The Mess that is the Euro – and What May Keep it Together

As I pointed out before, the basis of a monetary union is the agreement of all member states on a uniform development of the price level across the member states and nothing else.

So, ensuring that Unit Labour Costs and prices across member states develop in line with inflation in the European Monetary Union (EMU) as a whole is the only condition that needs to be fulfilled for the EMU to work. However, once Unit Labour Costs and prices across member states have been allowed to substantially diverge, the realignment of relative prices is extremely painful due to the absence of fiscal transfers and because (mainly due to language barriers) labour mobility is significantly restricted within the EMU.

Thus any substantial divergence of Unit Labour Costs and prices across member states threatens the survival of the EMU because member states are, of course, tempted to avoid the high cost of ‘internal devaluation’ by leaving the currency union (i.e. by devaluing externally instead).

Given that (due to lack of labour mobility and lack of fiscal transfers) a realignment of wages and prices is so costly, the EMU needs a mechanism to prevent asymmetric shocks from leading to substantial differences in Unit Labour Costs between member states.

Given that member states don’t have their own monetary policy any more, fiscal policy is the only tool left to achieve such a mechanism. That is, instead of the nonsensical 3% deficit limit, there should be a fiscal rule requiring member states to set the budget balance in such a way that Unit Labour Costs and prices develop in line with inflation in the EMU as a whole.

Using fiscal policy in such a way involves inefficiencies and may not work anyway. But if Euro policymakers want to prevent the Eurozone from breaking apart, they should at least try this approach because the EMU’s current framework virtually guarantees failure.

Do I believe the necessary adjustments to the Eurozone’s architecture are going to be implemented, preventing its break-up?

No, I don’t.

Most of the European policymakers haven’t even recognised the problem.

Leave Monetary Policy to the Market !

On EconLog, Scott Sumner leads us to a mind-blowing January 31st, 2009 article from The Economist. Here’s an excerpt from that article:

THE European Central Bank (ECB) believes it deserves a break. In a flurry of activity it took its benchmark interest rate from 4.25% in early October to 2% by mid-January. Its president, Jean-Claude Trichet, has hinted that interest rates will be kept at 2% when the bank meets on February 5th, though it may act again in March. But the euro-area economy is deep in recession and inflation is falling rapidly. Why delay?

The rationale for holding off seems a bit muddled. One worry is that once interest rates fall too far, it will be hard to lift them again. Low rates make risky assets look cheap, so policymakers may hold off from raising them for too long, for fear of derailing a recovery based on rising asset values. But this is more a plea for wiser policymakers than a case against reducing rates.

Another reason for caution, voiced by Mr Trichet, is to avert a “liquidity trap”. This ambiguous bit of jargon usually refers to situations, such as when interest rates fall to zero, where orthodox monetary policy can no longer affect demand.

Trying to avert the liquidity trap by not loosening monetary policy is the most hilarious thing I’ve heard in a long time – and Scott Sumner is accordingly outraged:

That’s an EC101 level error. If the Economist magazine is right, and this was the motive, then the Great Recession in Europe was partly caused by an almost unbelievable level of ECB incompetence. Lowering rates to zero with easy money does not make a liquidity trap more likely, it makes it less likely. A liquidity trap is often assumed to occur when the actual market interest rate is stuck at zero. Actually, it’s a situation where the Wicksellian equilibrium interest rate is zero or below. What Mr. Trichet doesn’t seem to have understood is that lowering the policy rate of interest with an expansionary monetary policy actually tends to raise the Wicksellian equilibrium rate, making a liquidity trap less likely. This is just basic EC101.

The article in The Economist illustrates again why monetary policy shouldn’t be left to central bankers and why Market Monetarists call for Futures Targeting, where the central bank pegs the price of futures on NGDP, inflation or whatever else constitutes the monetary policy target. This way, the market, not central bankers, would set both the level of the monetary base and short-term interest rates. Monetary policy would be endogenous and fully market based.

Milton Friedman once said that money is much too serious a matter to be left to the central bankers.


The conduct of monetary policy by the ECB during the Great Recession should convince even the last sceptics that handing over monetary policy from central bankers to the market is the sensible thing to do.

Why the Eurozone will break apart

The basis of a monetary union is the agreement of all member states on a uniform development of the price level across the member states and nothing else.

If, for example, the monetary union’s central bank has an inflation target of 2%, this means that the price level in each of the member states is to increase by 2% each year.

This fundamental basis for the functioning of a monetary union has been utterly disregarded in the case of the European Monetary Union (EMU), resulting in a huge gap in competitiveness between Germany on the one hand and Southern European countries on the other.

The following chart shows the development of the prices of new, domestically produced, final goods and services in the largest economy (Germany) and the third-largest economy (Italy) of the Eurozone as well as the development of Unit Labour Costs (ULC) in these two countries.


Unit Labour Cost growth, which is roughly equal to the growth in nominal wages minus the growth in labour productivity, closely corresponds with the development of the price level over time: if nominal wages grow by more than labour productivity, prices will rise. Assume, for example, that nominal wages increase by 5% and labour productivity increases by 3%. Then Unit Labour Costs have increased by (about) 2% and will eventually translate into (roughly) 2% inflation.

As the chart demonstrates, the development of Unit Labour Costs (and therefore of the prices of goods and services) within the Eurozone has been dramatically divergent. Furthermore, the European strategy of “internal devaluation”, which means expecting Italy to cut wages and thereby restore competitiveness has failed to achieve a significant reduction in the competitiveness gap vis-a-vis Germany.

The meagre results of Italian internal devaluation have been associated with tremendous economic and social costs. What would have been needed was German boom-and-inflation helping internal devaluation in Italy. Alas, Germany, which has never been big on basic macroeconomics, has been ruled by a curious obsession with fiscal probity, so the much needed German boom-cum-inflation has not happened.

Closing the competitiveness gap vis-a-vis Germany inside the Eurozone may well be too painful to be politically feasible. Already, all of Italy’s opposition parties favour exiting the euro. As is common in democracies, they will eventually come to power.

But even if the Eurozone managed to emerge from the ongoing crisis intact, the next euro crisis would not be far away because the EMU has no mechanism to prevent asymmetric shocks from leading to substantial differences in Unit Labour Costs between member states. Instead of a fiscal rule requiring member states to set the budget balance in such a way that Unit Labour Costs and prices develop in line with inflation in the EMU as a whole, there is a nonsensical deficit limit of 3%.

That is, the EMU would be as unprepared for the next asymmetric shock as it has been for the last. And given how painful and costly the not-yet-completed realignment of the regional price levels within the EMU has turned out to be, I cannot imagine Europeans would be willing to go through that all over again.