Reflections on the Euro

To conclude its spring program, and in cooperation with the Clausen Center for International Business and Policy, IES welcomed Barry Eichengreen, Professor of Economics and Political Science at UC Berkeley and leading expert on the Euro economy, for a lecture providing a retrospective on the euro crisis and the viable way forward for the Eurozone. Eichengreen started by summarizing research he conducted 25 years ago, which used the Aggregate Supply- Aggregate Demand model and time series analysis on prices and outputs country by country to analyze symmetry and asymmetry of macroeconomic shocks as well as the speed of adjustment across the European economy. He distinguished between two types of shock: AS shock that both raises output and reduces prices permanently, and AD shock that raises output temporarily but prices permanently. Using the output growth coefficient of the US economy for comparison, he observed that the correlation of output fluctuations among members of the EU core largely resembled those in the US, while those which occurred amongst Southern European countries did not. Asymmetric shocks were observed particularly in Portugal, Ireland, Italy Greece, Spain and the UK. More recently, Eichengreen updated his data so as to cover 1994 to 2014, and, interestingly, he observed that Portugal and Italy, as opposed to the northern countries, have become more symmetric with Germany. This reflects the effect of large capital flow from Germany to southern Europe. He also noted that, while in the US analysis, empirical data look very much like the theoretical AS/AD shock adjustment, in the EU, AD shock actually lowered prices and AS shock increased them. He theorized that positive supply shock unleashes large capital flows that bide up asset prices. Periphery booms, in conjunction with consumption, lead to an increase in housing and government spending, ultimately resulting in higher output and higher prices. Behind the mirage of prosperity, however, is the loss of competitiveness. Thus, it is no surprise that the Euro economy continues to face difficulties, as shocks are still asymmetric and idiosyncratic and adjustments still difficult. Eichengreen then moved on to discuss potential changes to be made in order to help the Eurozone move forward. As highlighted in this presentation, his proposition would involve establishing a normal Central Bank able to pursue flexible inflation targeting and backstop banking systems and government bonds market; completing the banking union; renationalizing fiscal policy, and removing debt overhangs. Eichengreen further used Club Theory as the guiding principle for future EU integration. If tastes are homogenous, spill-over significant, and an increasing return to collective action, then the decision should be centralized. Regarding fiscal policies, for instance, countries clearly have heterogeneous tastes, but, in order for renationalization to work, there must be a credible no-bailout rule to discipline countries. Removing inherited debt overhangs is important to providing sufficient scope for national action and preventing spill-over due to default and insolvency. To conclude, Eichengreen expressed his belief that the EU needs both more and less integration, stressing that club theory marks the direction. He also emphasized that, in light of the plethora of overlapping schemes that coexist today, the two-speed Europe is not the right model. Within the current framework, he proposed that separate committees be formed (i.e. Schengen countries solely vote on Schengen matters, etc.). According to Eichengreen, an EU Parliament invested with more power as well as direct election of the EU Commission’s president are also important.