Impossible Macroeconomic Trinity: The Challenge to Economic Governance in the Eurozone

Abstract

Europe now faces a new impossible macroeconomic trinity: it is no longer possible to combine monetary union, German political requirements and coherent economic analysis. Economic analysis shows that there must be more inflation in Germany, a significant fiscal expansion in Germany, a significant easing of austerity in the GIIPS countries and a write-down of much of the debt of southern European sovereigns. These changes will be resisted by Germany. But they are necessary if the monetary union is to survive.

Key Words:

• Monetary union
• fiscal austerity
• debt forgiveness

Acknowledgements

I am grateful to Christopher Allsopp, Lukas Freund, Wendy Carlin, Russell Kincaid, Klaus Regling, Peter Temin and Guntram Wolff for helpful discussions. An anonymous referee has made a number of helpful suggestions. And I am especially indebted to the late Max Watson who, over many years, helped me to think more clearly about European issues.

Disclosure statement

No potential conflict of interest was reported by the author.

Notes

1. I deliberately use the phrase ‘incoherent macroeconomic analysis’, rather than using Keynes’ language.

2. Greece, Italy, Ireland, Portugal and Spain.

3. I use this word to refer to a set of privileges and obligations which I do not discuss here.

4. See Stark (2015), for a very clear exposition of the German position. My article focuses on the position taken by Germany. It is correct that a change in the German position on these matters may not be sufficient to lead to an acceptance the reforms which I propose. But a change in the German position is necessary. That is why I focus on Germany.

5. Sapir (2012) identifies an inconsistency between free capital movements, financial stability and national financial supervision within a monetary union. Pisani-Ferry (2012) finds a contradiction between the no-monetary financing rule, the absence of a banking union and the fact that there is no co-responsibility for public debt. Bibow (2012) identifies an impossible trinity for the German nation: perpetual export surpluses, a no transfer/no bailout monetary union and a ‘clean’, independent central bank.

6. An arrangement of this kind — very different from what might have been contemplated for economic policy in the 1950s or 1960s — was already conventional by the time that EMU was established. Such an arrangement had already been established, with some difficulty, in the US, the UK, Australia, Canada and New Zealand, during the 1980s and 1990s. See Woodford (2003) and Allsopp and Vines (2000).

7. See also Issing (2002).

8. This Article demanded that ‘Member States … avoid excessive government deficits’. It called upon the ‘Commission [to] monitor the development of the budgetary situation and of the stock of government debt in the Member States with a view to identifying gross errors’, i.e. substantial excesses over ‘reference values’ (3 per cent of GDP for the deficit and 60 per cent for the debt) specified in the protocol on the excessive deficit procedure annexed to the treaty. Article 104c foresaw the Council being able to impose sanctions if a Member State persisted in failing to correct its situation.

9. This would allow EMU countries to deal with normal cyclical fluctuations while keeping their government deficit below the reference value of 3 per cent of GDP. In essence, the SGP was designed to transform the 3 per cent reference value specified in the treaty, which remained untouched, into a hard ceiling.

10. Erik Jones, in Chapter 7 below, agrees with this identification of the Eurozone’s problems, but nevertheless offers a ‘solution’ which does not address them. He instead argues for financial reforms, because ‘a close focus on financial markets promises to offer the greatest leverage over the largest number of national economies’. This is clearly a non-sequitur.

11. See Temin and Vines (2013, Chapter 5) for a plot of these cumulative divergences, which remorselessly built up over a period of nearly 10 years.

12. Such a two-for-one feature results from the fact that the trade-off between inflation and unemployment is only a short run trade-off (see Alesina et al. 2001).

13. ‘The ECB aims at inflation rates of below, but close to, 2 per cent over the medium term’.

14. See Temin and Vines (2013, Chapter 5).

15. It is clear that the real interest rates which emerge in this way do not respect the Taylor principle, which requires that real interest rates rise as inflation rises (see Woodford 2003).

16. A country in a monetary union is more likely to have a stable economy if the private sector in such an economy is also forward looking in its expenditure decisions; see Allsopp and Vines (2008) and Kirsanova et al. (2007). But this additional point seems rather unimportant in the light of our experiences in the GFC.

17. Watson was then Economic Adviser to the Director General of the Directorate General for Economic and Financial Affairs (DG-ECFIN).

18. The SGP was violated during this period, for which Germany is often criticised. But if the SGP had been respected, German fiscal policies would have been even tighter.

19. Some of the papers in this Journal consider some of the reforms which I propose, in particular Chapters 1, 2, 5 and 7. But these reforms need to be located within a changed macroeconomic framework of the kind which I describe.

20. Britain’s overvaluation in 1925 was less than half of what there is in Europe at present, and yet adjustment proved to be impossible.

21. This statement is correct even although there have been repeatedly extended extensions of deadlines.

22. For a discussion of how this needs to be done, see Allsopp and Vines (2005, 2007, 2008), HM Treasury (2003), Kirsanova et al. (2007), Kirsanova, Stehn, and Vines (2005), Leith and Wren-Lewis (2004), Pisani-Ferry (2002), Swedish Government (2002), Westaway (2003), and Wyplosz (2005).