Ifo Viewpoint No. 137: An Open Currency Union

Hans-Werner Sinn
Munich, 18 July 2012

It is time to start thinking of new approaches to solve the euro crisis, given that the current rescue strategy has not worked. The troubled countries have been kept afloat with cheap credit from the European Central Bank (ECB) and the community of nations for nearly five years now. According to the Ifo Institute's latest calculations, the ECB, the EU, the EU member countries and the International Monetary Fund combined have provided a total of €1.53 trillion in rescue funds.

It hasn’t helped. The crisis still rumbles on – unsurprisingly, since a bottomless barrel simply cannot be filled. When the ESM and EFSF rescue funds are used up, the rescue sums will have climbed to €2.2 trillion. Should the six stricken countries – Greece, Ireland, Portugal, Spain, Italy and Cyprus – become insolvent, exit the Eurozone and default on their debts, Germany would face a loss of €771 billion, or €9,400 per capita. Similar per capita figures hold for France, the Netherlands, Belgium, Austria, Slovakia and Finland, with €8,900, €9,900, €9,300, €9,500, €4,800 and €9,500 respectively.

The politicians and economists who hold this course to be the correct one, and who seemingly consider the discussion of alternatives objectionable, should explain how they imagine the process down the road. How many years yet are they willing to countenance a policy of soft budget constraints? Have we forgotten Janós Kornai, who predicted the demise of the Soviet Union as a result of its soft budget constraints? Should we stick ad infinitum to a Keynesian debt policy to contain the crisis?

The Eurozone’s private and public-debt problems cannot always be solved with just more debt. What we need instead is radical debt restructuring within the affected countries that is undertaken at the expense of the creditors instead of the taxpayers. A large portion of the money has in any case already been lost, and the earlier the losses are charged to the creditors, the sooner the problem can be solved.

The harder task is to change the relative prices. Greece and Portugal need to become more than 30 percent cheaper and Spain 20 percent, in order to regain the necessary competitiveness. In the absence of price realignment, rescue operations will continue indefinitely, since if they should stop, the crisis would be instantly rekindled.

The Eurozone is not a homogeneous nation with its own currency. It does not possess the sovereign interstate enforcement powers required to counteract centrifugal forces and put a stop to unlawful behaviour. On the other hand, it is more than just a fixed-exchange-rate system of the Bretton-Woods type that can be dissolved when the internal pressures resulting from different inflation rates become too strong.

What we need is a middle way between the dollar system of the USA and a Bretton-Woods-type fixed-exchange-rate system. This middle way could be offered by an “open currency union,” in which some formerly full members attain associated status by returning to a separate currency temporarily (while remaining legally attached to the EMU) to regain financial and economic health, all the while holding the right to return at a later stage. The associated status could be interesting for countries that do not want to take it on themselves to attempt a real depreciation within the Eurozone, with the harrowing real contraction that is needed for the price and wage decreases that would re-establish competitiveness. Associated members would be helped financially by the remaining full members during their exit and currency conversion period, but must reform in order to be readmitted to using the euro.

At the same time, further European integration should be pursued with renewed zeal. Europe urgently needs a unified system of banking regulation that makes it possible for the banking system to grow closer together, putting a stop to ruinous regulatory competition. This, however, should not mutate into a bail-out or transfer union, but become instead embedded in a system of hard budget constraints in which the markets and not the ECB set the risk premiums. Only a system in which the investment decisions are taken by portfolio managers instead of central bankers or the ESM governing council can allocate capital efficiently among competing uses, and it is only fair that the investors themselves bear the corresponding risk.

Deposit insurance schemes and other protection systems can only be agreed upon behind the “veil of ignorance”, before the catastrophe strikes. But the catastrophe in this case has long been common knowledge. It is clear that banks in the South are facing huge write-off losses on property and commercial loans, because they did not act against the inflation bubble that the cheap euro credit brought about; it is now too late to provide insurance. The banks' domestic and international creditors instead must foot the bill themselves. And even if it were not too late for insurance, such systems must be approached with caution in order to keep the moral hazard effects to a minimum. To throw all the write-off risks into one pot in order to shift the burden from the banks' creditors to the taxpayers of the still-solvent countries, as the EU is contemplating, clearly does not provide the right incentives for a long-term functioning of the Eurozone.

A policy focused on hard budget constraints and simultaneous improvements in competitiveness also requires curbing the excessive use of the regional money-creation machines. The US accomplishes this by having the extra money paid with marketable assets instead of just having it chalked up to the issuer’s account.

Unfortunately, it appears that many decision-makers and their advisors would prefer instead to venture onto the slippery slope of even softer budget constraints by way of debt socialisation.

Published under the title “Die offene Währungsunion”, WirtschaftsWoche, No. 29, 17 July 2012, p. 39.

Prof. Dr. Dr. h.c. mult. Hans-Werner Sinn
Präsident a.D. des ifo Instituts