The Paradox of Euro Survival and Other Lessons from the Crisis

Michael Stephens | August 21, 2012

Since eurozone governments don’t issue the currency in which their debts are denominated and can’t borrow euros directly from the European Central Bank, member-states essentially have to run budget surpluses—generating euros by taxing the private sector—if they’re going to reliably meet their debt servicing costs, according to Jan Kregel, and they have to run even bigger surpluses if they’re going to reach the debt limits set by the Stability and Growth Pact.  Kregel puts this in Minskyan terms:  “member-states should be engaged in ‘hedge’ finance, which means producing a fiscal surplus well in excess of debt service. If it cannot do this, it must issue additional debt to the private sector, since it cannot borrow from the ECB. In this case, the government would be engaging in what Minsky called ‘Ponzi’ finance: it would be borrowing to meet debt service.”

But in order to maintain such budget surpluses, Kregel points out, the eurozone needs higher economic growth, and this sets up a fundamental paradox:

…governments cannot produce this growth through deficit spending; it must come from either domestic or foreign demand. Lowering government expenditures or raising taxes to generate the required fiscal surplus will only reduce domestic demand. This leaves external demand as the only solution. But without the ability to improve external competitiveness through exchange rate adjustment, internal depreciation through wage reductions or productivity increases in advance of wage increases will be required. However, this is also a policy that reduces domestic demand, offsetting the benefits of higher foreign demand. And here is the paradox: all the policies proposed to increase growth of incomes and generate fiscal surpluses ultimately have a negative impact on income growth. Keynes called it the paradox of saving; here, it is the paradox of euro survival.

This is partly why, he argues in a new Policy Note, more political integration can’t solve the most fundamental problem facing the eurozone.  According to Kregel, this is one of the six lessons we ought to have learned from the crisis.

The other five lessons:

1) Currency zones don’t solve the problem of payments imbalances.

2) The “structuralists,” who argued that it was important to create common structures, and that the member economies would eventually conform to them, got it wrong.

3) There is no French-German compromise on policy convergence.

4) Competition reduces inflation but does not produce growth and convergence.

5) A common currency does not eliminate the need for internal adjustments.

Read more here.


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