After a discussion on the United States and China, the world’s two largest economies, it’s time to focus our attention on Europe. The continent, troubled by the sovereign debt crisis, poses the most systemic risk for the world economy.
The Problem with a Common Interest Rate
To help you understand the structural problems faced with the eurozone, we’ll discuss the lack of adjustment mechanisms in a currency union in this post.
(Comment: Let’s review the typical argument first. In a currency union, individual countries lose the autonomy of monetary policy and must share a common nominal interest rate. Since the 17 eurozone members are in very different economic conditions – where some are in a serious recession and others aren’t, and where some face high inflation and others don’t – they need different interest rates to manage the national economy.
In many European countries, monetary policy is especially important because fiscal stimulus isn’t an option given the high level of public debt and the high cost of borrowing. The lack of independent monetary policy means both booms and busts will last longer and be more severe, since the central bank doesn’t have the tools to manage the economy.)
The Problem with a Common Exchange Rate
The problem goes deeper than that though. Not only is a common interest rate problematic, but a common exchange rate also causes problems. When market participants trade the euro, they factor in the productivity and the current account balance of all euro members.
Under these market forces, the value of the euro can be thought of as a weighted average of national exchange rates (assuming hypothetically every country uses a separate currency), where the weights are proportional to the size of the economy.
Similarly, when a country – such as Greece – has low productivity and a current account deficit (see Figure 1), its currency tends to depreciate so exports will be cheaper. Cheaper exports will help the country regain cost competitiveness and bring the current account to balance over time.
However, with a single currency this adjustment process doesn’t work. Under the euro, Germany’s exchange rate is artificially lowered (an undervalued currency), while Greece’s exchange rate is made artificially high (an overvalued currency). As a result, Germany’s workers and exports are competitive in the world economy, but those from Greece aren’t.
This has led to a huge productivity gap between Germany and the peripheral countries. The result is persistent trade imbalances, which have made the eurozone unsustainable and prone to economic crisis.
(Comment: Persistent current account deficits imply the accumulation of external debt. If the country isn’t in a currency union, it can increase the money supply and lower its interest rate, with the aim to instantly depreciate its currency and stir up inflation in the long term. Depreciation restores cost competitiveness and increases net exports to correct the imbalances, while inflation reduces the country’s real debt burden if the debt is denominated in the domestic currency.
In a currency union, a country with current account deficits is unable to devalue the currency. In theory, it can use deflation to restore current account balance. Deflation, just like currency depreciation, causes domestic goods and services to be cheaper in terms of foreign currency.
However, the adjustment process is painful. Deflation is typically accompanied by serious recession as people delay consumption. Besides, under a constant exchange rate, deflation increases the real debt burden, making it even harder to repay the debt.)
(Entry 4 of 6 in The Global Economic Landscape in 2012 series)