Imaginary interview about the European monetary system

“What did the Romans ever do for us”? This well-known question made its first appearance in the film ‘Life of Brian’, during a scene when Jewish resistance members were contemplating the raison d’etre of their rebellion. The rhetorical question ended up making a good case for Roman rule. It turns out that the ‘oppressing’ Romans provided all the institutions that a well-functioning state requires. However, as these perks and benefits became part of the Jews’ everyday lives, they tended to forget about their existence. It needed a mocking, rhetorical question to realize all the advantages of being a part of the Roman state. 

In the last six years since the Euro crisis, the ‘pegged’ or common monetary system represented by the Euro has been constantly criticized for the Cyprian, Greek, and— lately—Italian problems. According to these critics, these economies could quickly recover given that they have their monetary independence, and that their slow regeneration is only the product of the Euro system. Let us see what is behind these critics and what are the common monetary system’s forgotten benefits.

What does a currency crisis mean for the money and capital markets?

We don’t have to go far in time to understand the effects of the currency crisis. The year-to-day performance of emerging countries’ currencies universally affected the entire scope of the developing world. Tens of millions of consumers could get a first-hand experience of what a weak domestic currency means: the price foreign consumer good inflates, and the value of domestic wages and savings erode. Not surprisingly, household from Argentina to Turkey were gritting their teeth as their currency plunges before their eyes.

The weakness in the Turkish and Argentine markets were caused by the loss of their credibility and the following flight of capital. We could see similar indicators in Southern Europe, mainly in the forms of increasing borrowing costs and deposit outflows from the banking system. It is probable that the Italian and Greek economies could face similar faith as these emerging countries if they weren’t part of the monetary union.

How is the Southern-European case affected by their Euro membership?

It is often said that the European Central Bank’s (ECB) current quantitative easing program is actually making the imbalances worse within the monetary union. Previous bond holders get redemption in the form of bank deposits. However, if the deposits are guaranteed by a weak commercial bank, investors see it fit to reallocate their savings. As a result, investors on the periphery rather choose a core Euro member’s bankfor example a German or Dutch bank, which leaves the Spanish, Greek or Italian banking system short of funding.

On the one hand, it is arguable whether the deposit flight is created or amplified by the ECB’s programm. On the other hand, it is a frequently proven historical fact that savings will leave an economy if its financial safeness deteriorate. Controversially, one of the reasons why this capital flight has not resulted in funding gaps yet is also due to the common currency. Since the intra-eurozone money flows are accounted by the European system of central banks, liquidity doesn’t have to leave the countries. The flows will simply be accounted for on the national central banks’ balance sheets. Moreover, as we have seen in Greece in 2015, bankruns can also be offset by the vast liquidity provision on the ECB.

Regarding the capital and bond markets, we also have seen precedents for ECB stabilization during market turmoil. For instance, following the unexpected outcome of the Brexit referendum the ECB re-adjusted the capital key ratios of its bond buying program to support the periphery countries. Furthermore, the Frankfurt based lender had both the figurative and literal credibility to run another, long-run funding program, which still supports Euro banks with summable funds for ‘free’. Besides, we must also take all the natural benefits of the common currency into account. The lower currency risk and access to deeper debt markets benefited all the firms and workers who sold their products or services in a member country.

If the common currency has indeed so many perks, why does the system have so many critics?

The political incentives are easily understood. The ‘pegged’ system requires more disciplined and harmonized fiscal policies. I cannot overheat my economy as that would result in higher inflation and prices, while the currency cannot adjust for this. With these restraints, the governments of the member states find it more difficult to make campaign promises or follow populist agenda. Furthermore, they cannot utilize the monetary tool of seigniorage to ‘tax people’ by printing money.

The economic perspective is a bit more complex. The main fear is the lack of currency flexibility will make it impossible for relative prices to adjust and reach equilibrium. Consequently, different price levels will not reflect the differences of the economies’ productivity, which eventually leads to persistent imbalances and lopsided financial flows. Similar nominal rigidities have led to deep recessions or even depressions throughout the economic history, as real factors are forced to adjust to correct for the lack of nominal flexibility. Less competitive economies often see their exports, employment, and investment falling as a result of these imbalances.

Given that we mentioned money printing and seigniorage, can’t we say that the ECB’s bond purchasing program is a tax on the private sector as well?

Of course, we can, but it is a tax on the wealthy. It is not shocking that the Germans are the loudest to denounce the program. However, we must note that the ECB is not motivated by some populist agenda, or reelection ambitions. The easing program is a technocratic attempt to reconcile the economic issues of the imbalances mentioned above.

Liquidity injection creates an inflationary environment, ceteris paribus. However, countries fighting deflationary forces might just realize that they did not realize anything. Optimal monetary policy can equate the deflationary pressures caused by recession, hence the overall price level might be unchanged.

The ECB’s goal is to achieve that relative price adjustment what now the ‘pegged’ system obstructs. The supportive monetary policy is designed to inflate the prices in core economies, while it can simultaneously combat deflation on the periphery. Since prices are less reluctant to adjust upwards, and the policy creates a positive aggregate output gap, it is easy to see why decision maker prefer this way over the painful devaluation of periphery economies. Yet, higher inflation in the core would inevitably lead to the erosion of the savings, which is not the most popular policy. The core countries are trying to fight this ‘evil’ by consolidating their expenses to avoid overheating the economy.

All in all, current fiscal decision makers put the cart in front of the horse. The governments follow classical economic principles, where they act as a macroeconomic stabilizer. However, special circumstances would require them to do the opposite: follow disciplined policies on the periphery, and implement lavish social programs in the core.

Wouldn’t it make sense to just abandon the Euro project, and let fiscal decision makers to deal with the business cycles?

Open economies have proven to more efficient in a number of instances throughout history. Even the most critical economists have to admit that. To serve such an immense market, European firms will need supportive institutions. Such institutions are the deep capital markets, which can provide funding on this larger scale, or the common banking system, which helps consumers and firms to finance their day-to-day transactions conveniently. In case of a Euro breakup, the firms supplying onto the common market would face higher volatility and risk, hence higher costs. These cost increase would most probably be passed on to the consumers as they have a weaker negotiating position due to market imperfections.

The silver lining is that this adjustment has to be done only once: we cannot open the Pan-European market again. Yet, the benefits of the open market are here to stay. The solution is to go forward, not backwards. A unified European fiscal policy could be a possible solution to avoid reliance on the ECB technocrats every time there is a regional recession. The reallocation of the cohesion funds from ‘East’ to ‘South’ in the next 2021-2027 EU budget is one step towards this direction. However, this political response comes almost nine years after the Euro-crisis. Unfortunately, the old continent is not ready for federalism.