View metadata, citation and similar papers at core.ac.uk brought to you by CORE provided by Research Papers in Economics The Journal of Economic Analysis YEAR 2010, VOLUME I, ISSUE I, PAGES 1-14 THE PROBLEMS OF THE ECONOMIC AND MONETARY UNION: IS THERE ANY ESCAPE? PHILIP ARESTIS University of Cambridge & University of the Basque Country MALCOLM SAWYER* University of Leeds ABSTRACT: The financial crisis and recession have highlighted a range of problems with the ‘euro project’, but these problems and difficulties are related to some fundamental issues for the euro. The convergence criteria established by the Maastricht Treaty focused on nominal rather than real variables, failed to relate to issues such as current account positions. There are well-known difficulties of macroeconomic policies under the Stability and Growth Pact including its deflationary nature and the ‘one size fits all problem’ of imposing common deficit requirements on all countries. The economic performance of the eurozone countries is briefly reviewed with attention paid to the differential inflation rates; also accounted for are the changes in competitiveness as well as the current account deficits, and their implications for the future of economic performance within the eurozone, and the euro itself. The patterns of current account deficits and surpluses are linked with unemployment, lack of competitiveness and budget deficit issues. The nature of the reforms to the operations of the eurozone is examined. The political limits (including those arising from the nature of the Treaty of Lisbon) and the ideological constraints (associated with the neo-liberal agenda) on serious reforms are discussed from which the general conclusion is that the needed reforms will not be carried through. This discussion also includes consideration of the possible role for a substantial EU-level fiscal policy and some other aspects of political union. It is argued that the deep-seated problems are unlikely to be resolved, casting a dark shadow over the future of the euro. I. INTRODUCTION The ‘great recession’ of 2008/10 (and perhaps beyond) following the global financial crisis has raised many severe economic problems for countries around the world but in many ways no more so than in the eurozone countries. The sharp increases in budget deficits as the economies slowed and tax revenues plummeted meant that the limits of the Stability and Growth Pact (SGP) were breached. Fortunately, the immediate response was generally to accept the breaches of the SGP but it was not long before the calls for concerted action for reduction of budget deficits and fiscal consolidation started. The danger now is that attempts by countries to cut their budget deficits will have cumulative negative effects on employment and growth and have little actual effect on budget deficits. * Received: March 30, 2010. Accepted: June 09, 2010. Email: M.C.Sawyer@lubs.leeds.ac.uk. THE JOURNAL OF ECONOMIC ANALYSIS (Vol. I, No. I) 2 The need for substantial budget deficits well in excess of the 3 per cent of GDP limits under the SGP and the, in effect, temporary suspension of those limits focused attention on the shortcomings of the SGP with regard to the use of budget deficits for fiscal stabilisation. But, there is a range of other inherent difficulties in the policy framework of the eurozone. These difficulties arise from policy omissions rather than commissions, and include lack of an effective policy on inflation notably with regard to differences in inflation between countries, and the effects of continuing current account deficits for a number of countries, counterbalanced by surpluses in others, with the associated need to borrow from outside the country with lack of any adjustment processes. The interaction of the deflationary tendencies of the SGP, inability to address differential inflation and the resulting misalignment of competitiveness between member countries, and the patterns of current account deficits and surpluses, provide a toxic mixture for the economic prospects of the eurozone countries. In this paper we first review the convergence criteria and the Stability and Growth Pact in order to understand the failings, which were built in to the euro project. This is done to illustrate the nature of the ‘euro project’ and also to indicate how some problems (such as current account deficits in many Mediterranean countries) were left unaddressed at the start of the project and have now come to undermine the edifice of the Economic and Monetary Union (EMU). The next section briefly considers the Stability and Growth Pact as the governing framework of the euro, which again highlights some of the policy faults which lie at the heart of the euro. Section 4 highlights key features of economic performance of the EMU members since the formation of the euro. In section 5 we review a number of policy considerations leading to suggestions for major policy changes, which could enable the euro to function effectively. The final main section then turns to the question of whether the euro can be saved, where it is argued that the constraints of the Treaty of Lisbon and the neo-liberal framework, within which most of the countries of the EU operate are likely to preclude relevant policy changes being made. This is likely to consign many countries with a choice between remaining members of the euro and economic prosperity. II. THE CONVERGENCE CRITERIA It is well-known that the Maastricht Treaty established a set of ‘convergence criteria’ which a country had to satisfy to join the single currency; and in the other direction, if they did satisfy the criteria were obligated to join, except for those countries securing an opt-out. These ‘convergence criteria’ are largely of historic interest, though are still relevant for those EU countries who may seek to join the euro in the future. But the ‘convergence criteria’ do provide some insights into the nature of the ‘euro project’ and to which elements were deemed significant and important (and by omission which not so deemed). The adoption of a national ‘independent’ Central Bank, as a forerunner for inclusion into the European System of Central Banks