Euro Quandaries: Should a Country Exit the Euro Area?

Listener: 13 August, 2005.

Keywords: Macroeconomics & Money;

When an Italian politician proposed that Italy should exit the euro area and return to the lira, specialists just laughed.

For the traveller, there is great convenience not having to change deutschmarks into lira in Rome, after a flight from Frankfurt, the great finance centre of continental Europe. Euro notes may look like play-money, but they are accepted as the real thing in 12 of the European Union member states, with another 10 to join as soon as they can. (Only Britain, Denmark and Sweden are given permanent exemptions.) European businesses producing in one of the currency-member states and selling in others may be equally pleased.

Italy is a vigorous exporter and importer, including in tourism. Why should it withdraw? Particularly as it now borrows at much lower interest rates. Under the old regime there was the real possibility that the lira would depreciate against the deutschmark. Lenders demanded a premium in order to protect their return. Today the relationship between the Italian euro and the German euro is fixed – it’s the same currency – so there is no danger of a depreciation, and no exchange-rate risk premium. The cheaper borrowing costs benefit Italian businesses and its Treasury.

However, the German Bundesbank (central bank) demanded a Stabilisation and Growth Pact as one of the conditions for joining the euro area. Germans went through two dreadful hyper-inflations in the last century. (Hitler came to power in part because the middle class had their savings destroyed by the first one in 1923.) They were intensely proud of the price stability that went with the deutschmark, and very nervous that less disciplined countries would destabilise the euro when it replaced it. So they demanded that no member country could run a fiscal deficit (broadly, the government’s spending over revenue) higher than three percent of GDP, other than in exceptional circumstances. They did not want any country issuing unlimited euro-denominated bonds at others’ expense, to finance any fiscal profligacy.

Portugal was the first to break the pact. Shortly after, so did France and, ironically, Germany. Their fiscal deficits show little sign of soon returning below the pact’s limit. That is one of the reasons that the (left-wing) German Chancellor, Gerhard Schroeder, called an early election for next month, despite his party being hopelessly behind in the polls. If he can’t get a proper mandate, the other party can clear up the fiscal mess.

There is a view that the deficit limit is too restrictive. By abandoning their currency for the euro, individual countries lose control over monetary policy, which is now set by the European Central Bank for the entire euro area. If one region is out of sync with the rest, it needs to use fiscal policy. So, it is argued, the three percent should be an average over the cycle rather than an annual maximum.

Some German economists argue that their high unemployment rate is caused by consumers not spending enough, so they deserve tax cuts. In effect, private savings are too high and the public sector should dis-save more. (Not, sadly, our problem.) Other economists think that the German cost structure is still too high and needs to be reduced, by increasing labour market flexibility so that wages can fall. Once the exchange rate is fixed, a country cannot realign its internal costs down except by deflation, which may require a fiscal nudge. The Italian cost structure may be too high, too. But those who argue for returning to the lira want to run a bigger fiscal deficit.

It seems likely that the stability and growth pact may be revised, so its fiscal limit becomes more flexible. But as countries sell more bonds to finance their deficit, lenders will require a higher interest-rate premium because of the greater risk of their not repaying their debt. That is what happens in the US, where counties and states can go bankrupt. So, although it may be easier for you to go through the euro-airport without bothering a money exchanger, macroeconomic management remains as complex as ever.

This is the last of four columns, made possible by support from the Federal Republic of Germany and its Goethe-Institut