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Paul Krugman is an esteemed Nobel prize-winning economist: an authority on international trade policy in particular. You might expect that he would have had sharp insights on the Euro to offer to his audience at the Council of European Studies conference in Philadelphia on April 15. But no: we got instead the tired old story that the euro area is not an ‘Optimal Currency Area’ (OCA). Martin Sandbu, who spoke recently at Birkbeck about his new book Europe’s Orphan: The Future of the Euro and the Politics of Debt, was on the podium as respondent and presented an authoritative critique, but Krugman was not swayed, as he explained the next day in his blog.

To be honest, the blog post is so tangential to the issues that one wonders whether Krugman is really following the Euro debate at all. It might help him to understand the force of the criticism directed to OCA theory if he had a bit more idea of the direction the European debate has taken. Here’s a summary in a few paragraphs, for the aid of OCAistas everywhere. (Sandbu has given his own response, more on the economics than the political economy of the debate, in a ‘Free Lunch’ blog  entitled ‘I love the smell of devaluation in the morning’, but unfortunately that lunch is only free to Financial Times premium subscribers.)

Put very briefly, OCA theory produces the policy recommendation that countries should only lock themselves into a fixed exchange rate if their economies are sufficiently similar (‘convergent’) that the policy instrument of exchange rate adjustment is not needed. It implies that the countries in the euro periphery have suffered badly in the crisis because they could not devalue. It also suggests that, if the euro is here to stay, then the euro area needs to become more like an OCA by adopting ‘structural adjustment policies’ to make its constituent economies converge. Weirdly, Krugman states his critics advocate structural reform, whereas this is the prescription favoured by OCA adherents.

Critics of OCA theory point out the singular lack of evidence that countries which devalued had a ‘better’ crisis, and ask for the causal mechanism whereby devaluation helps a country to deal with the results of a financial crisis. They note that ‘orderly’ devaluations, whereby the exchange rate is set at just the level the real economy needs, are not available to most countries in our world of high capital flows. Floating exchange rates (such as the UK has) do not help the export sector to thrive, because the exchange rate is an asset price determined in financial markets. Exporters did not rush to invest when the pound depreciated in the crisis, as they were doubtful how long the new parity would last (a well-founded doubt, as it turned out). Krugman interprets these issues as a revival of ‘elasticity pessimism’ (the belief that exports are not elastic – responsive – to changes in relative prices brought about by exchange rate changes). This is a trivialising interpretation: the real issue raised by critics is whether the exchange rate can be made to function as a policy instrument for steering the real economy, given that it is subject to speculative over- and under-shooting.

But most important of all, critics of OCA theory challenge the idea that ‘structural adjustment’ by the periphery is needed to deal with the euro crisis. They offer a different analysis of what has gone wrong in the euro area and a different set of policy prescriptions. Their starting point is that the euro crisis came in the aftermath of a global financial crisis. The euro area did not have the institutions necessary to deal with the financial crisis. The ECB acted as lender of last resort to the banking system, but there was no euro-wide mechanism for bank resolution and restructuring; nor was there a common debt instrument that would prevent sovereign borrowers being picked off by the financial markets. Papers presented at the conference by Waltraud Schelkle and Geoffrey Underhill (the latter co-authored by Erik Jones) set this out in detail. Jones and Underhill have coined the term ‘Optimal Financial Area’ (OFA) to describe the financial institutions needed for stability in a common currency area. The challenge for the euro area is building these institutions, not imposing more structural adjustment on the struggling periphery.

One of the ironies of trying to explain all this to an American economist is that the US offers a great case study of how a currency union might not start life as an OFA. During the C19, the US suffered repeated banking crises which imposed high costs on the real economy due to the lack of institutions to limit their impact. Those institutions were put in place only slowly: progress was impeded by deep conflicts between the north-east and the south-west, which were at least as far apart in their economic indicators as the euro core and periphery are today.

Euro pessimists argue, with some force, that the euro area will not be able to turn itself into an OFA, and it should not even have tried. This might be true, but not for the reasons that the OCA contingent give. According to OCA theory, the problem is that the underlying economic structures of the countries making up the euro area are too different. According to the OFA analysis, economic diversity is not a problem for sustaining a currency union: on the contrary, diversity increases the amount of risk-sharing that can be achieved. Instead, the problem is political: national governments might not agree to build the needed institutions if their perceived conflicts of interest are too deep.

