Consider the travails of the euro-area in terms of the macroeconomic policy trilemma (1/). Here is the framework:
i. Balance of payments trouble when external credit dries up (sudden stop) ==> solvency threat via banking system and sovereign debt via lender-of-last-resort / contingent debt.
ii. Maintenance of the existing monetary order (the system of irrevocably fixed exchange rates) is conflated with the preservation of society itself (e.g. Angela Merkel in May 2010 conflated euro-zone integrity with the existential status of the EU.)
iii. In fealty to (ii.), pursue austerity. Adjustment is attempted on the backs of taxpayers/ workers. In the trilemma framework, the ‘policy independence’ piece is sacrificed in order to preserve free capital flows and fixed exchange rate. Prices must deflate sufficiently to generate external surplus.
iv. Monetary non-neutrality (2/) makes deflation a highly unlikely means of generating the surplus. Debt problems are exacerbated and labour is under-utilized because too expensive.
v. Repeat (iii.) until …
vi. Political upheaval or solvency crisis (the official lending stops and the sovereign cannot raise funds on the capital markets).
vii. Adjustment comes in one or a combination of the following:
a) Devaluation (for competitiveness, to achieve external surplus) and default (partial or total; also to achieve external surplus).
b) Capital controls (first on current account, then covering all transactions). Note that capital controls can be instituted precisely in order to repay external creditors; it is a way of marshalling all available foreign exchange for that purpose.
c) Trade barriers
Note that c) is really just a version of a) for those unwilling for several reasons to part with the irrevocably fixed currency regime. Does this suggest that if euro-area is unable to countenance disintegration (new currencies), then trade barriers and/or capital controls are next? Maybe not as crazy as it sounds.
Right now, we’re in stage (v.) What keeps us in this loop is official lending. I think the potential for an extended period of such lending is vast. It goes beyond the EU itself; official sources of finance can be brought to bear from much further afield, in the form of sovereign wealth funds and other long-term investors. Yet even though official lending can sustain the loop implied by (v.), it is not clear the population can. My sense is that if loans are piled on top of existing loans, and the adjustment is squeezed out of taxpayers and working people, the limits will be reached. Someone will come to the fore offering the clarity to say, Enough. Because, actually, there is an alternative to (v.). It is located in (vii). Does it threaten the existence of the EU? No, and European leaders should stop conflating the euro-zone with the EU.
1/ The trilemma is the recognition that policymakers cannot simultaneously enjoy all three of the following: fixed exchange rate; policy independence; and currency convertibility.
2/ In order for deflation not to be injurious, money must be ‘neutral’ — in other words, real effects must be indifferent to price increases and declines. The reality is that, with a few notable exceptions (Hong Kong), money is non-neutral in some key ways. For example, deflation might well contribute to insolvency through heightening the real debt burden and unemployment by raising the real wage. Workers DO accept eye-watering wage cuts but rarely on the order required to achieve competitiveness for the economy. Remember, in a balance-of-payments crisis, the economy needs to shift into a surplus, not just a balance. The implied adjustment in the real exchange rate is sizeable, unless you believe in the “immaculate transfer”. But that is yet another story.