with the European Central Bank (ECB) at its apex signalled the adoption of a neo-liberal agenda1. The requirements for budget deficit below 3 per cent of GDP and public debt below 60 per cent were signals of the fixation with budgetary position, though in practice the 60 per cent limit was not attained by many who joined and the 3 per cent limit reached in a number of cases only through the use of creative accounting2. The requirements for the interest rate and inflation rate in a country to be close to the average achieved in the three countries with lowest inflation had the inherent rationale that since after the formation of EMU, a single interest rate regime would apply and a common inflationary experience would be required for the successful continuation of the euro. A stability of a country’s exchange 1 2 Refs to other discussion Lucarelli (2004), Arestis and Sawyer (2006a). See Arestis et al. (2001). P.G. Michaelides, National Technical University of Athens © 2010 Kindly hosted on-line: http://users.ntua.gr/jea 3 THE JOURNAL OF ECONOMIC ANALYSIS (Vol. I, No. I) rate relative to the other countries of the EMU had a similar intuitive appeal since after all the exchange rates of the EMU countries were about to be locked together. The omissions from the convergence criteria were notable for what they indicate was deemed to be important and what unimportant, and those omissions were the source of many problems which followed. There was no mention of convergence of the business cycle, which was significant in relationship to EMU macroeconomic policy, which was in effect monetary policy. Monetary policy is of necessity an undifferentiated policy and inevitably runs into a ‘one size fits all’ problem. There was also a lack of concern over the level of unemployment in terms of a lack of any reference to low levels of unemployment being an objective of monetary policy (or any other policy). There was a lack of concern over differences between countries over unemployment on entry into a fixed exchange, which constrains high unemployment countries to draw level with fellow eurozone member countries with relatively low unemployment. Whilst the convergence criteria required convergence of inflation rates at the time of admission into the EMU, there was little concern as to whether there was a similarity in inflationary conditions; for example, whether meeting the inflation target (initially in the range 0 to 2 per cent per annum, the interpretation of price stability) would require different rates of unemployment. There was also rather surprisingly little attention given as to whether the exchange rate at which a country entered the euro was a sustainable one – the only regard paid in that respect was that prior to entry the currency concerned had been within the Exchange Rate Mechanism (ERM) and hence that the exchange rate of the currency had remained relatively close to the central value. But no regard appears to have been paid to whether the current account was in deficit or surplus, and hence whether the corresponding capital account position would prove sustainable. The mixture of the dissimilarities of inflationary conditions and the lack of regard to the sustainability of the current account position on entry has now come to haunt the EMU. The competitiveness of some countries has deteriorated adding to their current account deficits, and the need to borrow from abroad to meet the deficit. What had been private borrowing from overseas turned into public borrowing under the impact of the ‘great recession’. III. THE STABILITY AND GROWTH PACT The SGP and its approach to fiscal and monetary policy is at the heart of the policy framework of the EMU and provides a strong indictor of the nature of the euro project. ‘Member States shall avoid excessive government deficits’ (Treaty, Article 127(1)) is the key concept of the Stability and Growth Pact. ‘The Commission shall monitor the development of the budgetary situation and of the stock of government debt in the Member States with a view to identifying gross errors. In particular it shall examine compliance with budgetary discipline on the basis of the following two criteria: (a) whether the ratio of the planned or actual government deficit to gross domestic product exceeds a reference value, unless: — either the ratio has declined substantially and continuously and reached a level that comes close to the reference value; — or, alternatively, the excess over the reference value is only exceptional and temporary and the ratio remains close to the reference value; (b) whether the ratio of government debt to gross domestic product exceeds a reference value, unless the ratio is sufficiently diminishing and approaching the reference value at a satisfactory pace.’ (Article 127(2)). The Protocol 12 on excessive deficit procedures gives 3 per cent of GDP as the reference level for budget deficits and 60 per cent of GDP P.G. Michaelides, National Technical University of Athens © 2010 Kindly hosted on-line: http://users.ntua.gr/jea THE JOURNAL OF ECONOMIC ANALYSIS (Vol. I, No. I) 4 for debt. There is also the view that ‘Adherence to the objective of sound budgetary positions close to balance or in surplus will allow all Member States to deal with normal cyclical fluctuations while keeping the government deficit within the reference value of 3 % of GDP.’ (Resolution of the European Council on the Stability and Growth Pact Amsterdam, 17 June 1997 Official Journal C 236, 02/08/1997 P. 0001 – 0002) It can first be noted that the aim of a balanced budget over the cycle is actually for an aim for a surplus in real terms when allowance is made for inflation and the reduction in the real value of public debt: with a 2 per cent inflation rate and 60 per cent debt ratio, this would be of the order of 1.2 per cent of GDP. A 60 per cent debt ratio is consistent with a continuing deficit of around 3 per cent of GDP – that would be based on a nominal growth rate of 5 per cent per annum (say 2 to 3 per cent real growth and 2 to 3 per cent inflation), and the formula b = d/g where b is the government debt to GDP ratio, d budget deficit (including interest payments) and g nominal growth rate. Hence, there is an inconsistency between a balanced budget requirement and a 60 per cent debt ratio. It has been the general experience of EU (and most other) countries that government budgets are in deficit – otherwise it would not be the case that many EU countries have (even before the present recession) debt to GDP ratio well in excess of 60 per cent. For example, the average budget deficit in (West) Germany in the two decades 1970 to 1991 was 2 per cent of GDP, and hence would not have meet the budget balance over the cycle requirement. It is then a mystery as to why countries have sought to impose upon themselves a fiscal constraint, which has rarely been observed in the past. For such fiscal constraints to make economic sense it needs to be shown that they are compatible with high levels of economic activity, and that the same constraints are relevant for all countries and across time. If it were to be accepted that there was no need for a budget deficit on average, based on some notion of Say’s Law and Ricardian equivalence, then imposing the same rule on all countries might follow. But unless there is a strong belief in Ricardian equivalence and Say’s Law, there is no justification for a budget balance requirement. The SGP brought a rather strange set-up for fiscal policy – at the EU level a very small level of expenditure (just over 1 per cent of EU GDP) and the requirement for a strictly balanced budget (and with no allowance for the differences in membership of EMU and the EU), and the appearance of a requirement for an overall balanced budget at the national level with allowance for the operation of the ‘automatic stabilisers’ over the business cycle; though that was in principle circumscribed by the 3 per cent of GDP upper limit. It was never explained why a balanced budget could be compatible with a high level of employment and economic activity. IV. ECONOMIC PERFORMANCE IN THE EUROZONE The economic performance of the eurozone countries are briefly reviewed in terms of growth, unemployment, inflation and current account, as well as the extent to which the requirements of the Stability and Growth Pact were met. Particular attention is paid to the differential inflation rates, the changes in competitiveness and the current account deficits, and their implications for the future of economic performance within the eurozone and the euro itself. The patterns of current account deficits and surpluses are linked with unemployment, lack of competitiveness and budget deficit issues. P.G. Michaelides, National Technical University of Athens © 2010 Kindly hosted on-line: http://users.ntua.gr/jea THE JOURNAL OF ECONOMIC ANALYSIS (Vol. I, No. I) 5 Table I: Growth for 1990s calculated 1991 to 2000 Austria Belgium Finland France Germany Greece Ireland Italy Luxembourg Netherlands Portugal Spain Eurozone average Budget surplus/GDP (%): average 2002-07 -1.85 -0.60 3.40 -3.15 -2.68 -5.07 1.07 -3.22 1.08 -1.12 -3.67 0.63 Current account position/GDP (%) 2002-09 2.54 1.96 4.53 -0.44 4.83 -9.73 -2.76 -2.00 8.61 6.51 -9.06 -6.68 Annual inflation rate 2002-08 Change in unit labour costs 20012008 (%) 2.07 2.28 1.81 2.16 1.88 3.65 2.87 2.62 3.04 2.20 2.68 3.33 3.50 11.96 4.33 7.66 5.37 17.02 34.55 9.73 9.48 11.41 7.44 16.49 -2.20 0.31 2.37 Source: Calculated from OECD, Economic Outlook database Table II: Growth for 2000s for period 2000 to 2007 Austria Belgium Finland France Germany Greece Ireland Italy Luxembourg Netherlands Portugal Spain EU-12 Growth 1990s* Growth 2000s** 2.3 2.3 2.9 2.1 1.7 2.3 7.7 1.6 4.6 3.2 2.7 2.8 2.1 1.9 1.6 2.1 1.5 0.7 4.3 3.9 0.3 3.7 1.6 0.7 3.0 1.3 Unemploy-ment rate (%) 2000 4.8 6.9 9.8 8.6 7.4 11.4 4.3 10.2 2.6 2.8 4.0 10.8 8.2 Unemployment rate (%) 2009 5.8 7.9 8.3 9.1 7.6 9.3 11.9 7.6 5.9 3.7 9.2 18.1 9.4 Current Account (% GDP) 1.9 -0.8 0.8 -2.0 4.0 -11.1 -2.8 -2.7 1.9 6.2 -9.7 -5.3 -0.5 Source: Calculated from OECD, Economic Outlook database Some summary data relevant for economic performance of the eurozone relating to the near decade since the euro was launched as a ‘real currency’ (and after three years as a ‘virtual’ currency) are provided in Tables I and II. The lessons which we would draw from Table I (and much more extensive data) are: (i) even over the years of 2002 to 2007 when the global economy was booming the average budget deficit was 2.2 per cent of GDP (which rises to 2.7 per cent if 2008 and 2009 included) (calculated from OECD Economic Outlook); four countries had a budget P.G. Michaelides, National Technical University of Athens © 2010 Kindly hosted on-line: http://users.ntua.gr/jea THE JOURNAL OF ECONOMIC ANALYSIS (Vol. I, No. I) 6 in surplus on average (Finland, Luxembourg, Ireland and Spain), but when the period is extended to 2009 the latter two countries average a deficit; (ii) there were large and continuing current account imbalances between the EMU countries; (iii) inflation rate was outside the 0 to 2 per cent range deemed to constitute price stability, albeit by only a small margin with the inflation rate lying between 2 per cent and 2.5 per cent in every year of the new decade until 3.3 per cent in 2008; (iv) there were substantial differences between countries in terms of changes in unit labour costs, and implied changes in competitiveness. In addition, the public debt ratio targets were generally missed, and even before the onset of the recession only the four countries named above plus the Netherlands had a debt ratio below 60 per cent of GDP. These outcomes did little to bolster the credibility of the EMU and it was the bolstering of credibility in the euro which was the rationale for the SGP. The growth performance of the eurozone during the 2000s was somewhat below the growth of the 1990s (as indicated in Table II) although the global economy was growing rather faster. The growth figures in that time run through to 2007, whereas, of course, if 2008 and 2009 were included the comparison between the 2000s and 1990s would be even less favourable to the euro project. Unemployment did fall during the mid part of the 2000s but the recession wiped out those gains. The figures in Table II indicate that current account positions vary substantially between