By Simon Wren Lewis
The Eurozone institutions had three flaws.
First, the ECB was (at least initially) prevented from acting as a lender of last resort to member states governments. Second, the Stability and Growth Pact prevented sufficiently counter-cyclical fiscal policy. Third, monetary policy was too conservative, with too much of an emphasis on inflation control, relative to the stability of real activity, perhaps an inflation target that was too low (remember the ‘close to, but below’ wording), and these things contributing to the premature raise in interest rates in 2011.
The charge is that these institutional design problems reflected bad economics in the head of the German economic and policymaking elite.
This thesis has a lot to be said for it. I think Simon is right that old-fashioned monetarist economics, and excessive monetary and fiscal conservatism lives on to an unfortunate degree in Germany.
But I don’t think it’s the whole story.
Regarding the first ‘failing’, that of there initially being no promise to act as purchaser of sovereign bonds of last resort, it is debatable whether this is a failing.
The notion, debated much in the blogosphere, is that it is desirable and credible to have the central bank promise to act as purchaser of last resort, in order to stave off market runs on sovereign bonds. However, providing that financing has a cost. The money creation needed will generate inflation whose costs may be recognized to be too high (expected money printing is not an efficient way to do government financing). Following this reasoning, the promise won’t be believed. And if it is carried out, it may be more harmful than a default. This is why there is an attempt at a legal bar in the UK and other countries (and Germany before the Euro). (One which I hope Simon does not suggest – in his role as contributor to the BoE remit review led by Labour’s John McDonnell – is qualified.)
And because such lender of last resort purchases are problematic, I’ve argued before that as far as the ECB promising to roll out OMTs for Italy or Spain or France is concerned, this is a bluff. There would be no support – rightly – for unlimited purchases on such a scale were things to come to that.
The second and third failings relate to the foregoing of strongly counter-cyclical monetary and fiscal policy in the Eurozone make-up.
In the non-German EZ member states, monetary and fiscal instability/freedom had often been a curse, and not a blessing. Such countries had seen many episodes of high inflation, resulting from an abuse of the monetary freedoms later given up; episodes of fragile exchange rate fixing, with no say in monetary policy at all. They had also seen decades of less than optimal fiscal policy, with sustained over-borrowing and abuse of the fiscal freedoms craved now.
The memory of the efficacy with which monetary and fiscal freedoms were used lived on in the hefty pre-Euro spreads between German and other sovereign bonds.
In some countries – Portugal, Spain, Italy, Greece, Cyprus – this lack of monetary and fiscal discipline was symptomatic of an acute political-economic malaise. As an outsider to this literature, I can’t do justice to it. But an example is what Kalyvas and other political scientists term ‘clientilism’ and corruption; the use of state resources to reward pressure groups on the left or right who had helped win the election.
These pressures arguably distorted monetary and fiscal policy, applying a too-short horizon, over-reliance on the inflation tax, and offering influential jobs in monetary and fiscal policy to political clients rather than those most competent.
The Germans’ insistence on the Eurozone’s actual design may have been a strategy to ensure that whatever caused these abuses in the past were not going to cause a problem for ECB monetary policy.
Rewinding history a little further, the Germans’ own institutional design, which they insisted be reflected in the Eurozone, is plausibly seen as a response to its own experience of how political dysfunction (which, if we want to get into a blame game, we can lay at the doors of the victorious allied powers at the end of WW1) leads to bad monetary and fiscal policy.
Concluding, Simon is right to point the finger at the economics in the heads of German policymakers. However, the monetary and fiscal conservatism they built into the Eurozone was certainly explicable given the dysfunctional monetary past of Germany itself and other countries too. And, who knows, perhaps even a decision that has a coherent rationale; perhaps an enlightened New Keynesian in those pre-Euro negotiations over the design of the Eurozone might have recognised that the monetary and fiscal freedom prescribed in that framework were not as feasible as they appear in the institutions-free versions of those models.
Simon Wren Lewis is professor of economic policy, Blavatnik School of Government, Oxford University.
Featured Image Credits: Pixabay