In Paul Krugman’s OCA fantasy world, the alternative to euro membership is that each country has a managed exchange rate, whereby it can adjust its peg as required to maintain international competitiveness. In the Q&A session, he defended the euro’s predecessor, the Exchange Rate Mechanism (ERM), because it allowed pegs to be adjusted. But there were a number of problems with the ERM, not least that it could be subject to speculative attacks, like the one by George Soros that pushed the UK out, at huge cost to the public finances, on ‘Black Wednesday’ in 1992. Krugman joked that the Brits should erect a statue honouring Soros for keeping them out of the euro. It may seem a good joke today, but if the euro area can become more like an OFA, its members may have the last laugh.

Deborah Mabbett is Professor of Public Policy at Birkbeck

Deborah Mabbett and Waltraud Schelkle

It’s all quiet on the Euro front at present. We would not be so reckless as to predict that this will last, but this pause gives us a chance to reflect on the lessons so far. During the crisis, we learned about the importanc e  of monetary sovereignty, a notion that had become somewhat discredited in the 1980s and 1990s. We learned that the GIPSIs suffered because they could no longer adjust their nominal exchange rate, and so were fated to experience a secular decline in competitiveness. And we also learned that a central bank should act not only as lender of last resort to the banking system but also to the government: monetary sovereignty is valuable because it means that the central bank can buy government debt by printing domestic currency.

Somewhat surprisingly, we learned this from economists such as Paul De Grauwe and Paul Krugman whose work had contributed to the discrediting of monetary sovereignty before the crisis.  Paul Krugman founded a literature on speculative currency attacks which showed that the exchange rate would not stabilise the economy in a world with free capital movement; instead, currencies were liable to overshoot the values that would produce stability. Paul De Grauwe made his name as a critic of the theory of optimal currency areas, showing that it overestimated the usefulness of the exchange rate as an adjustment mechanism. Recently, however, they have returned to the praise of monetary sovereignty. Paul Krugman applauds, for instance, that Britain stayed out of the Euro area, based on a ‘real economic framework– optimum currency area theory’ (Rationality and the Euro, New York Times 6 July 2013). Paul De Grauwe has illustrated his idea that the Euro area crisis is self-fulfilling with the comparison of Spain and the UK: Spain rather than the UK is in trouble because it has lost control over its own currency (Managing a fragile Eurozone, vox 10 May 2011).

What has happened to all the empirical and theoretical objections to the exchange rate as an adjustment mechanism? Was the prime motive for entering the monetary union, namely to escape the self-fulfilling panics of financial markets, a mere folly of Europhile elites? We looked into this in a recent paper (forthcoming in the Review of International Political Economy) where we compared the experience of Hungary and Latvia with that of Greece. All three countries were recipients of external assistance in the crisis, but Hungary and Latvia seem to be more or less out of the woods (apart from damage self-inflicted by Hungary’s nationalist government) while Greece is still in depression. We asked two main questions: did Hungary benefit from being able to devalue? And why did Latvia recover faster than Greece, despite maintaining a fixed peg to the euro?

We found that membership of the euro area did make a difference, but not in the ways that proponents of monetary sovereignty claim. Our first relevant observation is that, before the crisis, extreme financial imbalances affected countries outside as well as inside the euro area. It is not correct to claim that the euro area allowed current account imbalances to go unheeded; they were unheeded outside the common currency area too. Table 1 shows the accumulated deficits of countries grouped according to their exchange rate regimes. Greece takes the prize for the largest accumulated deficit, but only just, from Latvia and Bulgaria. It is clear that the financial markets were ready to lend regardless of Euro membership or currency regime.

Table 1: Cumulative current account imbalances, 2000-2008 (in % of GDP)

Euro members Non-Euro fixed rate Temporary deval’n Sustained deval’n
Greece

-119

Bulgaria

-103

Czech Rep

-35

Hungary

-68

Ireland

-19

Denmark

25

Sweden

61

Poland

-32

Italy

-8

Latvia

-111

UK

-19

Romania

-66

Portugal

-89

Lithuania

-75

Slovenia

-21

Spain

-58

Source: AMECO

The second observation is that both Hungary and Latvia got into trouble almost a year  before Greece. During this period when financial markets froze, it seemed to be a blessing to be inside the monetary union, protected by the supply of liquidity by the ECB. But it was a mixed blessing: Greece’s problems deepened because external investors could unwind their positions. When Hungary and Latvia sought external assistance, the lenders (led by the IMF) cajoled foreign banks into burden-sharing under the framework of the Vienna initiative, and the outflow of private capital slowed. We found that the euro area is an area of extreme capital mobility, in which the liquidity supplied to the banking system suppresses warnings of trouble to come.