countries with most Southern European countries having substantial deficits whereas Northern European countries have surpluses. We would draw the following conclusions. First, the record on achieving the targets of the EMU has not been a particularly good one, with inflation target persistently missed albeit by a small amount, and budget deficits frequently exceeding 3 per cent of GDP. Second, the economic performance in terms of growth and unemployment has been lack lustre. Third, there are clear problems of differential inflation, of major changes in competitiveness and the persistence of large current account imbalances. V. REFORMING THE ECONOMIC AND MONETARY UNION The arguments above have been to the effect that the economies of the eurozone have not been performing particularly well, and that the financial crisis has highlighted problems at the heart of the euro project. In this section we consider some of the changes in the policy framework and structures of the EMU which are required. Adjustment processes and Optimal Currency Area considerations The ideas on the ‘optimal currency area’ (OCA)3 had rather little influence on the formation of the ‘euro’. ‘The negotiators who prepared the Maastricht Treaty did not pay attention to the OCA theory’ (Baldwin and Wyplosz 2009, p. 345) and those authors pose the question of whether Europe is an optimum currency area with the answer that ‘most European countries do well on openness and diversification, two of the three classic economic OCA criteria, and fail on the third one, labour mobility. Europe also fails on fiscal transfers, with an unclear verdict on the remaining two political criteria’ (p. 340). The literature starts from Mundell (1961), McKinnon (1962) and Kenen (1969). For review see, for example, Baldwin and Wyplosz (2009, Ch. 11). 3 P.G. Michaelides, National Technical University of Athens © 2010 Kindly hosted on-line: http://users.ntua.gr/jea 7 THE JOURNAL OF ECONOMIC ANALYSIS (Vol. I, No. I) The OCA literature clearly pointed out that a monetary union means that the exchange rate between constituent members cannot be changed in nominal terms. Hence, the possibility of using changes in the exchange rate as a means of adjusting to economic ‘shocks’ or indeed to continuing difficulties was ruled out. There can though be changes in the real exchange rate through a change in the relative prices of constituent members. The OCA literature pointed to the possibility of ‘price flexibility’ as a device through which a country could adjust to an ‘economic shock’. But the expectation would be that a negative shock would be compensated by a fall in relative prices (of a country). In the eurozone it appears that there have been substantial changes in the real exchange rate of countries, as relative prices of countries have changed reflecting differential inflation between countries. But it is rather unlikely that these changes in relative prices have been responses to differential shocks and that those changes are an adjustment process – if anything the changes in relative competitiveness have worsened rather than lessened the disparities in current account positions. The emphasis of the OCA approach was on the ability (or otherwise) of an economy to adjust to shocks, where the adjustments were viewed in terms of market ones of price and factor mobility. What was little considered in the OCA or other literatures was the consequence for an economy, which joined the currency union with an economy, which was ‘unbalanced’. By that we mean an economy (or parts thereof), which had high levels of unemployment or one that had a large current account deficit. It is then not a matter of asking how could an economy adjust to a shock (particularly a negative one) to restore full employment but rather whether there is any prospect of an economy in a currency union escaping from high levels of unemployment. In order to reach a lower level of unemployment, the demand for the output of that economy has to be increased faster than output increases in other EMU countries. This would generally require that the productive capacity on which workers could be employed would also have to be created. Whilst there may be spontaneous increases in investment, there are clear limits on the policy instruments available to promote such investment. Further, those countries have to find additional markets for their exports without the benefits of devaluation. In a similar vein, an economy which enters into a currency area with a current account imbalance lacks the ability to correct that imbalance. When that economy is able to borrow to meet any deficit (and similarly is willing to lend when there is a surplus) the position would be sustainable, though its debts would mount. But such an economy has to rely on borrowing from overseas and being able to continue to do so. In our interpretation it is difficulties arising from such borrowing which underlies many of the problems of the EMU at present. The development of a substantial EU budget, which operates to make fiscal transfers between the relatively rich and the relatively poor countries and to act as some form of stabiliser (that is a country experiencing a downturn receiving a greater inflow of funds) is a major policy way in which concerns of OCA literature could be addressed. But the current account imbalances would remain, which would seem to require mechanisms by which a country with a current account deficit can in effect devalue in real terms, and hence a country with a surplus revalue. This is not possible of course within the EMU area, while the experience of the past decade in the EU area does not suggest that such adjustments would readily occur, and indeed it appears that on the whole prices have adjusted in a manner opposite to that. Fiscal Policy Two basic changes in the fiscal policy arrangements in EMU are required. The first is the need for an EU-level fiscal policy under which the scale of the EU budget P.G. Michaelides, National Technical University of Athens © 2010 Kindly hosted on-line: http://users.ntua.gr/jea THE JOURNAL OF ECONOMIC ANALYSIS (Vol. I, No. I) 8 would be greatly increased and the EU would be able to run