Scott Sumner  

Could a well designed euro have worked?

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As the Greek crisis approaches some sort of resolution, it's worth asking whether the euro ever had a chance of working. While we may never know the answer to this question, we do know that a well-designed euro would have worked far better than the actual euro. And we also know that it actually would have been pretty easy to design a much better system, even assuming that fiscal union was politically infeasible.

Let's start with what we knew even before the euro was created:

1. The one-size-fits-all problem.

2. The need for strict monetary policy rules, to prevent the monetary authority from monetizing public debt.

Normally there are trade-offs in economic policymaking. But not in this case. The optimal policy rule to overcome the one-size-fits-all problem is also best for preventing monetization of the debt.

To minimize the one-size-fits-all problem, you need to minimize eurozone-wide business cycles. That's because there will always be country to country variation in recession intensity. But if you start from a position where the entire eurozone is deeply depressed, then you'll end up with the worst performers being catastrophically depressed. In contrast, if the entire eurozone has stable NGDP growth, even the worst performers will probably be only modestly below normal. So the worst monetary regime (of the plausible alternatives) is actually pure inflation targeting, which puts zero weight on stabilizing the business cycle.

But wasn't inflation targeting supposed to prevent monetizing the debt? Yes it was, but NGDP targeting does just as well. Even better, NGDP level targeting prevents debt monetization even more effectively than NGDP growth rate targeting. And even, even better, NGDPLT avoids severe recessions more effectively than NGDP growth rate targeting.

And note that this is not Monday morning quarterbacking; all of this was easy to anticipate, even back in 1999. That's not to say the actual crisis was anticipated---it wasn't. Rather it was easy to anticipate which type of policy regime would make this sort of crisis least likely to occur.

NGDPLT would not paper over problems like Greece's reckless fiscal splurging; rather it would prevent the contagion effect from occurring. Greece would still struggle, but speculators would not anticipate the crisis spreading to the other eurozone countries. And Greece would only be punished for its own fiscal errors, not both its fiscal irresponsibility and the ECB's overly tight monetary policy.

Just to be clear, I am not endorsing the euro. The system is what it is. It's a bad system precisely because we cannot trust central banks to do the right thing. And in a world where central banks don't do the right thing, individual countries need the flexibility to devalue or revalue.




COMMENTS (13 to date)

Inflation targeting would be an improvement over the de facto policy of "target German inflation".

Fiscal union is more a matter of degree than a bright red line. A surprising amount of it has already been happening.

Don Geddis writes:

Actual "inflation targeting" would also be better than the observed inflation ceiling, especially when combined with the observed opportunistic deflation.

Andrew_FL writes:
It's a bad system precisely because we cannot trust central banks to do the right thing. And in a world where central banks don't do the right thing, individual countries need the flexibility to devalue or revalue.

A strange statement, it almost sounds as if you believe the bodies in individual countries given the "flexibility" to devalue or revalue wouldn't be monopoly banks of issue.

What makes nineteen separate central banks more trustworthy than one?

ThomasH writes:

Agreed. However there was another problem. Private lenders up until 2009 largely confused the disappearance of currency risk for the disappearance of country risk (if it was not moral hazard). That is why bailing out Greece's creditors in 2010 was so damaging.

Scott Sumner writes:

Andrew, Obviously that's possible, but on balance I think smaller central banks (in developed countries) are less likely to make severe mistakes for two reasons:

1. Governance is more effective in smaller regions, due the principal-agent problem. Political pressure has more influence over central banks serving individual countries.

2. The fundamental nature of the macroeconomic problem is more difficult to identify in a large system like the eurozone.

Gene Laber writes:

Are you really questioning whether the eurozone is an optimum currency area, a la Mundell? Stable NGDP growth for the area as a whole does not rule out structural imbalances among member countries that require an adjustment mechanism. Since the common currency eliminates exchange rate changes, how would stable NGDP growth reduce Germany's large current account surplus,for example?

D. F. Linton writes:

Am I missing something or is the US dollar ill-designed by these criteria?

The USD is one-size-fits all for the 50 States. While there is a unitary national government the States themselves don't share a common fiscal policy.

How is QE (coupled with the announced intention to hold to maturity purchased federal bonds) anything but a debt monetization polcy?

Lastly, the effects of the Great Recession where most certainly uneven across the States.

W. Peden writes:

D. F. Linton,

In an ideal world, I don't think that the dollar would exist, at least not as a monopoly currency. A series of currency zones across the US, plus the dollar, would be close to the "hard ECU" proposals for the EU in the 1990s.

As Hayek pointed out, more tends to be better when it comes to types of money the citizenry can use. It's the power of exit, applied to money. It's obviously most useful when the ordinary medium of exchange and/or unit of account is being so mismanaged that the gains of having a single currency for those purposes throughout an economy are lost.

Thomas B writes:

I am constantly bemused by this notion that it is helpful when countries can revalue (almost always, devalue) their currencies, while virtually everyone agrees that it would NOT be helpful if corporations could do so.

I put it to the group that both cannot be true. Either corporations should be able to revalue currency, or governments should not. If "should" is the answer, there presumably is some scale effect, where the larger the economic institution, the more power it should have to revalue its currency.

Scott Sumner writes:

Gene, It's a myth that current account surpluses steal jobs from neighboring countries. It's just not true.

And no, I'm not arguing that the eurozone is an optimal currency area.

DF, You said:

"While there is a unitary national government the States themselves don't share a common fiscal policy."

Actually they do.

You said:

"How is QE (coupled with the announced intention to hold to maturity purchased federal bonds) anything but a debt monetization policy?"

How can it be a debt monetization policy if the Fed is paying interest on reserves, at rates higher than the rates paid on debt of similar maturity?

Yes, the effects were uneven across the US, but far more uneven across the eurozone.

Thomas, You said:

"I am constantly bemused by this notion that it is helpful when countries can revalue (almost always, devalue) their currencies, while virtually everyone agrees that it would NOT be helpful if corporations could do so."

I've never seen anyone make that claim. Corporations typically don't have currencies. But anyone who favors flexible government currencies would also presumably favor flexible corporate currencies.

D. F. Linton writes:

@WPenden,
A Scott Sumner post is hardly a convivial venue for a discussion of denationalized money, perhaps we could meet sometime at Alt-M.org

@ThomasB,
A devaluation is pretty much an all-at-once inflation. It "works" by inverting the mechanism of Fisher's debt deflation depression, plundering those who's incomes and outstanding loans are in fixed dollars and providing a windfall to those in opposite circumstances.
The reason that governments can do this and corporations can not is that governments can shoot people and then sit in judgement of their own actions, whereas corporations, thankfully, can not.

Gene Laber writes:

Scott,
I wasn't suggesting that current account surpluses steal jobs from neighboring areas, nor would I argue that they create jobs for Germany. But Germany is getting unsolicited advice from Ben Bernanke and Jacob Lew that it needs to adjust its current account, and I was wondering whether your proposal for stable NGDP growth would contribute to that.

My main point was to inquire about your thoughts on the eurozone being an optimum currency area. McKinnon (JCMS, 2004) quoted Eichengreen on his econometric analysis to the effect that Spain, Portugal, Greece and the UK are subject to asynchronous income shocks, compared with other EU countries (his analysis was pre eurozone), thereby weakening the case for their being part of a common currency area.

Ernst Ghermann writes:

What is NGDP? Defining your terms would keep me from guessing what you are proposing.

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