The Missing Piece of the Euro Model

When one attempts to continue a previously successful policy, and the results disappoint, it becomes paramount to double check to see if indeed the same policy is in place, as perhaps an element has been omitted that was more important than previously recognized. This is precisely the problem with the euro area economic policy as it is currently practiced.

Since the introduction of the euro, eurozone economic performance has fallen below expectations.  The eurozone output gap has continued to grow, as unemployment remains unacceptably high and capacity utilization unacceptably low. The European Central Bank has responded with ultra low real interest rates, which have now been in place for a number of years. But as some of us have been arguing for some time, and also recently suggested by J.K. Galbraith in his latest book, entitled ‘The Economics of Innocent Fraud’, it is highly unlikely in general that interest rate policy is a strong enough force to itself close a gaping output gap, and indeed reduce a stubbornly high unemployment. Euro area exports, once the engine of continental growth and a source of national pride, have been subdued, as the euro seems to seek a level just high enough to put a damper on export growth. While economists find reason to blame the failure of exports on softening world demand, the more fundamental problem is overlooked.

A bit of history is useful in recognizing what has happened.  Germany, before monetary union, kept fiscal policy sufficiently tight to constrain domestic demand, while the Bundesbank purchased sufficient quantities of $US to retard currency appreciation to support the German export industries.  While arguably this policy did not maximize well being for the German consumer, it did keep German exports competitive.  GDP was reasonably high, unemployment relatively low, and the notion of a ‘strong mark’ was politically popular as a source of national price.

The euro area, by design, continues the restrictive fiscal stance of the past, as evidenced by the low levels of domestic demand. Furthermore, the euro area export recovery has been subdued, as both the euro is just strong enough to put a damper on export growth and domestic demand remains rather flat. A number of cyclical factors, including the index of leading economic indicators, the business climate and manufacturing orders, suggest that the anemic recovery will gather pace for the remainder of the year, and world demand will expand at a faster pace improving the outlook for exports. However, the required foreign exchange purchase in response to the subsequent euro strength is lacking, leaving the export channel unsupported. This formally integral aspect of monetary policy, direct intervention in the currency markets by the Central Bank, is now thought politically unacceptable, as the purchase of $US and building of $ reserves would be read as a sign that the euro is ‘backed’ by $US reserves, rather than being recognized as a ‘challenger’ to the $US as the world’s ‘reserve currency.’ Note, too, the failure to recognize that to be a reserve currency the rest of the world must actually be able to obtain that currency. And the only way for the rest of the world to obtain and net save financial assets denominated in euros is to net export to the euro area. This means that if the euro area desires the rest of the world to hold euros as a reserve currency, the euro area must allow and even encourage net imports!

The result of current policy is both flat domestic demand and a euro that appreciates to levels just high enough to keep exports sufficiently expensive to prevent the export growth achieved by former regimes. By utilizing the export driven German economic model without the option of direct currency intervention, not only is a strong and sustainable economic recovery in the euro area not in sight, but also the risk of a further slowdown is increasing. Operationally, the euro area does have the option to expand. Unfortunately, self-imposed constraints, such as the political disposition not to buy $US, impose obstacles even to their traditional export-led approach to increased output and employment. Instead, they look towards improving world demand, which they fail to see would only further strengthen the euro and keep it just high enough to frustrate export growth. We have argued in this short piece that the euro area requires a different set of policies than what is currently pursued.

Philip Arestis
Cambridge Centre for Economic and Public Policy
University of Cambridge
Levy Economics Institute.

Warren Mosler
Associate Fellow
Cambridge Centre for Economic and Public Policy
University of Cambridge

Address for both authors:
Cambridge Centre for Economic and Public Policy
Department of Land Economy
University of Cambridge
19 Silver Street
Cambridge CB3 9EP

Tel. 01223 766 971
Fax: 01223 337 130

posted 8/24/04