The latest initiative to save the Eurozone is the “Geithner Plan.” It would have the Eurozone leverage up the EU’s €440 billion bailout fund to €1 trillion by making it act as an insurance fund for investors buying up debt of the troubled Eurozone countries. Though big, this plan would only address the current debt problems. It would not solve the large real exchange rate misalignment–30% according to Ambrose Evans-Pritchard–between the core countries and the the troubled periphery. The ECB, on the other hand, could address fix this problem.
Here is how. If the ECB were to sufficiently ease monetary policy, it would cause inflation to rise more in those parts of the Eurozone where there is less excess capacity and nominal spending is more robust. Currently, that would be the core countries, particularly Germany. Consequently, the price level would increase more in Germany than in the troubled countries on the Eurozone periphery. Goods and services from the periphery then would be relatively cheaper. Therefore, even though the fixed exchange rate among them would not change, there would be a relative change in their price levels. This would provide the much needed real depreciation for the Eurozone periphery as they move forward in their attempts to salvage their economies.
Ambrose Evans-Pritchard explains it this way:
Nor can this gap in competitiveness be bridged by austerity alone, by pushing Club Med deeper into debt-deflation and perma-slump. Such a strategy must slowly eat away at Italian and Spanish society, undercutting the whole purpose of the EU Project. It would ultimately risk trapping them in a debt spiral aswell, leading to collosal losses for Germany in the end.
The Geithner Plan must be accompanied a monetary blitz, since the fiscal card is largely exhausted and Germany refuses to lower its savings rate to rebalance the EMU system. The only plausible option is for the ECB to let rip with unsterilized bond purchases on a mass scale, with a treaty change in the bank’s mandate to target jobs and growth.
This would weaken the euro, giving a lifeline to southern manufacturers competing with China. It would engineer an inflationary mini-boom in Germany, forcing up relative German costs within EMU. That would be the beginning of a solution, albeit a bad one.
So how much inflation would this approach entail? Paul Krugman gives his estimates based on a 20% real misalignment:
A reasonable estimate would be that Spain and other peripherals need to reduce their price levels relative to Germany by around 20 percent. If Germany had 4 percent inflation, they could do that over 5 years with stable prices in the periphery — which would imply an overall eurozone inflation rate of something like 3 percent.
Ambrose Evans-Pritchard says this solution would be unfair to Germany, but he also says that is the cost of a monetary union. It may be unfair to Germany now, but arguably Germany helped pave the way for this crisis over the past decade. For the decisions of the ECB were influenced heavily by developments in Germany at the expense of the periphery. Could this dynamic change in a new and improved Eurozone? If not, it may make more sense to have two currencies in the EU.
This post originally appeared at Macro and Other Market Musings and is reproduced with permission.
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