Reasons for confidence in the euro

It had been a while since I wrote about the euro before my column this week, largely because good news is no news, to turn the old dictum around. With the absence of drama around Europe’s single currency, there is less interest and less need to discuss it. But Croatia’s accession on January 1 — which brings the euro’s membership to 20 countries — made it timely to return to it. As far as I can see, all the arguments about how the euro was inherently unsustainable, at least without some great leap to large-scale common budgeting, have simply receded into silence rather than been formally retired by those who believed them.

You will not be surprised that I see the euro’s recovered attractiveness as something of a vindication for those of us who argued (at book length, in my case) against the old 1960s-style arguments about optimal currency areas and using floating exchange rates as shock absorbers. Of course, “never” is a long time and some big shock could in time come around that caused the euro to disintegrate. But it would clearly have to be a worse shock than the combination of the deepest economic downturn, the steepest energy price shock and the most violent military conflict in generations.

The euro has proved rather more robust, to put it mildly, than its forerunner, the European Exchange Rate Mechanism. Late last year, I participated in a Centre for Economic Policy Research event to mark 30 years since its unravelling (in the last panel of the webinar recorded here). I contrasted the ERM chaos of 30 years ago, as well as the euro dramas from a decade ago, with what I see as the situation today, which is that the euro is now an uncontested acquis. In any serious sense, the debate over whether the euro is here to stay is over.

That claim can be taken in a number of ways. It could be about the politics: the eurozone debt crisis put Europe’s leaders to the test of whether politically they would stick together or not, and they passed. The political endorsement of Mario Draghi’s “whatever it takes”, as much as the central banking mechanics of what it meant in practice, was what mattered. This is the argument many people have made as to why the worst predictions did not come true.

That argument is correct enough, but my own take is that the economic debate, too, is largely over. Not in a literal sense, of course: a lot of people hold unreconstructed views of how a monetary union cannot “work” without much larger fiscal transfers than Europe will ever see (or the flip side of that view, that since the euro hasn’t broken up, the large fiscal transfers must already have happened, maybe through the Target2 ledgers of the accounting system for intra-eurosystem bank transfers).

My point is, rather, that there is little credibility left in the old arguments. In the column, I mention (admittedly only in passing) two reasons. One is that monetary independence is mostly an illusion for small open economies in a dollar-centred world of full capital mobility. The other is that a falling currency can’t be relied on any more to boost export volumes. That should not be particularly surprising when so much trade relies on complex supply chains that criss-cross national (and currency) borders.

In some of the social media reaction of the column, Karthik Sankaran reposted an earlier essay he wrote about his own intellectual journey from euro sceptic to friend, aptly entitled “How I learned to stop worrying and (mostly) love the euro”. It is well worth reading, and I think representative of how a lot of people’s thinking has shifted. There are two clear steps: a re-evaluation of the political commitment to the euro around 2010, but then an increasingly nuanced revision of the economic arguments in the years that followed. Sankaran is particularly instructive in drawing comparisons with emerging market balance of payment crises, which make him think that the alternative to the euro would have been a lot less benign than the standard arguments would have it.

His essay links to a 2014 piece by Raja Korman that I missed at the time, which gamed out how a Europe of small national currencies would have weathered the huge financial boom and bust of the early 21st century. In a word, terribly: the booms would have featured even bigger cross-border financial flows, real appreciations and capital misallocation, and the bust would arguably have been worse given how floating currencies tend to overshoot. (In my 2015 book Europe’s Orphan I made the same counterfactual arguments.) I think anyone who holds on to the classic criticisms of the euro should read these pieces and consider carefully where they think they go wrong — or, better, I suspect they will be led to update their own views.

So I think the economic argument about the euro’s survival has been settled, just that the losers may not have realised it yet. But even if that is right, there is a lot about the eurozone economy that is very far from uncontested. In the CEPR webinar, I mentioned three things. One is the performance of the eurozone economy, and in particular of its financial markets, where difficulties abound in integrating national banking systems and deepening capital markets. Even the single market for goods and services is fragmented in ways that prevent the full benefits of a single currency from being harvested. A second one is the international role of the euro.

The third is monetary policy and how to handle the current inflationary episode. That is not a problem “with” the euro of course, any more than the equivalent challenge in the US or the UK is a problem with the dollar or pound. It is a problem of the eurozone economy, the right solution to which is contested.

As readers know, I worry that central bankers look too negatively at wage growth and exaggerate the risk it will fuel entrenched price inflation through a wage-price spiral. On both sides of the Atlantic, central bankers look at high wage growth with horror, and it has increasingly featured as the central observation justifying continued tightening. To simplify, many central bankers and economists think if workers manage to secure full compensation for the real wage cuts that energy-driven price rises have caused, it will set off a long cycle of wage and price rises as capital and labour in turn try to force each other to bear the cost of the real income loss the economy has suffered. One way this is expressed is a worry that wage demands are “backward-looking” — trying to make up for lost ground — rather than forward-looking and therefore under control because expected inflation remains well contained.

In the US, there are three important objections to this analysis: the US is net self-sufficient in energy so there is no overall terms of trade loss; wage growth has been slowing in parallel with falling price inflation; and most wage growth seems to reflect workers moving from less productive to more productive jobs, as I explained last week. All this ought to temper the Federal Reserve’s fear of a wage-price spiral.

What about the eurozone, however? There, the first is not true, the third we have too little updated data on and the second is hard to tell because inflation has only recently started to slow down. But research by economists at the Central Bank of Ireland and an international job advertisement platform, analysing wage offers in posted job ads, documents trends that give some tentative indication that in Europe, too, central bankers may be too negative about wage growth.

One finding is wage growth has indeed been trending down for several months:

Another is that wage growth tracks core inflation closely — so if energy and commodity deflation spreads through general prices in the reverse of what happened last year, wage growth will moderate too. Finally, just like in the US, it is the lowest wages that have risen the fastest.

This, it should be clear, is a positive aspect of an economy running hot — which should be weighed against the negatives of overall price growth. But more importantly, it lends a bit of hope to the idea Europe may also be seeing some of the virtuous kind of wage inflation as a result of reallocation that is occurring in the US. To be sure, however, we need updated data on the rate of job-to-job moves in the eurozone. One place where the single currency still underperforms is in the timeliness of comprehensive statistics.

Other readables

Numbers news

• Vladimir Putin’s war is weighing on the Russian budget.

• Might a decades-long deflationary mindset finally begin to lose its stranglehold on Japan’s economy? Uniqlo’s parent company is raising wages there by up to 40 per cent. Today’s issue of the Unhedged newsletter has an excellent discussion of Japanese reflation.