This is a momentoussummer for Europe, because both the eurozoneand the European Union could be in danger of unraveling,despite the important steps toward a banking union and direct recapitalizationof Spanish banks taken at the June meeting of eurozone leaders. Implementationof the proposed reforms is lagging; theremay be legal challenges to the European Stability Mechanism in Germany; and the Netherlandsand Finlandseem to be backtracking on some parts of theagreement.
Even in a worst-case scenario, some degree ofintra-European cooperation will surely survive. But it is hard to see how theEU as we know it could survive even a partial disintegration of the eurozone.
Those who argue that one or more countries on theeurozone’s periphery should take a “holiday” from the euro underestimate boththe economic and political repercussions of such a move. The sense of failure,loss of trust, and the damage inflicted on so many if two or three countrieshad to leave would shake the entire Union.
One of the key challenges is the negative feedback loopbetween the weaknesses of many banks and the doubts about the peripheralcountries’ sovereign debt. The sovereign-debt and banking crises have becomeeven more closely interlinked as banks bought greater amounts of their homecountries’ sovereign debt.
That said, Europe’sdisparities in production costs and competitiveness, reflected in the “problem”countries’ substantial current-account deficits, may prove to be an even moredifficult problem to resolve. Unit labor costs in Greece,Portugal, Spain, and Italygrew 20-30% faster than in Germanyin the euro’s first decade, and somewhatfaster than unit labor costs in northern Europeas a whole.
This disparity reflected some differences in productivitygrowth but even more so differences in wage growth. Broadly speaking, capitalinflows led to real revaluation and a lower domestic savings rate relative toinvestment in the southern countries, resulting in structural current-accountdeficits. In Greece,large fiscal deficits accompanied and exacerbatedthis trend. In Spain,the counterpart to the current-account deficit was private-sector borrowing.
The eurozone crisis will not be resolved until thisinternal imbalance is reduced to a sustainable level, which requires not onlyfiscal adjustment in the troubled peripheral economies, but alsobalance-of-payments adjustments across the eurozone as a whole. That, in turn,implies the need for a real exchange-rate adjustment inside the eurozone, withperipheral countries’ production costs falling relative to those in the core.
Real exchange-rate adjustments inside a monetary union, oramong countries with fixed exchange rates, can take place through inflation differentials. The real value of the Chineserenminbi, for example, has appreciated considerably relative to the US dollar,despite limited nominal exchange-rate changes, because China’s domestic prices have risen faster thanhave prices in the United  States.
A similar adjustment within the eurozone, assuming similarproductivity performance, would require wages in the troubled peripheralcountries to rise more slowly than in Germany for a number of years, thusrestoring their competitiveness. But, because Germany and the other northernsurplus countries remain hawkish on pricestability, real exchange-rate adjustment within the eurozone requires actualwage and price deflation in the distressed southern economies.
This pressure on the peripheral countries to deflate theiralready stagnant economies is turning into the eurozone’s greatest challenge.The ECB’s provision of liquidity can buy time, but only real adjustment cancure the underlying problem.
That could be achieved with less wage contraction and lossof real income if productivity in the peripheral economies were to startgrowing significantly faster than in the core, thereby allowing prices to fallwithout the need for lower wages. But, while structural reforms couldundoubtedly lead over time to fasterproductivity growth, this is unlikely to happen in an environment in whichcredit is severely constrained, investment is plummeting, and many skilledyoung people emigrate.
Price deflation is not conducive tobringing about the sort of relative price changes that could acceleratereallocation of resources within the countries under stress and increaseoverall productivity. Relative prices are much easier to change when there ismodest inflation than when nominal price reductions are required. The need forhigher productivity in the troubled countries is undeniable;but achieving it in the current climate of extreme austerity and deflation isunlikely, given an atmosphere of latent, oropen, social conflict.
These economic adjustments could occur much more smoothlyif the eurozone as a whole were to pursue a more expansionarypolicy. If the target inflation rate for the eurozone were to be settemporarily at, say 3.5%, and if the countries with current-account surplusesencouraged domestic inflation rates somewhat above the eurozone’s target, therecould be real price adjustment within the eurozone without price deflation inthe troubled countries. There are finally some signs that Germany willwelcome more rapid domestic wage growth and somewhat higher inflation.
This could and should be accompanied by an overalldepreciation of the euro, though that would be no panacea.High public-debt levels would still have to be reduced to create fiscal spaceand keep interest rates low enough to restore long-term confidence. That meansthat courageous structural reforms must still be pursued in the peripheralcountries – indeed, throughout Europe.
Similarly, the eurozone would still need to strengthen itsfirewalls, as well as its mechanisms for cooperation. But a temporary andmodestly higher inflation rate would facilitate the adjustment process and givereforms a chance to work.
Deflation discourages optimism about the future. Shiftingthe entire adjustment burden onto peripheral countries with current-accountdeficits, while core countries continue to run surpluses, obstructs adjustment.
The eurozone’s inflation target is not a magic number, andit is irrational to let it determine the overall macroeconomic framework. Iflower is always better, why not set the target at 1%, or even zero? In fact,there are times when 3-4% is better than 2%. Europeis at such a moment.