Gaping flaws in the Eurozone are brutally exposed by the crisis

by Warwick Lightfoot

The Coronavirus crisis has presented the world economy with a massive adverse exogenous shock that has required extraordinary measures. These so far have been about putting the economy to sleep to promote social isolation and disease control. As the disease appears to be controlled the shift will be to bring the economy back to life in the context of a slump in business confidence, the absence of effective aggregate demand and the potential for unexpected inflation if supply chains turn out to be broken rather than disrupted.

To get a purchase on this crisis there are three international dimensions that need to be understood. These are the central role of the dollar and US policy, the absence of effective European macro-economic policy that results from the institutions of the Eurozone and the challenge of ensuring active G20 co-ordination and effective engagement with China.

The onset of the health crisis in March exposed many latent financial imbalances. These anxieties about the world economy had worried economists and financial market practitioners in the long years of economic expansion and recovery that followed the financial crises that brought on the Great Recession between 2007 and 2009.

Central to this concern is that central banks hugely expanded their balance sheets to get economies out of the financial crisis and to sustain steady yet anaemic economic growth. They injected huge amounts of the liquidity into the international economy to amplify their low interest policies. The result has been very low interest rates and bond yields, and energetic search for yield and return. This has resulted in asset price inflation and asset price bubbles that are detached from any conventional market valuation of economic assets and their future permanent income.

All these worries blew up in March, while the full economic consequence of placing the world’s biggest economies in a form of deliberately induced coma became apparent. It exposed a brutal truth that was apparent in the previous crisis in 2007. The world economy is financially dominated and dependent on the US dollar. In a crisis of liquidity, it is dollars that economic agents want and in the market response to the crisis the dollar rose but the currencies of emerging market economies, solid currencies such as sterling and even the Swiss franc plummeted.

There was only one monetary authority that could stabilise world financial markets. The Federal Reserve acting on the authority of the US Treasury Department, which has responsibility for international monetary affairs, with the central bank acting as its agent, responded fully and effectively. It has energetically acted as a central bank for the world.

Monetary policy alone cannot be relied on to stimulate demand in economies. It will require active fiscal policies – cuts in taxes, increases in spending and bigger budget deficits – to stimulate demand. The lead has been taken by the US Administration and Congress, which have passed stimulus measures the equivalent to 10 per cent of GDP and are preparing to do more. The IMF and the OECD recognise that, given the limitations on monetary policy in the context of almost zero and negative interest rates and a scramble for liquidity and cash hoarding by businesses, fiscal measures will have to stimulate demand.

This will require international co-ordination if it is to be effective, because stimulus measures in one country leak out through the balance of payments. Without co-ordination, an open economy will stimulate its neighbours, yet not enjoy the full benefits of its own policies. This means that renewed life must be breathed into the G20. Realistically the lead in doing this will have to come from the US authorities, who are key to everything.

This crisis has again exposed the international misadventure of the creation of the Eurozone. When it was created, the absence of a clear lender of last resort was immediately identified as a problem. This vulnerability was clearly exposed it the Eurozone’s sovereign debt crisis in 2011. Yet the fundamental defect of the single currency is the difference in the economies that formed it and the risk that individual member states would be exposed to shocks – so-called asymmetric shocks – that would not affect the monetary union as a whole, but would require specific economic monetary and fiscal measures to manage locally.

Governments in southern Europe need a different exchange rate and monetary conditions to the north. They need to be able to use fiscal measures and budget deficits supported by an accommodating central bank to manage their problems. Membership of the Eurozone prevents both. A pan Eurozone monetary stimulus and fiscal response is the superficial but misdirected answer.

If the reluctance of Austrian, Dutch and German taxpayers can be overcome to agree transfer payments and collective EU mutually financed fiscal measures to support the southern economies, the problem does not go away. The risk of such a response is that it would sort a problem in one part of the monetary union only to cause problems elsewhere. The Eurozone is an obstacle to the fiscal measures that national governments need to take because a sovereign state issuing bonds in a currency, where it does not control the central bank managing that currency, is a constrained borrower, in the same way that US states and Canadian provinces or countries that borrow in a foreign currency are constrained.

The modern international economy extends far beyond China, Europe and the US. Effective co-ordination in crises needs to embrace the G20 countries and beyond. The role of China is critical. Its central bank, the Peoples Bank of China, has shown itself to be an astute financial market and economic practitioner. It has responded swiftly to the economic crisis by trying to stimulate its economy by loosening banks’ reserve asset ratios and interest rate. China will almost certainly try to act in its own narrow interest and often, in terms of overall international economic stability, that interest will coincide with that of the wider community. Given the elevated level of credit as a ratio of GDP, however, China’s capacity to act today, is more constrained than it was decade ago.

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