Sunday, September 25, 2011

The Geithner Plan to Save Europe is Not Enough

The latest initiative to save the Eurozone is the "Geithner Plan." It would have the Eurozone leverage up the EU's €440 billion bailout fund to €1 trillion by making it act as an insurance fund for investors buying up debt of the troubled Eurozone countries.  Though big, this plan would only address the current debt problems.  It would not solve the large real exchange rate misalignment--30% according to Ambrose Evans-Pritchard--between the core countries and the the troubled periphery. The ECB, on the other hand, could address fix this problem.

Here is how.  If the ECB were to sufficiently ease monetary policy, it would cause inflation to rise more in those parts of the Eurozone where there is less excess capacity and nominal spending is more robust.  Currently, that would be the core countries, particularly Germany.  Consequently, the price level would increase more in Germany than in the troubled countries on the Eurozone periphery.  Goods and services from the periphery then would be relatively cheaper.  Therefore, even though the fixed exchange rate among them would not change, there would be a relative change in their price levels.  This would provide the much needed real depreciation for the Eurozone periphery as they move forward in their attempts to salvage their economies.  

Ambrose Evans-Pritchard explains it this way:
Nor can this gap in competitiveness be bridged by austerity alone, by pushing Club Med deeper into debt-deflation and perma-slump. Such a strategy must slowly eat away at Italian and Spanish society, undercutting the whole purpose of the EU Project. It would ultimately risk trapping them in a debt spiral aswell, leading to collosal losses for Germany in the end. 

The Geithner Plan must be accompanied a monetary blitz, since the fiscal card is largely exhausted and Germany refuses to lower its savings rate to rebalance the EMU system. The only plausible option is for the ECB to let rip with unsterilized bond purchases on a mass scale, with a treaty change in the bank's mandate to target jobs and growth.

This would weaken the euro, giving a lifeline to southern manufacturers competing with China. It would engineer an inflationary mini-boom in Germany, forcing up relative German costs within EMU. That would be the beginning of a solution, albeit a bad one.
So how much inflation would this approach entail?  Paul Krugman gives his estimates based on a 20% real misalignment:
A reasonable estimate would be that Spain and other peripherals need to reduce their price levels relative to Germany by around 20 percent. If Germany had 4 percent inflation, they could do that over 5 years with stable prices in the periphery — which would imply an overall eurozone inflation rate of something like 3 percent.
Ambrose Evans-Pritchard says this solution would be unfair to Germany, but he also says that is the cost of a monetary union.  It may be unfair to Germany now, but arguably Germany helped pave the way for this crisis over the past decade.  For the decisions of the ECB were influenced heavily by developments in Germany at the expense of the periphery.  Could this dynamic change in a new and improved Eurozone?  If not, it may make more sense to have two currencies in the EU.


  1. Milton Friedman (May 2001):

    "Will the euro contribute to political unity? Only, I believe, if it is economically successful; otherwise, it is more likely to engender political strife than political unity…Ireland requires at the moment a very different monetary policy than, say, Spain or Portugal. A flexible exchange rate would enable each of them to have the appropriate monetary policy. With a unified currency, they cannot. The alternative adjustment mechanisms are changes in internal prices and wages, movement of people and of capital. These are severely limited by differences in culture and by extensive government regulations, differing from country to country. If the residual flexibility is enough, or if the existence of the euro induces a major increase in flexibility, the euro will prosper. If not, as I fear is likely to be the case, over time, as the members of the euro experience a flow of asynchronous shocks, economic difficulties will emerge. Different governments will be subject to very different political pressures and these are bound to create political conflict, from which the European Central Bank cannot escape." we need to say more?

  2. Lars,

    That reminds me of Martin Feldstein's 1997 article in Foreign Affars titled "EMU and International Conflict."

  3. Lars,

    Where can I find this Milton Friedman article?

  4. David, it is from Friedman e-mail debate with Mundell:

  5. Another solution would be a legally enforced 20% or so cut in all wages in PIG countries, which would amount to a 20% devaluation of their currency. The cost of enforcing that, and costs of persuading the population to accept the idea would be horrendous, but the cost of the current protracted deflation in PIG countries is horrendous as well.

    What might help persuade the population is to point out that the 25% devaluation of the British pound in 2008 was a total non-event for British citizens.