budget deficits (or surpluses) to support the level of economic activity within the EU. The particular concern here is with the eurozone, and as such the European fiscal policy could be limited to EMU members. The scale of such a policy has been variously put at 7½ per cent of GDP (Commission of the European Communities 1977), 5 per cent (Huffschmid 2005, Chapter 16), 2 to 3 per cent of GDP (Currie 1997, Goodhart and Smith 1993). An EU fiscal policy would, in general, only be able to address EU-wide ‘shocks’. The present crisis could be considered such an EU-wide shock (though perhaps one on a scale only experienced every several decades) but figures such as those suggested above would not be on a scale to cope with such a shock, unless combined with substantial deficits at the national level. The second is, in effect, to permit each member country to set its fiscal stance in what it judges to be its own best interests. There has always been concern of ‘spill-over’ effects whereby one country’s deficit affects the credit ratings and interest rates faced by others. These concerns have been very much overstated. In the absence of a substantial EU-wide fiscal policy designed to achieve high levels of economic activity, each country has to be free to pursue that objective (if it wishes to do so). The proposition of ‘functional finance’ (starting from Lerner 1943) is that the budget deficit should be set with a view to ensure a high level of economic activity and not tied to any notion of a balanced budget (whether in current budget or total budget terms, whether on an annual basis or over the business cycle). There is the well-known accounting relationship of (G – T) = (M – X) + (S – I) (where G is government expenditure, T tax revenue, M imports, X exports plus net income from abroad, S private savings and I private investment). The scale of the budget deficit (or indeed budget surplus) then depends on the sizes of the current account deficit, private savings and investment at a high level of economic activity. It then follows that the appropriate budget deficit depends on the conditions surrounding the current account (propensities to import, exports) and the net savings position (savings minus investment). For a country with a current account deficit and a tendency for savings to exceed investment would require a large budget deficit, while in contrast for a country with a current account surplus and investment tending to exceed savings a budget surplus would be appropriate. This is the basis of the ‘one size fits all’ problem, which comes with the SGP. The shortcomings of the present SGP is that it seeks to impose the same conditions on all countries regardless of their broader economic circumstances and that it is a balanced budget (over the cycle) which is imposed on all. The latter will inevitably lead to deflationary tendencies in many countries without any compensating stimulatory tendencies in other countries. European Central Bank There is a need to make some fundamental changes to the operations of the ECB. The ECB (and the ESCB European System of Central Banks) has been established as an ‘independent’ central bank. ‘Independence’ is to be interpreted in a political sense: ‘When exercising the powers and carrying out the tasks and duties conferred upon them by the Treaties and the Statute of the ESCB and of the ECB, neither the European Central Bank, nor a national central bank, nor any member of their decision-making bodies shall seek or take instructions from Union institutions, bodies, offices or agencies, from any government of a Member State or from any other body. The Union institutions, bodies, offices or agencies and the governments of the Member States undertake to respect this principle and not to seek to influence the members of the decision-making bodies of the European Central Bank or of the national central banks in the performance of their tasks’ (Article 130). P.G. Michaelides, National Technical University of Athens © 2010 Kindly hosted on-line: http://users.ntua.gr/jea 9 THE JOURNAL OF ECONOMIC ANALYSIS (Vol. I, No. I) It is not ‘independent’ in an ideological sense, and the ECB has frequently advocated fiscal and other policies which are formally outside of its remit but which conform to the anti-Keynesian approach of fiscal consolidation and advocacy of ‘flexible labour markets’. For example, writing in December 2009, ECB (2009) wrote that ‘As regards fiscal policies, the Governing Council [of the ECB] re-emphasises how important it is for governments to develop, communicate and implement ambitious fiscal consolidation strategies in a timely manner. These strategies must be based on realistic output growth assumptions and focus on structural expenditure reforms, not least with a view to coping with the budgetary burden associated with an ageing population. … With regard to structural reforms, most estimates indicate that the financial crisis has reduced the productive capacity of the euro area economies, and will continue to do so for some time to come. In order to support sustainable growth and employment, labour market flexibility and more effective incentives to work will be needed. Furthermore, policies that enhance competition and innovation are also urgently needed to speed up restructuring and investment and to create new business opportunities’ (p. 7).4 The ‘independence’ of a Central Bank has been based on ideas that politicians are not to be trusted with key elements of macro-economic policy particularly in that elected politicians would favour expansionary policies with little regard to the inflationary implications. This view in part has been based on the ideas of the Phillips’ curve of a short-run trade-off between economic activity and inflation but the absence of any longrun trade-off (Sawyer 2010). The experience of monetary policy over the past decade has indicated that the ECB has not been able to achieve the objective of inflation which was initially inflation rate across the eurozone between 0 and 2 per cent per annum, modified in May 2003 to ‘below but close to 2 per cent’. The degree to which the target was missed was rather small but persistent. But inflation