19 Mar 2019
Mody has first-hand knowledge of the inner workings of the euro zone; as a senior official at the International Monetary Fund, he designed Ireland’s financial rescue programme in 2010. In his new book, EuroTragedy: A Drama in Nine Acts, he tells the story of the crisis and argues the project of ever closer union is politically unworkable. Instead, he advocates a ‘decentralisation’ of the euro zone to see off future chaos and revitalise the European economy. He spoke to AIQ about his ideas.
In EuroTragedy you argue the euro zone has been hampered by structural issues since its inception. What is the central flaw in the euro zone’s construction?
The flaw of the euro zone’s construction is that it creates a single monetary policy for a diverse set of countries; by its very nature, monetary policy is going to be too tight for some countries and too loose for others. That creates a conflict. That conflict then leads to decisions which favour or disfavour particular countries, and that is the source of policy errors.
Can we draw a direct link between the management of the euro zone crisis and the subsequent rise of political populism across Europe?
There is no question about it. The link is clearest in Italy and Germany. The German Alternative für Deutschland party was born in late 2012, at virtually the same time as the surge in support for the Five Star Movement in Italy. They are flip sides of the same coin; there was a sense of grievance in Italy that Chancellor Merkel was imposing her will on the Italian people, while in Germany there was a view she was not pushing indebted countries hard enough. This is a consequence of conditions being so disparate that any policy is always going to be seen by one side as unduly favourable to the other side – that’s inherent in the monetary union.
Is an Italian crisis inevitable, given the weaknesses in the public finances?
There is no question Italy will have a crisis. Italy has zero or negative productivity growth, so any time there is a tremor somewhere its financial superstructure will remain vulnerable, because the only way to support the large amounts of debt – and the large amounts of banking credit that Europe circulates in the Italian economy – is for the economy to grow. Because Italy isn’t growing, it is perennially vulnerable. A combination of factors in the global economy – a slowdown in world trade growth and a rise in global interest rates – will put a huge squeeze on the Italian economy and I don’t think the economy will be able to bear that stress.
What can the euro zone do to help Italy?
I don’t think it can do very much. Italy is too large for the euro zone to bail out, and the euro zone authorities’ first instinct will be to push for more austerity, which will make things worse. The ECB could use what it calls its “outright monetary transactions authority” to buy Italian bonds and try to stabilise the Italian government’s finances. But I’m not sure there will be the political will to allow that. The ECB already owns around 20 per cent of Italian bonds and the possibility that it may have to hold 50 per cent of Italy’s bonds will cause a lot of anxiety, especially among northern members of the governing council.
Could Italy leave the euro zone? Or would such an outcome be too catastrophic to contemplate?
In Italy you have an economy that has had no growth for 20 years - either zero or slightly negative productivity growth - and no exchange rate appreciation, in the sense the dollar-euro exchange rate remains where it was on January 1, 1999 when the euro was introduced. If the Italians shift to the lira it could depreciate by a very large amount against the euro and the dollar; when Argentina exited from the so-called ‘currency board arrangement’, [in 2002] the peso depreciated by 200-300 per cent. A sharp devaluation would mean Italy’s euro debts would not be repayable. People say the debt is owed to other Italians, but there will eventually be a foreign creditor at the end of that chain, and those cascading defaults in my view could become completely unmanageable.
In the final chapter of the book you argue that a ‘competitive decentralization’ of the euro zone is the best way forward. What would be the key benefits of a looser confederation?
My reading of 70 years of economic and political history shows that the euro zone authorities will never create a proper fiscal union because this in effect requires a political union, which requires national parliaments to be subordinate to a European parliament. I don’t believe that will ever happen. I don’t believe the German Bundestag will ever become a provincial legislative body inside a bigger Europe.
Given that premise, what’s the way forward? I say get rid of the fiscal rules because they make no sense and only make things worse. If you’re not going to have fiscal transfers, you need to go back to the original inception of the Maastricht Treaty, with its ‘no bailout’ clause, which means countries will have to enter into debt restructuring arrangements with their private creditors.
Wouldn’t the possibility of debt restructurings spook financial markets and make matters worse?
I understand the prospect of a debt restructuring is a very frightening possibility. What I argue is that a) the transition to the new framework should happen over five to seven years, so everyone is warned about what is going to happen; and b) there is no alternative. We pretended debt would not be restructured in the Greek case, which created an extraordinary depression in Greece, and then the debt was ultimately restructured anyway.
I argue we should get rid of the fiscal rules and create a framework for sovereign debt restructuring. Beyond that, the ECB should have a dual mandate, where it is explicitly required to consider unemployment conditions and not just price stability. This would allow for a better balance between north and south in terms of monetary policy.
What would be the longer-term benefits of this plan?
We have to recognise Europe is a declining continent in terms of its ability to keep pace with the most dynamic countries in the world. We know that from the time of the Industrial Revolution growth has been based on productivity, which requires innovation. Europe is falling behind in that race. Competitive decentralisation would revitalise economies, because fixing the problem of low productivity requires a sensitivity to local conditions.
I draw an analogy with the period of the Enlightenment, where innovation was part of a competitive structure in which each country or regional entity competed by creating better universities and attracting the best minds. It is competition to get ahead in a race that leads to a collective upsurge of innovation. In contrast, trying to centralise this process deadens these incentives rather than encouraging them.
Author: Ashoka Mody, Princeton Economist