Pressing concerns: questions for the Euro area.

Alesina, Alberto

The big question for today's international monetary system is: will the Euro survive? I believe that it will, and that Euro-land will muddle through its current serious difficulties.

The common currency in Europe has run into two problems. One was well understood by skeptics of the entire plan of a monetary union in Europe, while a second was less anticipated. The first is the fact that countries with very different levels of productivity growth are tied together by a common exchange rate and monetary policy.

Countries like Greece, Portugal, Spain, and Italy would benefit, at least temporarily, from a devaluation of their currencies to help them overcome their economic stagnation, which seems to have followed the Great Recession of 2008-2009. Other means of adjustment certainly exist, but those would imply lower growth or even a reduction in monetary wages to compensate for the relatively strong Euro and the low productivity growth in these countries. Such adjustments are also politically difficult, and devaluations would, at least in the short run, help. In addition, the European Central Bank will have to follow a monetary policy not only specifically targeting the needs of these countries, but also considering the needs of the Euro area as a whole, which includes other economies on more solid ground like Germany.

The second problem emerged from the ability of many countries to borrow at very low rates during the first decade of the Euro. Greece, Spain, Ireland, and Portugal could borrow abroad at rates close to those of Germany because the exchange risk was removed. These countries thus went on borrowing sprees and became intoxicated by the temptation of low interest rates in world markets. Ultimately, however, the market woke up, realized that Greece is not Germany in terms of fiscal solidity, and demanded compensation for risk. The system then unraveled, and the higher interest rates demanded by markets increased the fiscal problem of these indebted countries. The worse the finances of these countries became, the more the market demanded compensation for risk and higher interest rates. This demand, in turn, caused deficits to rise, ultimately creating a vicious circle that started with Greece, went to Ireland and Portugal, and marginally touched even Spain and Italy.

At this point, a third problem of a political nature surfaced: the lack of an institutional process to deal with crises of this nature. Europe was like a town hall deciding how to organize its fire department while several houses burned. Many observers advocated more power for European-level institutions in the area of fiscal policy. Everybody recognized that the Growth and Stability Pact, set up to ensure fiscal prudence, was failing due to lack of enforcement. Yet the burden of fiscal restraint will remain in domestic hands, as national governments prove reluctant to abandon any fiscal discretionary power. They have exercised this power with monetary policy, but fiscal policy is more directly linked with politics. Government alliances are kept intact with fiscal favors, constituencies are "bought" with spending programs, and fiscal transfers are the glue that keeps government together. This is why most governments want the European Union off their fiscal turf. Although Germany is pushing for fiscal rules to be added to the national constitution, it is unlikely that many countries will follow.

Thus, the question at the beginning of this piece can be rephrased with two more specific ones: will European countries manage to live together with the same exchange rate and the same monetary policy? And will they be more fiscally prudent in the future? The answer to both questions is yes, at least for the foreseeable future. The cost of abandoning the monetary union would be quite large, possibly entailing trade isolation, serious transaction costs, and major loss of credibility for the exiting country with the associated high borrowing costs. As for fiscal prudence, various European countries seem to have learned the lesson from their recent near-death experience and are indeed trying to put their fiscal houses in order, some more aggressively than others. Does this trend mean that Europe is out of the tunnel? Not quite. Some debt restructuring (partial default) for Greece is likely, and some contagion effects will surely follow and influence other countries. If productivity does not increase quickly in southern Europe, growth differences will persist for a while, creating tension for the monetary policy of the European Central Bank.

The economic road ahead is rocky for Europe, and the second decade of the Euro will be much more difficult than the first. The Euro area needs fiscal restraint, a better mechanism for crisis resolution, and structural reforms, especially in southern European countries to make them more competitive. Hopefully, the European leaders have understood this message from the recent crisis.

ALBERTO ALESINA serves as the Nathaniel Ropes Professor of Political Economy at Harvard University.