In some ways the Economic and Monetary Union (EMU), in its current guise, resembles the gold standard between World Wars I and II. Every member state has pegged its (nominal) currency to the euro and cannot print extra money. In theory, this should not pose a problem, provided the economic cycles are in sync. The latter would allow the European Central Bank (ECB) to attune its monetary policy to the EMU as a whole.

In reality, many economic cycles are out of step. And since the introduction of the euro, the imbalances have increased. For example, asset prices and credit supply have barely boomed in several strong EMU countries (particularly in Germany), if at all.

Following the adoption of the single currency, Germany implemented substantial structural reforms (under Chancellor Gerhard Schroeder) in order to improve the growth prospects of the economy. When this process started, the country was known as the ‘sick man of Europe’ and German interest rates were low in European terms. The country also managed to avoid credit bubbles. Subsequently, Germany reaped the benefits of this restructuring – it became Europe’s growth engine.

Divergence within the monetary union

Between the introduction of the euro and the eruption of the credit crisis, economic growth blossomed in what are now identified as the weak Eurozone countries, where asset prices rose as interest rates fell (towards the level of bond yields in Germany). Here, borrowing mushroomed, especially for consumption purposes. One outcome was that trade deficits widened while the economies started to depend more and more on domestic sectors that were not greatly exposed to international competition (for example construction, the public sector and local consumption). High growth meant that the politicians barely saw the need for structural reforms. As labour costs rose, the countries in question lost competitiveness and their trade balance continued to deteriorate.

After the credit crisis broke out, the debt-based growth in the weak countries collapsed. At the same time, a decline in global trade activity undermined the German economy. More recently however, trade has improved around the world. As a result, things are looking up for Germany. Yet the situation in the peripheral EMU countries is worse than ever. They desperately need to regain competitiveness and can only grow through exports; the domestic economies continue to shrink (due to fiscal consolidation and deleveraging in the private sector).

Easy way out or the bitter pill?

Theoretically and from a macroeconomic standpoint, Europe’s problem countries can boost competitiveness in two ways. The first option is structural reforms, which underpin productivity and drive down labour costs. The second option would be a looser monetary policy, leading to a cheaper currency.

The struggling Eurozone countries place their hopes on the second option – a looser monetary policy, as this would reduce the need to carry out painful reforms; in addition lower wages make the debt burden more unbearable. An additional problem is that other major countries’ central banks are easing their policies. Unless the ECB follows suit, the euro will end up as one of the strongest currencies. This is an anomaly, as the EMU is in an economic quagmire, and it is bad news for competitiveness.

Source: Thomson Reuters Datastream/ECR

Meanwhile, Germany wants the debt-laden member states to implement structural reforms:

• It knows from experience that these work well.
• Germany envisages the EMU as an integrated union in terms of fiscal policy, banking and politics. In addition, Berlin wants the members of such a (future) union to be financially healthy, competitive and self-sufficient.
• Monetary easing is not the solution. On the one hand, it would take away the incentive for the ailing member states to execute the required structural reforms. On top of this, it would expose Germany to higher inflation risks, which is something the country wants to avoid at any cost.

Source: Thomson Reuters Datastream/ECR

Germany in charge

Germany is Europe’s strongest economy and the main capital provider for the peripheral EMU countries. By and large it rules the roost in the EMU. As a result, its ‘dependents’ meekly swallow the bitter ‘German medicine’ of cutbacks and structural reforms. Mainly under German pressure, the ECB is pursuing a policy that aims to prevent a liquidity crisis and break-up of the EMU. Unlike the Federal Reserve in the US and the Bank of England (BoE), it is not aiming to boost asset prices and/or growth. Yet it remains to be seen how much longer the ECB can adopt this strategy.

Clearly, the peripheral EMU countries are fighting a losing battle. The German remedy focuses on improved competitiveness. However, this aggravates the economic misery (rising unemployment, an ongoing contraction, more poverty, emigration and so on). At the same time, the intended effect – higher economic growth as a result of higher exports – does not materialise because the euro is too expensive.

Another analogy with the gold standard in the 1930s is that those economies that adhere to the standard the longest (ie pursue the least accommodative monetary policy), will suffer the most. A growth slump in peripheral Europe over a prolonged period means that the populations will be more inclined to listen to politicians who advocate an exit from the EMU. One consequence would be that the new currency of the country in question will be much cheaper than the euro, while its national central bank can pursue a much looser monetary policy. At first, the economy will be hit hard but there are various examples of countries that found their feet after a devaluation of their domestic currency (such as Iceland).

Will ECB give in to pressure?

The strong EMU countries, Germany included, do not think this is a desirable scenario. As soon as one country crosses this bridge, investors will expect the other problem countries to follow suit and remove their capital on a massive scale. This will place huge upward pressure on bond yields; many banks will end up in deep trouble. In the first instance, the ECB can take countermeasures. If so, the struggling states could quickly become ‘addicted to financial heroin’, and it will only be a matter of time before the EMU disintegrates.

This would be very unfortunate. The EMU is much stronger if it acts collectively vis-à-vis the economic blocs that are forming around the US, China and India.

These drawbacks, plus Germany’s wish to proceed with a more united Europe, will put pressure on the ECB to pursue a looser monetary policy. The ECB will not need to say aloud that it uses monetary easing as an instrument to drive down the euro. Also because the ongoing recession in peripheral Europe will put downward pressure on inflation (which has largely risen on the back of higher taxes in any case).

If the recession persists in the weak Eurozone countries, deflation will loom larger. Therefore the ECB has every reason to ease its policy. In combination with better growth perspectives for the US economy (see also ECR’s recent reports on the Global Financial Markets) this could result in more capital flows from the EMU to the US over the coming quarters, which will put downward pressure on EUR/USD.

Source: Thomson Reuters Datastream/ECR