Much recent discussion of the future of the euro, most notably that of Paul Krugman, has started from the idea that Europe is not an optimal currency area, and that a ‘one-size fits all’ monetary policy is therefore bound to lead to the kinds of problems we are now observing. At any given time, some countries would benefit from a more expansionary policy and others from a more contractionary policy, so the effect of monetary union is an unsatisfactory splitting of the difference.
Without resolving that issue in general terms, I want to argue that this is not an accurate description of the current state of the eurozone. It’s true that Germany is doing a lot better than the eurozone as a whole, and the peripheral countries a lot worse. So, the optimal policy for Germany alone would be tighter than for the rest of the eurozone. The peripheral countries might benefit from an even more expansionary policy (though that’s not as clear to me as it seems to be to others. A heavily indebted country that undertakes monetary expansion is likely to find it hard to sell bonds denominated in its own currency).
But when you look at the actual policies of the ECB, including Trichet’s recent threat to raise interest rates, it’s hard to see that this policy is optimal for any EU country, even Germany.
Particularly in GDP terms, Germany’s recovery has not been that strong, and an expansion based on exports could easily be derailed by the kind of currency appreciation that would follow an interest rate rise, or even a really credible commitment to hold inflation down. And given the difficulties of handing out explicit haircuts, a modest amount of inflation seems likely to be a low-risk way of easing debt burdens without endangering the (largely German and French, and also UK) banks that hold a lot of the debt.
As has been pointed out here on previous occasions, to say that the problem is the ECB rather than the euro is, for some purposes, a distinction without a difference. But in other respects it is critical. If the optimal currency area analysis is correct then a breakup of the euro is probably inevitable and the big question is how to manage it. On the other hand, on the analysis offered here, the ECB must, in the end, be bluffing. Faced with the end of the currency it has been set up to manage, the ECB must eventually back down on everything else, including its inflation targets. The problem on this analysis is how to broker the politics of pushing the ECB towards large-scale quantitative easing and a higher inflation target.
This is, of course, complicated by the fact that, as discussed in a number of the contributions to the seminar below, the actual policies being pursued and advocated by Germany don’t necessarily correspond to any reasonable conception of Germany’s national interest. In particular (and by no means uniquely to Germany) policies that are primarily driven by the interests of banks have become the basis of a popular backlash against other scapegoats – in this case the citizens of the peripheral economies who are on the hook for failures of the financial sector. Until that’s understood, the disastrous policies of the ECB will continue to go unchallenged.