did rise to over 3 per cent in 2008, which could be seen as a cost-push inflation from world oil and food prices. Monetary policy can at most address demand inflation and is impotent in the face of cost-push inflation. The experience of differential inflation between member countries has highlighted the ‘one size fits all’ problem of monetary policy. The manner in which monetary policy has operated may have exacerbated the problem in so far as the arguments underlying monetary policy and inflation targeting are correct. Under inflation targeting, monetary policy (in the form of interest rate setting) is said to operate on the basis that the threat of higher inflation is met by a rise in nominal interest rate sufficient to lead to a rise in the real rate of interest, which should then dampen down demand and thereby inflation. But with the interest rate set by the ECB applying across all EMU countries meant that a country with a relatively high rate of inflation had a relatively low real rate of interest, which would imply, according to the monetary transmission mechanism, a higher, rather than lower, rate of inflation. The financial crisis has emphasised, to say the least, the need for financial stability as a key objective of macroeconomic policy and of monetary policy. The recent Banking Act 20096 in the UK establishes that ‘an objective of the Bank [of England] shall be to contribute to protecting and enhancing the stability of the financial systems of the United Kingdom (the “Financial Stability Objective”)’, with the Bank working with other bodies such as the Treasury and the Financial Services Authority and with the establishing of a Financial Stability Committee. At present this is placed alongside the monetary stability objective under the heading of ‘inflation targeting’. This could be seen as a significant step away from the operational independence of the Bank of 4 6 The perceived fiscal effects of the ageing of the population seems to be another obsession of the ECB. Available at http://www.opsi.gov.uk/acts/acts2009/ukpga_20090001_en_1. P.G. Michaelides, National Technical University of Athens © 2010 Kindly hosted on-line: http://users.ntua.gr/jea THE JOURNAL OF ECONOMIC ANALYSIS (Vol. I, No. I) 10 England and from the single objective of low inflation. We would argue that the financial stability objective should be a prime objective and the operational independence of the ECB brought to an end. The adoption of financial stability objective would, of course, require the development of a range of policy instruments. The ‘independent’ Central Bank and inflation targeting provides a ‘one instrument—one objective approach’. The ‘one objective’ (inflation) perspective has been criticised on the grounds that it ignores employment and output as objectives of macroeconomic policy (and indeed other variables as well, though (un)employment is our focus). However, within the rationale of the Phillips’ curve that criticism can be readily deflected in that the level of economic activity which has to be achieved is the one consistent with constant inflation. When the level of economic activity is seen in terms of unemployment, this would be the NAIRU; when in terms of output it is generally taken as a zero output gap, that is actual output equal to trend or potential output. Any other level of economic activity would lead to continuously rising or falling inflation. But the assumption is that the NAIRU or the zero output gap correspond to supply-side equilibrium positions, and more significantly they are unaffected in either the short run or the long run by the levels of aggregate demand and economic activity. In Sawyer (2002), Arestis and Sawyer (2005) and elsewhere, we have argued for the impact of economic activity (through capacity utilisation, profitability) on the level of investment, which in turn is an addition to the capital stock and productive capacity. The ‘independence’ of the ECB (as indicated in the quote given above) would appear to preclude co-operation and co-ordination between the different bodies responsible for aspects of macroeconomic policies. Yet, in a world of multiple objectives (including high levels of economic activity and employment, financial stability, inflation etc.) there is a need for multiple instruments which are operated by different authorities, and where there should be some co-ordination. At present, it is more like subordination with monetary policy taking pride of place and fiscal policy neutered by the lack of EMU fiscal policy and the constraints of the SGP on national budget deficits. Money can be described ‘state money’ in the sense that it is the State which determines what is regarded as legal tender and what is accepted in payment of taxes. In that way, the State determines what is to constitute money, and that provides a close link between a monetary union and a political union. Further, at least some part of what is regarded as money is created by the State or its agent (Central Bank) for which the State receives seignorage. It has generally become the case that it is the Central Bank which issues base money in exchange for ‘acceptable’ financial assets, and that the State itself does not directly issue money. The mechanism is then along the lines of: government borrows, bonds acquired by banks, bonds exchanged with Central Bank for ‘base money’. This is consistent with the post-Keynesian endogenous money approach in that there are ‘borders’ of endogeneity in the sense that the banks determine their exchange of bonds for ‘base money’ (at the price set by the Central Bank) and the loan creation process and the interchange between banks and the non-bank public determine the extent to which loans are extended and repaid and the ways in which bank deposits (viewed as part of the stock of money) are created and destroyed7. Sub-national government can differ from national government with respect to its debt and deficits in that the bonds of the sub-national government tier may not be accepted by the Central Bank as an ‘acceptable’ financial asset and its debt cannot be monetised, and further lacks any ability to ‘print money’. The national government cannot itself ‘print money’, but through its relationship with the Central Bank its debt It may very well be that it is for this reason that the ECB despite its concern with the money supply, as in their monetary analysis of their two-pillar approach, it specifies a ‘reference value’ for the money stock rather than a ‘monetary target’. 