At long last, this is going be a good year for the eurozone economy. But to maintain the present annual rate of growth of about 2 per cent, policymakers will need a strategy, or at least an agreed procedure, to deal with external shocks.
Some shocks you cannot prepare for. Others can be anticipated, such as the eventual unwinding of global imbalances. My hunch is that the eurozone’s policymakers are hopelessly unprepared for such an event.
An unedifying fight over policy co-ordination between the eurozone’s two most senior policymakers is a sign that the policy machine is dysfunctional. The big issue in eurozone economics appears to be whether Jean-Claude Trichet, president of the European Central Bank, was right or wrong in not answering a letter written by Jean-Claude Juncker, president of the eurogroup of finance ministers, calling for closer co-ordination.
When it comes to dealing with external shocks, it matters a great deal whether the two are on speaking terms. What they should say to each other obviously depends on the nature of the shock. There are several shades of opinion about global imbalances. The mainstream view argues that the US current account deficit, at 7 per cent of gross domestic product, is unsustainable. Any inevitable rebalancing would require a big depreciation of the dollar exchange rate, especially against the euro.
A more recent line of argument suggests that the true US current account deficit may be much lower than the official figures indicate. The current account balance is the sum of the trade balance, changes in net foreign assets and net labour income. The second category includes items such as dividend payments but not capital gains, which have been substantial. Some economists have argued that this valuation effect significantly reduces the need for a global adjustment.
If the optimists prove right, Mr Juncker and Mr Trichet can continue to squabble over whether or not to meet for breakfast. If not, they need a strategy.
The Europeans have a point when they say they are not part of the problem. Global imbalances are a predominantly transpacific affair. The US may have an unsustainable current account deficit, just as many Asian countries have an unsustainable current account surplus. Likewise, the dollar is overvalued against Asian currencies on most measures. The eurozone does not figure here at all. It runs only a small current account deficit against the rest of the world.
But the fact that the eurozone is not part of the problem does not make it immune to the effects of the solution. As a report by Cesifo*, the economic research network, on the European economy concludes, a substantial depreciation in the dollar’s real exchange rate could cause problems for the eurozone: a sudden drop-off in global demand for European exports; a fall in Europe’s wealth relative to the US through the valuation effect of investments; a collapse in house prices in parts of the eurozone such as Spain; a widening of business cycle and inflation differentials across eurozone member states; turmoil in European markets that could destabilise financial institutions.
This is the kind of situation in which you wish your two most senior policymakers would talk to each other. Unfortunately, this is probably not quite what Mr Juncker had in mind when he proposed closer co-ordination. If he were serious about effective policy co-ordination, he would offer a unilateral and unconditional 1 percentage point cut in the eurozone’s structural deficit now.
The eurozone, if it ever faced a big financial shock, would need much more fiscal flexibility than it has now. With a structural deficit of 2 per cent as forecast by the European Commission for 2006 and a 3 per cent deficit ceiling imposed by the Maastricht treaty, there is not enough headroom to deal effectively with an external shock. With fiscal policy constrained, most of the burden would fall on a reluctant central bank. But even if the ECB did everything it should, this might not be enough to solve the simultaneous problems of financial distress, falling prices and a sudden drop in demand.
An appropriate response to a shock would require two ingredients that are not in place in the eurozone: a central bank that does not see co-ordination as an inevitable threat to its independence, and a political commitment to achieve fiscal balance over the economic cycle. The Cesifo report concludes: “Perhaps the most important risk for Europe associated with global imbalances is that of facing a severe crisis without effective policy instruments to stabilise the European economy.”
This is a damning judgment on the world’s second largest monetary area. The role of the euro as an international transaction currency is already significant and its importance is likely to increase in future years. Yet European policymakers continue to have a predominantly small-country mindset. They are obsessed with small-country issues and they have petty, small-country fights. Come to think of it, the eurozone’s policy regime is probably just as unsustainable as the US current account deficit.
*Report on the European Economy 2006; www.cesifo.de/link/70eeagreport