Working for recovery from within the euro zone

 

ECONOMICS:The EMU framework has its flaws, but it is not responsible for the financial crisis

THE CURRENT crisis has re-opened a debate about the pros and cons of EMU membership. Indeed, some have suggested that vulnerable member countries might even consider leaving the euro zone.

However, it would be a mistake to view the problems facing Ireland as intrinsically linked to EMU membership. Equally, it would be a serious misjudgment to believe that abandoning the euro would be helpful in promoting economic recovery.

In relation to the first point, the analytical issue here is to identify the relevant counterfactual: what would have happened had Ireland opted not to enter EMU? It is probable that a significant housing boom would still have occurred.

The world economy experienced a major liquidity expansion over the last decade, which stimulated a credit boom in quite a number of peripheral European countries (including both members and non-members of the euro area).

With the exception of the UK, the impact was smaller in the more advanced European economies (including both members and non-members of the euro area), due both to a longer history of low interest rates and tighter regulation of their banking systems.

Even if Ireland had been able to raise interest rates, policy rates have relatively limited impact on the housing market if expectations of price appreciation grip investors. Moreover, to the extent that high levels of immigration helped to fuel perceptions of strong fundamentals in the housing market, that factor had nothing to do with EMU: the two other countries that opened up their labour markets to workers from the new member states were not participants in EMU (Sweden and the UK).

Accordingly, if the relevant comparison set is composed of other non-advanced European countries (in terms of income levels in the late 1990s), it is not clear that EMU was a fundamental factor in driving the Irish credit boom.

Rather, the key differentiating factors include the quality of banking regulation and the probity of fiscal policy. Countries (whether members of EMU or not) that maintained tougher control over banking practices and countries that ran more counter-cyclical fiscal policies are now better positioned than countries that ran less prudent policies.

At the same time, the crisis has underlined the incomplete nature of the EMU institutional framework.

In particular, the rapid growth of cross-border inter-bank lending among euro area countries was not sufficiently matched by a greater level of effective co-operation among national banking regulators.

A main reform priority now is to establish a European-wide regulatory framework which recognises that the largest banks require supervision by a trans-national authority.

Moreover, national governments need to agree burden-sharing rules for the future, to avoid a recurrence of the co-ordination problems that have been evident in resolving the current banking crisis.

In addition, national governments must accept that the European banking system would be more stable if a small number of tightly-regulated pan-European banks were allowed to emerge from a consolidating process of cross-border mergers and acquisitions.

Such geographically diversified banks would be less exposed to the damage caused by region-specific property booms and busts and, if properly supervised, have the potential to provide a more stable source of funding for European firms and households.

A second key reform that would make EMU membership less stressful is for national governments to establish fiscal procedures that would avoid damaging episodes of pro-cyclical budgetary excesses.

Since each member country has a different political tradition and faces different economic circumstances, it is inevitable that the Stability and Growth Pact can provide only general guidelines.

National governments must recognise the need to develop procedures which enable sufficiently large surpluses to be accumulated during the good times.

This allows for fiscal easing during the downturns.

A third fundamental principle is that nominal wages must be allowed to fall when a member country suffers a negative shock that drives up unemployment.

Since the ECB is committed to keeping area-wide inflation low at around 2 per cent, the adjustment of relative wage levels requires struggling economies to accept the occasional decline in nominal wages.

The alternative is a prolonged phase of high unemployment that only gradually achieves adjustment through a long period of wage stagnation.

While EMU membership does require national governments to maintain discipline over budgets, the banks and the labour market, the benefits from the elimination of currency risk have been shown to be immense during the current crisis.

A country that seriously entertained thoughts of leaving the euro area would be hammered by capital flight and steep increases in risk premia.

While euro sceptics in Britain and US may like to indulge idle thoughts about the break-up of the euro area, the likelihood of this scenario is truly remote.


Philip R Lane is professor of international macroeconomics at TCD and founder of The Irish Economy blog (www.irisheconomy.ie).