7 P.G. Michaelides, National Technical University of Athens © 2010 Kindly hosted on-line: http://users.ntua.gr/jea 11 THE JOURNAL OF ECONOMIC ANALYSIS (Vol. I, No. I) can be monetised, and in extremis, could require the Central Bank to buy central government bonds in exchange for ‘base money’. In effect, through its relationship with the Central Bank, a national government would never need to default on its own debt, provided that the debt is denominated in the domestic currency. The arrangements within the EMU leave a national member government in the position of a sub-national tier in the sense that the ECB can decide whether or not to accept its debt as ‘acceptable’ financial assets and on what terms. The position needs to be changed such that all financial assets issued by EMU member governments are always accepted by the ECB. The key reforms required with regard to the ECB are: (i) A reformulation of the objectives of the ECB to include high and sustainable levels of employment and economic growth and financial stability; (ii) The ECB must be made accountable to the European Parliament, and its statutes changed so that it can clearly be involved in the co-ordination of fiscal and monetary policies, and indeed that ultimately it can take instructions from other European bodies such as ECOFIN. (iii) The ECB operates with regard to national governments within EMU in the ways in which a national central bank would operate with regard to a national government, and specifically be able to, in effect, monetise the debts of national governments. Inflation As indicated above, the policies on inflation have been, at best, a limited success. Further, in so far as inflation has been kept close to but above 2 per cent is through good luck (including the low inflation environment internationally for much of the decade) rather than through the efficacy of the policy instrument. In our view, inflation in the EMU (and elsewhere) is influenced only to a limited extent by domestic policies. Although there has been an EMU level inflation policy operated through the ECB, there are also inflation policies at the national level. To a greater or lesser extent there are national policies on wage and price determination. As seen above, whether for reasons of national policies and/or differences in the price and wage setting institutions, differences in national inflation rates have persisted. Some of the proponents of the euro acknowledged that the conditions to be in place for a successful single currency suggested by the OCA literature were not present (at least to the degree needed) but that the continuing process of integration under a single currency would generate changes in the direction of those conditions. One of the conditions of OCA is price flexibility, understood to mean that the general level of prices in one country could change relative to those in other countries within the currency union where there was a ‘shock’ to the relative standing of that country. Essentially, changes in the demand or supply position would be compensated by corresponding changes to relative prices. But it has turned out that while there was in a sense price flexibility between countries, it was not in the manner envisaged. As seen above over a period of nearly 10 years prices in Germany fell by around 15 per cent relative to prices in Greece and Spain. Yet Germany was running a current account surplus and Greece and Spain deficits. The differences in inflation also had perverse effects in terms of inflation policy – the real rate of interest was lower in those countries with higher inflation, whereas the Taylor’s rule approach to monetary policy would point towards higher real interest rates when inflation is higher. P.G. Michaelides, National Technical University of Athens © 2010 Kindly hosted on-line: http://users.ntua.gr/jea THE JOURNAL OF ECONOMIC ANALYSIS (Vol. I, No. I) 12 If the differences in inflation experience persist, then the euro will be further undermined. There is clearly no EU level policy at present which can address this issue. One approach would be to assert that the pressures of integration will lead to countries having to have similar inflation rates. Even if that is so, similar inflation rates may well be combined with different levels of unemployment. Paradoxically, this commonality of inflation rates could be engineered by national fiscal policy (though not a policy we would recommend). There is then a need for the development of some understandings between EMU member countries on this issue. Current account deficits and competitiveness The data in Table I indicate something of the scale by which relative prices and relative unit labour costs have changed, when the nominal exchange rates of the national currencies of the original EMU member states were locked together. One interpretation of those changes could be that they represent the adjustment of real exchange rates between EMU member countries in the face of a combination of inappropriately set nominal exchange rates (back in 1998 for most) and ‘shocks’. But that overlooks the prevailing current account deficits when the euro was formed and some tendency for the current account deficits to persist and widen. A country in a fixed exchange rate system (which is in the nature of a currency union for participating countries) in dealing with cumulative differential inflation and current account deficits can endure domestic deflation (to reduce imports and perhaps lower domestic costs) or can devalue its currency. The latter is ruled out by membership of EMU: so is deflation the only answer? A current account deficit can interact with a budget deficit in the following sense. It is clear from an equation such as (1) above that a current account deficit and a budget deficit will be related for a given net savings position. Other things being