are mixed up with those specific to the eurozone, often without a clear separation between the two categories. The first group includes discussions on hard (fixed) pegs versus free floats and on the causes of the financial crises. It also includes some newer issues like the proper fiscal policy during a financial crisis and the consequences of unconventional monetary policy. Obviously, one cannot avoid considering general issues in discussing the problems in the eurozone. However, general arguments are not enough for the proper diagnosis and the proper therapy with respect to the euro. In addition, one must isolate and analyze the specificities of the eurozone--for example, why differences in risk premiums between such different countries as Greece and Germany were so small until recently, and why fiscal constraints in the member countries of the eurozone have proven so weak. Moreover, to isolate and discuss these specificities, one must compare the EMU with other types of hard-peg arrangements.

Third, there is a lot of verbiage in the debate on the necessary solutions to the euro's problems, exemplified by such popular, but unclear, expressions as "fiscal union" or "political union." That rhetoric, used by the proponents of the further centralists integration in the eurozone, reflects, I think, wishful thinking and an unreflective belief that a monetary union necessarily requires a political union.

Finally, there are excessive generalizations in the discussions on the euro which mask a huge variation in the economic performance of the member countries, especially since 2008. (The same goes for the rest of the EU.) Not every member has turned out to be a problem country. The division into the center and the periphery has emerged.

The Variation in GDP Growth in the EU, 2008-13

Table 1 shows the large variation in the growth performance in the EU during 2008-13. The cumulative growth in the eurozone over 2008-13 ranged from 5.2 percent in Slovakia to -23.6 percent in Greece; among the non-euro EU members, it ranged from 12.5 percent in Poland to -4.1 percent in Britain. It is interesting to compare economic growth in the respective EU countries with that in the United States over the same period. As one can see, nine countries have outperformed the United States in terms of GDP per capita, and three of them (Poland, Slovakia, and Sweden) in aggregate GDP growth. The nine best performers included free floaters (Poland and Sweden), countries with hard pegs, that is, members of the euro (Germany and Malta), and four countries with euro-based currency boards (Bulgaria, Estonia, Latvia, Lithuania--known as the BELL).

The worst performers included the problem countries in the eurozone (Portugal, Italy, Ireland, Greece, and Spain--known as the PIIGS), along with Cyprus and Slovenia. However, the free floaters (Britain and Hungary) did not fare very well either. An interesting contrast is visible between the growth performance of the BELL and the PIIGS as well as other problem countries in the eurozone. The example of the BELL shows that a hard peg (i.e., not being able to use the nominal devaluation of the domestic currency) does not necessarily prevent a country from having a relatively good growth performance. The contrast between the BELL and the PIIGS is even more interesting because all of the BELL and most of the PIIGS (Greece, Ireland, Spain) developed the credit booms that went bust, and the boom-bust episodes in the BELL were more intense than among the PIIGS. This raises the question of what had allowed the BELL to outperform the PIIGS by such a wide margin. I will discuss that issue shortly.

What Problems Do the Problem Countries in the Eurozone Suffer From?

In this section I will discuss the types of problems that appeared in the PIIGS. As those problems are not specific to the PIIGS, I will also touch upon some broader issues.

The problems that appeared in the PIIGS were (1) the financial booms that resulted in large imbalances and declining price competitiveness of the affected economies, and (2) the accumulations of microeconomic distortions, which together with chronically stressed public finance, have acted as a break on economic growth.

Let me start with the boom-bust episodes. A sustained accelerated spending fuelled by credit and foreign capital inflows produced booms that tended to go bust. There is no bust without a previous boom.

The booms differed in their intensity and structure depending on the extent to which the accelerated spending was financed by domestic or foreign sources, and in the composition of funding--that is, in the share of FDI, portfolio investment, and debt finance. Finally, the booms differed depending on the sectors the extra spending was directed to--for example, the stock market, real estate and housing, consumer durables, fixed investment outside housing, and the fiscal sector. Differences in the intensity, structure, and location of the booms influenced the probability they would go bust and determined the consequences of such busts for subsequent economic growth, especially in the long run. This is an important and largely unexplored subject that I must leave aside here.

Among the PUGS, Greece, Ireland, and Spain developed intensive booms that were largely financed by foreign portfolio and debt capital, mostly coming from more advanced eurozone economies (Ebner 2013). In addition, Greece accumulated massive microeconomic distortions.

One can distinguish two types of boom-bust episodes that appeared in the eurozone (and more broadly): (1) fiscal to financial and (2) financial to fiscal. Those episodes differ in their sequence and root causes (Balcerowicz 2012b).

The fiscal-to-financial crisis is dramatically exemplified by Greece. It typically starts with a sustained budgetary overspending that spills over to the financial sector, as financial institutions are big buyers of government bonds. Moreover, domestic financial firms often own a disproportionally large part of their country's sovereign debt-witness the problems of the Greek banks. This "home bias" has been due to official regulations such as the Basle risk-weighted capital requirements and to the informal links between the government and the banks. It is, of course, especially strong when the banks are stated-owned (Gonzales-Garcia and Grigoli 2013).

The fundamental question that goes beyond Greece and the eurozone is: What are the root causes of the tendency of modern political systems to systematically overspend, which results in fiscal-to-financial crises or in chronically ill public finances that act as a brake on economic growth? This hugely important issue belongs to public choice and cannot be discussed here at greater length. I can only point to the interaction of the destructive political competition (i.e., competing for votes with spending promises) and the weak, if any, fiscal constraints. (1) The solutions consist, therefore, in making political competition fiscally more responsible and strengthening the fiscal constraints on governments. On the first issue, there is ultimately no good substitute for more active and effective engagement of those members of society who understand that freedom and economic growth require keeping the size of government in check. On the second issue, constitutional constraints on the budget may be of help. However, in order to introduce and maintain them, a strong participation of civil society is again required. This is especially important in the larger EU countries, as they are less susceptible than the smaller ones to European pressures; indeed, they are largely behind them. The European rhetoric should not mask the real-politik in the EU. The story of emasculating of the Stability and Growth Pact by Germany and France in 2005 is a case in point.

The financial-to-fiscal crisis in the eurozone had occurred in Ireland and Spain. The spending boom in the housing sector fuelled the growth of their economies and created a deceptively positive picture of their fiscal stance. Once the housing boom stopped and...