The euro was created on the premise that no extreme country-specific imbalance would ever pose a threat to the stability of the common currency area. An intergovernmental covenant on the Stability and Growth Pact was considered, on its own, to be sufficient. But recent crises in euro bond markets have highlighted the structural problems and the deficiencies of the euro architecture.
In response, led by Germany and France, the EU members have now agreed on adopting new budgetary arrangements that could eventually lead to fiscal federalism. At the same time, they have also agreed to enlarge the funds available to deal with the short-term problems. Indeed, budgetary integration is a necessary condition for running a currency union. So are interventions to contain the potential disruptive effects of high-risk premia on government debt that arguably reflect a combination of fundamental analyses and belief-driven speculations.
Yet, intra-Eurozone imbalances are not going to disappear overnight, and their re-emergence in different forms cannot be ruled out in the future. What can complement the new fiscal compact, to ensure the future of the euro?
Quantitative restrictions on public borrowing are not enough. We have plenty of examples of countries (Japan with a debt-to-GDP ratio of 213%) with high deficits and debt that are not charged significant risk premia, while there are countries (Spain with a debt-to-GDP ratio of 57%) that have conducted their fiscal affairs prudently by international standards, yet they are forced to pay high premia.
Another popular view attributes the Eurozone debt crisis to external deficits. Unfortunately, the cross-country correlation between risk premia currently charged and external deficits is just as feeble as that with public debt. Of course, in some (but not all) cases current-account deficits were associated with house price bubbles, and it might be argued that excessive movements in asset prices could be responsible for the current problems. But again no stable relationship seems to exist between house price changes and the observed market premia.
There are clearly many factors that could lead to imbalances, and focusing on one at the expense of the other factors could be misleading, and eventually costly. However, our analysis (supported by theory as well as measurement) suggests that, whatever the sources of the imbalances, they ultimately translate into real currency appreciation. In a currency union, this means rising inflation differentials. Whether or not excessive borrowing/lending comes from the government or the private sector, whether or not it is associated with bubbles, an imbalance raises demand and prices in one country above what is reasonably consistent with participation in a monetary union.
After the introduction of the euro, cumulated inflation differentials relative to Germany were as high as 21% for Greece, 16% for Spain, 14% for Ireland, 12% for Portugal, and 8% for Italy (despite the low Italian growth rate). Unsurprisingly, these are the countries now in the deepest trouble. For comparison, cumulated inflation differentials across states in the US rarely exceed 8% over a period of 10-20 years.
The close connection between inflation differentials and crisis is no accident. Real appreciation is not simply about ‘competiveness’, as a distinct pathology from financial and fiscal stress. To a large extent, real appreciation is the single most important indicator of macroeconomic imbalances that encompass all of the above: structural issues keeping growth low, governments in a spending binge, banks taking excessive risk on expectations that taxpayers will end up paying the bills if things go wrong.
That being so, why not use cumulated inflation differentials as a guide for pricing fundamental risk across countries? Fiscal integration on its own might not be sufficient; a more structural approach to the emergence of significant inflation differentials is also needed, particularly in the immediate future.
There is a sizeable consensus on the desirability of interventions (by the ECB or other EU institutions) to cap interest rates in Europe (see eg Tabellini 2011 on this site). Yet the design of these interventions runs into the obvious constraint that caps should not translate into a subsidy to countries with weaker fundamentals. A policy of differentiated caps would do, but this raises the issue of which standard should be applied to differentiate them.
Our proposal is to take cumulated inflation differentials as a reference measure of the adjustment required in each country. The empirical regularity we stressed above of the strong correlation between spreads and cumulated inflation differentials, would actually support operationally the idea of setting caps in line with current market debt prices, or some average over the past few weeks.
In the current circumstances, what we propose would be far superior to leaving the determination of interest rate spreads totally to the vagaries of market forces. If the euro is not going to break up, there is no reason to pay investors a fee for their unjustified mistrust in the future of the currency.
References
Tabellini, Guido (2011), “EZ rescue: Déjà vu all over again”, VoxEU.org, 27 October.
Appendix
Figure 1 shows the cumulated interest rate and inflation differentials (relative to German) over the period 1999 to mid-2011 for 21 industrialised countries. The correlation between the two series is above 90%. In contrast, the relationship between the cumulated interest rate differentials and debt-to-GDP ratios is non-existent (Figure 2).
Figure 1. Cumulative interest rate and cumulative inflation differentials
Figure 2. Cumulative interest rate and debt-to-GDP differentials
