The European Central Bank has deployed almost the last of its depleted supply of conventional monetary stimulus, cutting its benchmark interest rate last week to 0.5 percent from 0.75 percent. Few expect this to make much difference to Europe’s flailing economy, and financial markets were unmoved. If conventional monetary policy is all but used up, what else is there?
He said the crux of the challenge was the competitiveness gap between Greece, Portugal, Spain and the other troubled economies on one side and Germany and its successful neighbors on the other. The European Union’s problem isn’t that its economy as a whole is struggling, but that some countries are doing so much worse than others. This divergence calls for policies aimed at particular countries. Thanks to the single currency, orthodox monetary policy can’t play that role.
The choices, he said, boil down to three. First, presumably by resorting to unconventional stimulus -- such as quantitative easing -- the ECB could try to raise prices in the core countries faster than in the periphery. That won’t happen because Germany won’t stand for it. Second, Greece and the others could let the combination of very high unemployment and structural economic reform slowly grind down wages and prices. That will be impossibly painful, he believes. Third, there could be exits -- possibly temporary ones -- from the euro system. That would close the competitiveness gap by allowing for devaluations; on the other hand, the short-term costs of exits are severe.
All the possibilities are bad, Sinn said: “The solution set is in a sense empty for the euro zone.” All that can be done is to muddle through using a mixture of all three terrible options. Brutal adjustment in the periphery (plus debt restructurings that bail in investors, Cyprus-style). A pinch of above-target inflation in Germany and the rest of the core. Temporary exits from the euro area for the worst cases. That’s what Sinn expects and, indeed, recommends.
There’s a fourth option -- one that Sinn disapproves of so intensely he could hardly bring himself to mention it. That’s overt fiscal transfers, in one form or another, from strong economies to weak, to help ease the pain of adjustment. Such transfers supplant private investment decisions with political investment decisions, he said. It would be the end of Europe’s capitalist market economy. “I think it would be a disaster,” he said.
If you ask me, that’s ridiculous. In a situation that requires choosing the least painful mix of policies from some very unpalatable options, a degree of fiscal risk-pooling -- say, through the creation of conditional euro bonds -- ought to be part of the remedy. And it eventually will be, I’m willing to bet, because Germany and the core will come to see it’s in their best interests. (When the choice is between fiscal transfers and debt bail-ins for Germany’s undercapitalized banks, see what happens.) But Sinn is right that there will be no coherent strategy. That’s never how the EU does things.
He’s right, too, that narrowing the price-and-labor-cost gap between core and periphery is crucial. The ECB can’t act directly on that. In a way, it’s irrelevant to the main problem. The question is what national governments such as Greece, Italy and Spain can do to ease the process.
What’s needed is internal devaluation. An ordinary devaluation works by raising import prices, which reduces real wages. Living standards fall, but so do relative labor costs, which helps restore growth. Internal devaluation -- that is, “devaluation” with the exchange rate fixed -- has to reduce relative labor costs in some other way. One possibility is tax reform. Raise sales taxes while cutting payroll taxes, for instance. This has already been done in several countries, though on a timid scale.
Then there’s high unemployment, which eventually drives down wages -- or ought to. The signature problem of countries such as Greece and Spain is that extremely high unemployment has had so little effect on labor costs. That’s the sign of a broken labor market and a promise of prolonged economic agony. But internal devaluation has worked better in Ireland, for instance, which has now closed much of its competitiveness gap. Germany, as Sinn noted, achieved internal devaluation after its labor costs got out of line during the previous decade. This was done partly through wage moderation caused by reforms to its unemployment insurance system.
One approach I’m surprised hasn’t aroused more discussion is “incomes policy” -- mandatory or quasi-mandatory cuts in wages. This method of curbing inflation was popular in many countries during the 1970s, then fell into disuse. As you might expect, the countries that tried it found it ill-suited to curbing chronic inflation, because evasion, distortions and anomalies built up over time. It’s more promising as a way to cut labor costs abruptly and by a lot. Before you dismiss the idea, consider the relevant alternatives -- a cruelly extended spell of high unemployment or a conventional devaluation with the huge additional costs that would attend an exit from the euro system.
Despite reports to the contrary, internal devaluation can work. Ireland has shown that and so, oddly enough, has Germany. For Europe’s sake, it must be made to work in Greece and the other struggling economies -- not as the only treatment, but alongside fiscal transfers and other measures. To work, internal devaluation has to hurt. Whether the pain is bearable or unbearable depends on how it’s done.
(Clive Crook is a Bloomberg View columnist. The opinions expressed are his own.)
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