Will a fiscal policy fix Europe’s defective monetary policy?

September 3, 2017

President Macron and Chancellor Merkel are agreed that the EU should look again at the structure of the eurozone.  There appear to be two proposals to improve its functioning. The first is the creation of a eurozone finance ministry so that monetary policy can be complemented by a macro-economic fiscal policy, and the second a framework of transfer payments.

Reviving the Werner Report

In many respects these proposals reopen the agenda for economic and monetary union laid out in the Werner Report in 1970.  Back then, standard macro-economic theory and practice emphasised the role of active fiscal policies in managing the business cycle and there was greater confidence among policy makers about the efficacy of regional aid and other transfer payments.

Can we afford not to look at fiscal policy?

Over the last fifteen years there has been a revival of interest in the role that active fiscal polices can have in stabilising macro-economic activity. This has resulted from the apparent effectiveness of President Bush’s tax cut in 2001, the use that most governments in advanced economies made of fiscal stimulus policies between 2008 and 2010 and the challenges that central banks may face in stabilising output in the context of very low rates of inflation and very low interest rates – ‘policy rates’.

Part of last week’s Jackson Hole Economic Policy Symposium was devoted to a paper exploring Fiscal Stimulus and Fiscal Sustainability by Alan Auerbach and Yuriy Gorodnichenko. The commentator on the paper, Jason Furman, was until January the Chairman of President Obama’s Council of Economic Advisers, and posed the question ‘Can we afford not to engage in fiscal expansion in a severe recession?’  Considering the role of fiscal policy as part of macro-economic policy is not unreasonable. The big question remains, however, not about how fiscal policy may or may not have a role, but about the structural defects in the construction of the eurozone.

The eurozone’s fundamental problem: not an optimal currency area

The eurozone does not conform in even a rough manner to an approximation of an optimal currency area. Few currencies operate across an absolutely perfect or optimal currency area. As one Federal Reserve Board official commented at the time of the construction of the eurozone twenty years ago, the US has one currency but he would not for one moment suggest it covered a perfectly optimal currency area. The euro’s problem is the extent of its lack of conformity to the broadly agreed criteria for assessing the workability of a currency union.

It is composed of economies and political communities that are diverse. They have different economic structures, traditions and patterns of trade and output. They respond differently to incentives and to the principal instruments of monetary policy such as interest rates. They do not have flexible product and labour markets. As the IMF noted in June in its regular review, it faces deep rooted structural challenges. IMF economists commented that ‘real income convergence among the twelve adopters of the euro has stalled, bringing into question the promise of higher incomes through integration. At the same time , competitiveness gaps between euro area countries widened in the years after the euro adoption and remain wide, despite painful post crisis adjustments ‘.

A monetary union was always going to be awkward but its challenges were compounded

Many of these structural inflexibilities result from decisions about taxation, social security transfer payments and employment regulation made by national governments, entrenched and amplified in many instances by EU labour market regulation such as the Working Time Directive. EU member states that have pursued structural reform programmes have deliberately supported labour market regulation that would hinder competition from weaker members of the Single Market. President Macron’s sensible domestic employment reforms are matched by support for regulation that protects French workers from external competition and what German and French policy makers have called ‘social dumping’. These issues were at the heart of the argument between Margaret Thatcher and Francois Mitterrand and Helmut Kohl over Jacques Delors’ proposed European Social Charter and the action programme of directives to give effect to it in 1989. When the Delors Report on monetary union was published in 1989 it was clear that a single currency could only work if the EU became more flexible. Instead through the Social Chapter of the Maastricht Treaty it embarked on further regulation that hindered its proposed monetary union. It has amounted to policy at war with itself.

Asymmetric shocks and the problem of one size having to fit all

From the start it was clear that the eurozone would be exposed to asymmetric shocks. That is adverse events that have a disproportionate impact on one part of the monetary union yet do hardly any damage to the rest of it, requiring an entirely different macro-economic policy response. It was always likely that the appropriate monetary policies for Austria, Germany and the Netherlands would be inappropriate for Portugal, Italy, Ireland, Greece and Spain.  In short, one monetary policy at any one time would not suit all the economies that were subject to it. And these problems are aggravated by the absence of an exchange rate that can adjust to changing circumstances. A one size monetary policy would not be suitable for all and when things go wrong there is no monetary safety valve in the from of exchange rate adjustment .

The Maastricht criteria for admission to the euro-zone took no account of real economic matters such as product and labour market flexibility, competitiveness and differences in GDP per capita. Differences in income are important. A wealthy community will take a different approach to the same problem than a poor community would. A narrow financial convergence at one point in economic history is not the same as a genuine economic and social convergence that results in a natural comity of financial and political economy.