Thirdly, we found little support for the proposition that a flexible exchange rate is a useful policy instrument. The existence of an exchange rate makes surprisingly little difference to the extent of real devaluation. This is not to say that it is easy or even preferable to achieve real devaluation by other means (basically, internal contraction) but it is hard to sustain the argument that only nominal devaluations succeed. Furthermore, advocates of nominal devaluation may underestimate the real costs imposed on actors in the domestic economy: a particularly salient issue in Hungary and Latvia, where many households and firms had taken out foreign currency-denominated loans.

Table 2: Real exchange rate change, 2008-2012

Euro members Non-Euro fixed rate Temporary deval’n Sustained deval’n
Greece

-10.5

Bulgaria

17.5

Czech Rep

-0.2

Hungary

-9.0

Ireland

-19.4

Denmark

-0.8

Sweden

7.9

Poland

-16.9

Italy

1.2

Latvia

-15.4

UK

4.6

Romania

-8.1

Portugal

-6.5

Lithuania

-10.3

Slovenia

2.8

Spain

-10.7

Source: DG Ecfin quarterly competitiveness report, REER based on unit labor costs (total economy)

Surely, though, there is support for a fourth proposition, that a country that has monetary sovereignty can solve its problems by borrowing from its own central bank? Well, no: we can see not because Hungary and Latvia (and innumerable other sovereign states) have had to turn to external lenders for assistance. What stops them printing money is the prospect of catastrophic currency depreciation and capital flight. The constraint that appears as a financial market crisis for members of a monetary union appears as a currency crisis for countries with their own central banks.

The choice of comparator countries does matter here. The UK has done nicely out of its monetary sovereignty, with the Bank of England now holding about £375bn in gilts – 25-30% of the debt stock, depending on how you measure it. But it has been able to do this without inducing a deep slide in sterling only because of the fortuitous fact that sterling remains a reserve currency. Sterling could have lost that status, but it was aided by the problems affecting other reserve currencies, including the dollar and the euro.  No doubt Hungary’s nationalist government would like to exercise monetary sovereignty and sell bonds cheaply to the central bank, but the Forint is not a reserve currency. To finance the government in the crisis, the IMF and EU lent funds to the Hungarian central bank, which the government debt management agency drew on to purchase debt. In turn, the central bank sterilized the increase in the domestic money supply by issuing central bank bills. The IMF was quite open about the fact that it had engineered a monetization of government debt but without expansion of the domestic money supply: government bonds held by non-residents were largely replaced by central bank bills held by domestic banks. But this could not have been done without a foreign exchange loan.

We don’t deny that there are particular problems with the monetary financing of government debt in the euro area. In Greece, the banks hold a huge share of Greek debt, and this indirect channel of financing has created a ‘diabolic loop’ whereby a sovereign debt writedown will render the banks insolvent, while bank recapitalization deepens the sovereign’s indebtedness.  The diabolic loop can be traced to euro area’s prohibition on direct monetary financing of sovereigns, combined with the easy access to ECB funds enjoyed by banks. This is a major problem in the euro monetary system, and banking union is needed to address it and break the loop.

But it is a big step to go from acknowledging this problem to singing the praises of monetary sovereignty. Our comparison of Hungary, Latvia and Greece showed not the benefits of sovereignty but that countries outside the Euro area got more constructive external assistance than those inside. Why so? We think because the world has learned how to prevent self-fulfilling currency crises, not least from the writings of De Grauwe, Krugman and many others. The IMF’s botched intervention in the 1998 Asian crisis has also helped to concentrate minds, namely that shrinking public finances is not the appropriate response to all macroeconomic instability. The lesson to be learned now for tackling the Euro crisis is not so different: cooperative institutions are required to manage interdependence within a monetary union. But there is no return to monetary sovereignty for the GIPSIs; they did not have it before they entered the Euro area and will not get it should they leave.

Read the pre-publication version of the full paper here.

 Professor Deborah Mabbett is Head of the Politics Department at Birkbeck. Professor Waltraud Schelkle is an Associate Professor in Political Economy at LSE