The Euro is a noble political project that was mis-designed. If it falls apart it will inflict massive economic dislocation and destroy the political vision of five decades. It cannot be allowed to fail, but its flaws are too severe for it to persist in its present form.
The consequences of mis-design are manifest in both asset and labour markets – diverging interest rates and unemployment rates. Since the dynamics of asset markets are faster than labour markets, it is the former that is grabbing attention. Repeatedly, the Eurozone’s leaders have done just enough to stave off a market panic, buying time for a solution without actually providing one. But even a solution to the crisis in asset markets would not address the deeper problem in labour markets.
At a stroke, Chancellor Merkel could solve the asset crisis by guaranteeing the bonds issued by other governments in return for the power to enforce tough fiscal and banking rules. But the reform of Europe’s disparate labour markets is beyond German power, because it is even beyond the current powers of the governments with which Germany negotiates. Take Spain, where despite persistent very high unemployment, wages have not declined. Underlying this are labour market institutions: two thirds of Spanish workers are effectively in jobs-for-life, whereas the remaining third can readily lose their jobs. Wage rates are set by the secure two-thirds who thereby inflict unemployment on the remaining third with impunity; so wage setting is barely influenced by unemployment. Of course, this needs to change, but it will be a profound struggle of domestic politics, not something for Chancellor Merkel to impose as part of a midnight deal.
Further, even once the institutions of Europe’s labour markets are reformed, wage rates will take years to adjust back to equilibrium. During its first decade the Euro amplified the divergence in competitiveness as the fall in interest rates gave peripheral Europe a temporary bonanza. Unit labour costs in Spain and Italy have risen by around 30 percent relative to Germany. Even now that boom has turned to bust convergence through market pressure is dampened through stalled productivity in depressed markets. An asset market fix without a labour market fix, which currently looks to be the most politically likely outcome, would be disastrous. German-imposed fiscal and monetary austerity combined with slowly-adjusting labour markets is a recipe for political disorder and nationalism: the antithesis of the European vision.
So what is the way out? Europe’s labour market need a period in which competitiveness is restored by divergent exchange rates, but it must be done in such as way that asset markets do not go into crisis. Hence, it must be done gradually. The solution is approximately to reverse the sequence by which the Euro was created. The Euro would temporarily be divided into national currencies: the German Euro, the Spanish Euro, with a numeraire Euro set as a weighted basket. There would thus be no opprobrium on any particular ‘exit’. Exchange rates between these national Euros would initially be set at the existing parity, but bands would be introduced that gradually widen, at a maximum of half-a percent per month. Since the gentle divergence in exchange rates could be fully anticipated by markets, it would be fully offset by differences in nominal interest rates. Hence, there would be no incentive for capital to flow out of the periphery.
Such a bounded divergence of national Euro exchange rates would have several advantages. It would be more credible than commitments to maintain the single Euro, because it would provide a mechanism of adjustment to equilibrium. While deep German pockets would still be needed to guarantee that the permitted speed of adjustment was not exceeded, the guarantees would no longer be indefinite. It would also be far less costly that the disorderly collapse which current policies are risking. And it would be more humane than heading for the rocks of mounting unemployment and social disorder.
Bounded divergence need not significantly widen nominal interest rate spreads; more importantly it would narrow real spreads: the current tragedy is that being locked into a common price level all interest rate spreads are effectively destabilising differences in real rates reflecting the low credibility of current strategy rather than an adjustment process. Instead of high real interest rates, peripheral Europe would have moderately higher price inflation, accelerating the essential decline in real wages without spooking bond markets.
Politically, the temporary introduction of national Euros as a device for remedying an adjustment problem would be far less damaging to the European ideal that a return to the Drachma. It would recognise the need to learn instead of being an admission of defeat. Political leaders would commit to the reunification of the Euro, which for some countries could happen rapidly, at whatever new rates proved to be sustainable. There would be time to design both the necessary fiscal and banking institutions, and the labour market convergence criteria that last time were omitted.