equal (that is net savings) then a larger current account deficit would be associated with a larger budget deficit (there is no causal link implied). Political union? We have previously argued (Arestis et al. 2003, Arestis and Sawyer 2006a) that monetary unions which were not political unions did not in general have a good record of long term survival, though those involving very small countries (for example Eastern Caribbean Currency Union which covers a total population of half a million) had a better survival rate. From a state view of money, it can also be argued that a monetary union has one feature of political union in the sense that it is governments which determine what is treated as legal tender and accepted as payment of taxes. The need for a significant EMU fiscal policy (which runs into some difficulties given the differences in the compositions of EMU and of the EU) has been argued above. The implementation of such a policy does require that the levels of tax revenue and of public expenditure which come within the scope of EMU fiscal policy and the balance between them (i.e. the budget deficit/surplus) are settled at the EMU level. The current account deficits on the scale observed in a number of EMU countries are not sustainable. Yet countries are locked into a fixed nominal exchange rate system, where many have experienced a loss of competitiveness and in effect rising real exchange rates. There have to be developed mechanisms for the adjustments of those exchange rates, which would seem to require a co-ordinated mechanism for the adjustment of the prevailing exchange rates between member countries of the EMU and for the generation of similar rates of inflation. P.G. Michaelides, National Technical University of Athens © 2010 Kindly hosted on-line: http://users.ntua.gr/jea 13 THE JOURNAL OF ECONOMIC ANALYSIS (Vol. I, No. I) It has also been argued above the ECB should relate to member governments and their financial liabilities in a manner similar to the ways in which a national central bank would to a national government. These policy initiatives involve many of the features of a political union. VI. CAN THE EURO BE SAVED? The euro project could be seen to be based on two pillars. The first was an essentially neo-liberal policy framework (which has been outlined above). The second was to see the single currency as the final stage of economic integration in removing what could be seen as the final barrier to free trade (different currencies and the associated costs) after the removal of non-tariff barriers under thee Single European Act. The first was embedded in the Treaty of European Union in its various forms and now cemented in the Treaty of Lisbon (‘The Treaty on the Functioning of the European Union’). Changes to the Treaty of Lisbon require the unanimous agreement of the 27 member countries, and since the changes required to support the euro involve policies which could be seen as moves towards political union, the possibilities of making those changes is close to zero. This indicates not only the ‘stupidity’ of the policy framework, but also that of embedding economic policies into a constitution, which is virtually impossible to change. It would also have to be recognized that the dominant macroeconomic institutions in the EMU, notably the ECB and the D-G for Economic and Financial Affairs appear to be fully signed up to the neo-liberal agenda. With regard to the second pillar, it was recognised by some advocates of the euro, that there were many ways in which there was insufficient economic integration to support a single currency, but that in the presence of a single currency, integration would continue to a stage, which did support a single currency. The conditions indicated by the OCA literature could be seen as the nature of the integration–generating movements in relative prices and permitting factor mobility. The political limits (including those arising from the nature of the Treaty of Lisbon) and the ideological constraints (associated with the neo-liberal agenda) on serious reforms are discussed from which the general conclusion is that the needed reforms will not be carried through. This discussion also includes consideration of the possible role for a substantial EU-level fiscal policy and some other aspects of political union. VII. CONCLUDING COMMENTS We would argue that the policy framework (Stability and Growth Pact etc) within which the euro is placed is ‘not fit for purpose’. Three aspects of that standout. First, the ‘independence’ of the ECB precludes the ECB devoting its attention to financial stabilityand to co-ordinating and co-operating with other macroeconomic institutions in pursuit of other objectives, such as high levels of economic activity. Second, it does not have ways of developing fiscal policy, which would be supportive of high levels of economic activity, recognising that budget deficits are generally required. Third, there are no mechanisms for resolving the pattern of current account deficits and surpluses, which we argue are unsustainable in their present form. Without the ability to vary the exchange rate, countries with current account deficits will be thrown back on deflation. P.G. Michaelides, National Technical University of Athens © 2010 Kindly hosted on-line: http://users.ntua.gr/jea THE JOURNAL OF ECONOMIC ANALYSIS (Vol. I, No. I) 14 The EMU completely lacks any mechanisms by which countries can resolve their deficit problems. The choice faced by many EMU countries is then the stark one of remaining with the euro and suffering an indefinite future of deflation and high unemployment or in effect leaving the euro. The economic problems within the eurozone have been building since its inception and have become acute with the ‘great recession’. The faults lie in the neo-liberal design of the euro project, now embedded in the Treaty of Lisbon, and where there is little prospect of serious change because of the unanimity requirements for change. But without basic and fundamental change, many (perhaps all) eurozone countries face a bleak economic future. BIBLIOGRAPHY Arestis, P. and Sawyer, M. 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