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For years, I have warned my European students of the fiscal free-rider problem built into the structure of the euro area.My examples have always been fiscally undisciplined peripheral governments seeking political gain by running budget deficits at the expense of their euro partners.
Now, though, as the debate unfolds over measures to cope with the European sovereign debt crisis, it is becoming increasingly apparent that Germany, the long-time locomotive of the euro, is also, in its own way, free-riding on the common currency.
The free-rider problem arises whenever someone is able to capture the full benefits of an action while shifting all or part of the the costs to others.
I introduce the concept to my students with the example of 10 friends eating dinner in a restaurant. If they know they will get separate checks at the end of the meal, they all order hamburgers and beer.
If they know there will be one check, to be split equally among everyone at the table, they order steak and champagne.
In the case of deficit-prone peripheral members of the euro, individual governments capture the full economic and political benefits of fiscal stimulus while shifting part of the costs to other euro members. This happens in two ways.
In the short run, the shift works through monetary policy. Other things being equal, more fiscal stimulus puts upward pressure both on interest rates and inflation. To counteract the pressure, monetary policy must be tightened. In a country with an independent currency and its own central bank, the pain of tighter monetary policy (higher interest rates, a stronger exchange rate that hurts exporters) is fully internalized. In the euro area, though, there is just one central bank, so the pain is spread among all members of the currency area. Furthermore, the European Central Bank is in far-away Frankfurt, making it easy for the government of a peripheral country to shift the political blame for painful tightening measures.
The long-run costs of excessive short-run fiscal expansion come in the form of the tax increases or spending cuts that are eventually needed to avoid unsustainable debt and eventual default. Those costs, too, can be shifted to others. Even in a country with an independent currency, the current government is tempted to free-ride on the future governments that will have to pay the bills. With a common currency the problem is much worse because fiscally irresponsible governments can expect fiscal bailouts from their currency partners.
Even if the founding documents of the currency union include a “no bailout” clause, as is the case in the euro area, no such provision can be fully credible. That is because fiscally prudent members cannot, simply by refusing a bailout, force a profligate member to bear all the costs of a default. Even without a rescue the costs must be shared because default by any one member of a currency area would undermine the perceived credit risk of other members, thereby increasing their interest costs. That fact gives profligate members the leverage they need to extort a bailout, which is more or less what is happening now.
Germany understands all this very well. It is doing its best to assure that profligate peripheral states at least share the pain, even if some form of rescue cannot be avoided. Meanwhile however, Germany is open to the charge that it too is free-riding on the euro, although in a very different way.
Germany’s free-riding consists in using the euro as a mechanism for maintaining a weak exchange rate while shifting the costs of doing so to its neighbours. To see how that form of free-riding works, compare Germany and China.
Although there are vast differences between the two economies, each of them for its own reasons has chosen a growth model based on a high savings rate balanced by large net exports. In part, each country’s export success can be attributed to cultural traits favouring hard work, thrift, and efficiency. Far be it from me to denigrate those virtues, but they are not the whole story of China’s and Germany’s export success. The hyper-competitiveness of both countries is also due in part to policies that guard against unwanted exchange rate appreciation. Although the effects are similar, the mechanisms that China and Germany use to accomplish this are quite different.
China maintains its undervalued currency through classic methods of market intervention. As a country with an independent currency, it bears the full costs of doing so. To resist appreciation of the yuan, it has accumulated an ever-increasing mountain of low-yielding U.S. Treasury securities. Each purchase of U.S. securities results in an equivalent increase in the Chinese monetary base, thereby adding to inflationary pressure within China.
The inflationary pressure is relieved, in part, through sterilization in the form of selling central bank bills and raising commercial bank reserve requirements. However, the sterilization itself is costly. First, it involves an interest expense, since the central bank bills that are sold bear higher interest rates than the U.S. Treasuries that are bought. Second, high reserve requirements, interest rate restrictions, and other administrative measures distort the Chinese financial system. The whole package of monetary and exchange rate policy almost certainly involves costs to the Chinese economy that exceed the benefits. Many observers think that the policies are kept in place only by the concentrated political power of China’s export industries.
Germany, in contrast, can have its cake and eat it too. It is impossible to know what Germany’s exchange rate would be if its currency were independent, but as good a guess as any is that of Boris Schlossberg, Director of Currency Research at forex trader GFT, who thinks it would be the equivalent of about two dollars per euro. Germany does not have to engage in overt currency manipulation to maintain the current exchange rate; membership in the euro does the job without the need for intervention. The pressure toward appreciation that would be produced by the hyper-competitiveness of the German economy is offset by the opposite pressures from less competitive euro members like Greece and Portugal. On balance, the effect of the euro is to keep the German exchange rate undervalued at the expense of forcing overvaluation on peripheral members.
What is the bottom line? What should we want Germany to do that it is not now doing?
If we focus only on issues of fairness, it is tempting to say that Germany ought to be willing to pay for the benefits it gets from the euro by contributing more to the bail-out of peripheral members. One way to do so would be to back the concept of a common euro bond, something it has steadfastly resisted. However, I think that fairness alone is the wrong focus.
The real problem is that a currency area in which all members can free-ride on all others is inherently unstable. Restructuring the euro area to make it sustainable in the long run will require some fundamental changes.
First, as everyone acknowledges, the euro needs a better set of fiscal policy rules to replace the inadequate and unenforceable rules of the growth and stability pact. Sweden’s fiscal policy regime could be a good model.
Second, the euro undoubtedly needs more fiscal centralism. That is one reason the United States, where 60 per cent of total government spending and taxes take place at the federal level, works better as a currency area than does the euro, where only 2 per cent of fiscal activity is centralized. A common euro bond could be a part of the needed centralization. The concept itself makes sense as part of a general structural reform, despite the objections that can be raised against it as an ad-hoc bailout measure.
Stability of the euro as a currency area will also be improved if recent efforts at banking reform are successful. The case of Ireland shows that sovereign debt problems do not always begin with excessive government deficits. They can also arise from unsustainable private sector commitments entered into under implicit government guarantees.
Finally, like its Asian counterpart, Germany needs to think about the possibility that reforming the euro area in a way that makes it sustainable could also require a rebalancing its own economy. Edging away from single-minded reliance on exports would not have to mean abandoning national virtues. Instead, it would mean allowing workers and consumers to share more fully in the fruits of their own thrift, hard work, and efficiency. If the euro area is to be saved, it will not be enough to reshape other members in its own image. Germany will have to change, too.
Footnote: While writing this, I missed the excellent recent post by Christian Schoder, Christian R. Proano & Willi Semmler, on sustainability of current account balances in the euro. The authors provide empirical data that underscores some of the points made above. In particular, with regard to the need for change in Germany, as well as the deficit members of euro, they note that “the relative competitiveness of deficit countries needs to be increased. This cannot be achieved by limited wage growth in the deficit countries only, but must include an expansionary wage policy in the surplus countries.”
Originally posted to Ed Dolan’s Econ Blog at Economonitor.com. Reproduced by permission.