Business World

Sunday 25 March 2018

Eurozone is not in fit state to face another downturn

Ashoka Mody. Photo: Damien Eagers
Ashoka Mody. Photo: Damien Eagers

THIS begins to look worryingly familiar. The Irish economy is powering ahead, with a recovery which has tracked the most optimistic scenarios of past forecasts. But doubts are growing about the eurozone's prospects, as trouble in emerging economies threatens to derail the German export locomotive.

Surely we could not face again so soon the prospect of policies in Europe being too stimulating for a booming Irish economy? We have only just emerged from the opposite; where they were too restrictive for a collapsing Irish economy.

It is a bit too soon to say. At the very least, the prospect of an interest rate rise at the European Central Bank seems as far away as ever. It has receded in the US and UK.

For the eurozone, and especially its more indebted members, the concern is that the faults in the monetary union architecture, so painfully revealed during the crisis, have not been eliminated. The cracks could appear again in any significant downturn.

They were catalogued recently by Ashoka Mody, best-known here for his membership of the first IMF rescue team but, since his departure from the Fund, a scourge of eurozone policy and design through his work for the Brussels-based Breugel thinktank.

Mody noted that the euro area's regime requires member states to rely largely on their own resources when confronted with severe economic distress. Since ECB monetary policy is the same for all, national fiscal austerity must be the response to counter national fiscal stress.

It might be thought that monetary policy should take account of this less than ideal arrangement and offer more stimulus when any significant number of states are in severe distress. But that is not the ECB's mandate, and many of its central bankers dispute that there is a stimulatory role for interest rates at all.

That may explain why, in mid-2014, more than five years after the US Federal Reserve had brought rates close to zero and started quantitative easing, the ECB was still publicly debating if it needed to do more in the eurozone. This record is under increasingly hostile scrutiny. The debate goes on.

A cold eye is cast on eurozone policy since 2010 in a research paper by Kieran McQuinn, associate research professor at the Economic and Social Research Institute.

He concentrates on fiscal policy, arguing that it has been decidedly pro-cyclical, exacerbating the recession and thereby worsening already high debt/GDP observed in many European countries.

There is not much doubt about the fiscal stance. Deficits were reduced across the euro area, while the USA was providing a stimulus of more than $800bn.

It is argued that this explains the sharp divergence in the two entities from 2010, especially in unemployment.

It does not help that most euro countries behaved unwisely during the boom. They emerged from that with underlying budget deficits of around 4pc of GDP.

The European Commission calculated France's deficit at 6pc, with even higher figures for the southern states plus Ireland.

All did indeed tighten their budgets even as their economies contracted. The euro area's structural deficit - the estimated figure if the economy were growing exactly at its capacity - fell from 4pc of GDP to 0.5pc from 2010 to 2014.

Within that, France did a great deal of tightening, from 6pc to 2pc. That is not far off Ireland's fabled correction from 8pc to 2pc of GDP. And all of this in a severe recession. Even highly solvent Germany tightened its structural deficit moving from 2pc to a surplus of 1pc of GDP.

It is essentially a political question as to whether it could have been otherwise. The IMF maintains that most eurozone countries had enough "fiscal space" to increase their deficit and debt levels, although the worst cases - including Ireland - did not. In theory the less challenged could have provided some fiscal stimulus for the zone, which would have been a particular help in cases like Ireland's where there were high levels of household debt.

Their decision not to do so was a matter of separate national decisions, not a collective euro area one. The politics of most northern states, not just Germany, do not permit the kind of deficits run by the USA and UK. The philosophical gap is even larger when one considers how many economists, led by Paul Krugman, think the American and British borrowing wasn't large enough.

As well as that, to be effective, a less stringent fiscal approach in the creditworthy countries would have to be coupled with less stringent bailout conditions for the stressed ones. That takes us even further from the realities of European politics.

McQuinn recognises this and suggests that a substantial eurozone investment programme could in theory deliver results with minimum electoral difficulties. Most could be financed through the European Investment Bank and project bonds. Politicians would still have to sell the idea of a bigger EU budget and giving countries in weaker economic circumstances a larger share of the investments.

But, as he says, the feeble programme now on the table appears to represent the limit of what is politically achievable. That leaves only the even more difficult option of greater fiscal integration, with some form of "euro bonds" backed by a transfer of tax revenue from member states a eurozone treasury.

"This may well give rise to certain difficulties from an Irish perspective, with greater focus on issues such as the harmonisation of corporate tax rates. Ultimately, this will involve some estimation and assessment as to the relative trade-offs of the different policy options," he says.

The Irish recovery will have changed assessments of any such trade-off already. Didn't it come out alright in the end? The paper suggests the turnaround is much as would be expected in an economy like Ireland's. In the deflationary period, relative prices decline, competitiveness improves and exports start to increase. Once the government starts to relax the fiscal squeeze output starts to return its long-run level.

It also points out that, even with the strong growth rates, the Irish economy will not be back to its pre-crisis income levels until next year or even 2017. That may explain the limited political gain for the government from the recovery so far, as well as leaving the debate to rumble on as to whether different eurozone policies would have made things better. Even as possible new difficulties loom, there is little sign that the peoples of Europe will be asked to make any decisions on that.

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