A disappointing performance

Eighteen years after the launch of the euro, the ambitions of the authors of the Delors Report and the expectations of the economists who worked on the Single Market such as the late Thommaso Padoa Schioppa have been disappointed. Both the Single Market and Single Currency were intended to reinvigorate the EU economy and end eurosclerosis. Yet looking at the results it is hard not to conclude that the euro’s creation compounded the difficulties the EU economies had at the end of the 20th century rather than remedying them.

Weak economic growth

Economic Growth has been disappointing. Since the euro’s launch, national income in France and Germany has increased by 26 per cent and in Italy it has increased by 5 per cent in eighteen years. This compares with growth in GDP of over 40 per cent in North America.

GDP (Billions, National Currency) Change since 1999
Austria 319.49 130%
Belgium 418.583 131%
Finland 192.199 128%
France 2,149.98 126%
Germany 2,878.45 126%
Greece 188.457 103%
Ireland 265.269 219%
Italy 1,581.91 105%
Lithuania 35.368 200%
Luxembourg 49.659 176%
Netherlands 683.672 128%
Portugal 176.822 110%
Spain 1,131.40 137%
Australia 1,729.82 168%
Canada 1,830.42 146%
UK 1,903.61 139%
US 17,046.51 141%


Deep seated structural unemployment

In many respects the most disappointing part of the story has been unemployment. In much of the eurozone unemployment is double the rate in the US and the UK. The rate of youth unemployment is much worse with rates of 24, 37 and 44 per cent in France, Italy and Spain.

Youth Unemployment Rate (15-24, 2016, OECD)

Austria 11.2
Belgium 20.1
Finland 19.9
France 24.6
Germany 7.1
Greece 47.4
Ireland 17.2
Italy 37.8
Luxembourg 18.7
Netherlands 10.8
Portugal 27.9
Spain 44.5
Australia 12.7
Canada 13.1
UK 13.0
USA 10.4


Widening Unit Labour Costs that aggravate challenges arising from differences in competiveness

There remains a wide dispersion of incomes. Differences in Unit Labour Costs have actually increased since 1999. Indeed a single monetary policy in the form of a single policy interest rate has driven economies apart rather than helped them to converge. Booming economies with higher inflation had low or negative real interest rates while slower growing economies with low inflation had higher real interest rates. Thus booms and downturns were exacerbated rather than dampened – pro-cyclical policy in the jargon.  This aggravates the lack of competitiveness of many parts of the monetary union particularly in relation to Germany and increases the losses of economic welfare that arise from monetary conditions that are inappropriate for the economies that are affected.

How far can active fiscal policies and transfer payments overcome these fundamental defects?

In principle, within a monetary union without independent exchange rates or central banks, active fiscal policy could be even more important to adjust for asymmetric shocks. However, in practice, the clumsy construction of the Maastricht convergence criteria in relation to budget deficits has made this difficult. Moreover, there are fundamental limits on what fiscal policy and transfer payments can do when their purpose is to offset an inappropriate monetary policy. When the UK participated in the ERM at the depth of the recession in the early 1990s, it had an inappropriately tight monetary policy. Fiscal policy was deliberately relaxed to offset the monetary squeeze exerted by the ERM. Public expenditure was increased  and there was a large fiscal deficit of around 7 per cent of GDP, but the economy did not recover until domestic and external monetary conditions were relaxed. Monetary policy through interest rates influences all saving, investment and consumption decisions, whereas fiscal policy directly affects a much smaller part of the economy. Even President Obama’s close to $800 billion fiscal stimulus in 2009 was deemed to be too small for the US economy; it is not clear how large a discretionary fiscal intervention would have to be to influence the eurozone.

In terms of narrowing incomes between different regions it is not clear how effective transfer payments would be. Economists at the European Central Bank have looked at the effects of transfer payments within the EU. Cristina Chechenia, Christiane Nickel and Phillipp Rother’s paper, The Role of Fiscal Transfers for Regional Economic Convergence in Europe (ECB working paper number 1029, March 2009), found that public expenditure transfer payments on average impede output growth. Far from helping, there is a negative impact on the regions that receive fiscal transfer payments, and an even higher negative impact arising from net taxes on the growth of the regions that finance the transfers. The result is as they describe it a ‘process of “immiserising convergence” with output growth rates in the receiving poor regions declining by less than in paying rich regions in reaction to the tax-transfer scheme’.

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