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Departures from optimum currency area criteria

Currency area theory is concerned with extent to which efficiency gains from currency area membership are offset by losses due to increased vulnerability to external economic shocks, and the term "optimum currency area" (OCA) denotes an area in which such offsets are absent. Although an idealistic concept, it has practical implications because the increased costs of recessions, brought about by increased vulnerability to shocks, can be large compared with the benefits of the efficiency gains. For that reason it is generally accepted that a currency area may not succeed unless it goes a substantial way toward meeting OCA criteria. A currency area fully meets OCA criteria if there is complete price flexibility, or complete cross-boarder mobility of labour and capital. An alternative requirement arises from the fact that increased vulnerability to shocks need not occur if every shock has the same impact on all the economies of the member states. The term "convergence" is sometimes used to denote a condition in which the economies of members states are so similar as to eliminate asymmetric shocks - or to denote an approach to that condition.

The eurozone has not satisfied the OCA labour migration or price flexibility conditions. Labour mobility is low and there is only limited wage and price flexibility. Nor has it satisfied the convergence condition. There has been less price convergence among eurozone countries than among European Union countries as a whole,, and there have been large divergences of productivity, unit labour costs, and current account balances. The progress toward convergence as a result of membership, that was expected by the early proponents of monetary union, has not occurred.

The debt trap

If the annual interest payable on a government's debt were to continue to rise faster than the national income, it would eventually exceed the feasible revenue from taxation. The process is normally hastened by the fact that government debt is traded in a well-informed market. Operators in that market would be aware of the approach of the point at which the government would be forced to default on its debt, and they would be increasingly reluctant to allow that government to continue to roll over its debt. The government concerned could seek to overcome that reluctance by offering them higher interest on future loans, but an increase in the interest to be paid would hasten the process and increase the reluctance of further potential investors. That is what is known as the debt trap, the price formulation of which is the the debt trap identity.

The debt trap could be escaped:

- (i) by repudiation of the debt;

- (ii) (temporarily) by a negotiation with creditors to ease the terms of repayment (termed restructuring);

- (iii) (temporarily) by getting the country's central bank to purchase the debt; or,

- (iv) by a programme of reductions in public expenditure and/or increases in rates of taxation.

Options (i) and (ii) have the drawback of making future investors reluctant to buy the government's bonds. Option (iii) can also have that effect if it causes an inflation that reduces the value of the currency in which the debt is to be repaid. Option (iv) is free from that drawback, but is effective only if it avoids creating a recession that increases the deficit (by the operation of the country's automatic stabilisers).

Fewer options are available to members of a currency union, however. Option (iii) may be excluded by the fact that monetary policy is no longer under the control of the borrowing government. That fact also prevents the use of monetary policy to counter the recessionary consequences of (iv), (without which that option may be ineffective); and the rules of the currency union prevent the exchange rate deprecation that might otherwise counter them. To make (iii) possible and (iv) easier, a further option would be (v) - to leave the currency union.

Policy options

Conditional loans

The EU/IMF loans had been primarily intended to restore the confidence of the bond markets in their recipients' ability to meet their financial obligations and give the recipient governments time in which to restore their fiscal sustainability. They were subject to conditions that were to be expected to cause substantial reductions in economic growth and increases in unemployment. (The conditions attached to the loans to the Greece government were designed to reduce its budget deficit to 3 per cent of its GDP by 2014, from its 2009 level of 11.6 per cent, by means that included a tax increase of 4 per cent of GDP and public spending reductions of 5 per cent of GDP). When the first loan failed to restore confidence, it was decide to add a second loan and to reduce the interest rate charged on all loans from 5.5 to 3.5 percent, in addition to which EU financial institutions agreed to make a financial contribution and to agree to the restructuring of some of the Greek government's debt.

Bond purchases

At an early stage, the failure of conditional loans to avert the growing crisis prompted the exploration of possible alternatives. Some of them have since been adopted, and all of them are the subject of continuing debate. Among those that were adopted was the idea of sovereign bond purchases. Before May 2010, the European Central Bank had used bond purchases only for the purpose of monetary policy, but in May 2010, in a major policy change, it decided to buy European government bonds in order to assist governments who were experiencing funding difficulties - a policy change that was opposed by Axel Weber, the then President of the German central bank. Purchases are reported to have included the bonds of all of the PIIGS countries, including Spain and Italy, but they achieved only temporary stabilisations of the affected markets.

Eurobonds

The Greek government's funding problems would be solved if it were permitted to issue bonds that were guaranteed by the other eurozone governments, and several such "eurobond" proposals have been put forward at an academic level. The idea was advanced at a ministerial level in December 2010 by Jean-Claude Juncker, the Luxembourg prime minister and Giulio Tremonti, the Italian finance minister,, but rejected as unconstitutional by German Chancellor Angela Merkel. In August 2011, the financier George Soros argued that such a "eurobond" would have to be an essential feature of any effective Greek rescue package, an assessment that was endorsed by the eminent economist, Joseph Siglitz . The proposal was again rejected by Angela Merkel, but in September 2011 the European Commission President, Jose Manuel Barroso, announced that the Commission would soon present options for the introduction of eurozone joint bonds . Among variants on the concept are the "Blue Bond" proposal, under which eurozone governments would pool up to 60 percent of GDP of their government debt in the form of a common European government bond , and its "partial sovereign bond insurance" alternative .

Fiscal union

It has been argued by the economist Wolfgang Münchau, and others, that the eurozone embodies a logical inconsistency that will continue to make it vulnerable to economic shocks unless it is resolved by the introduction of some form of fiscal union. It is generally acknowledged, however, that the political obstacles that would have to be overcome are such as to put such a solution beyond reach for several years. (For example, the German constitutional court has ruled that political control over fiscal policy is a part of national sovereignty that cannot be transferred to the European Union).

Restructuring of debt

It is generally accepted that the costs of sovereign default to all concerned are such as to make its avoidance a high priority objective. However it is being argued that, when default becomes unavoidable, some of those costs can be avoided by a timely "restructuring" agreement with the country's creditors. In May 2011, European Finance Ministers discussed the possibility of a rescheduling of the Greek government's debt (also referred to as "soft restructuring" or "reprofiling").

Guntram Wolff, the deputy director of the Bruegel think tank believes that Greece's debt ratio needs to be reduced by around 50 percentage points if Athens is to approach long-term debt sustainability, and Greece's Finance Minister is reported to consider an "orderly default with a 50 percent haircut for bondholders" to be one of his government's options, but Lucas Papademos has argued that the net benefits of restructuring - after allowing for its associated costs - are limited.

Bank recapitalisation

European banks have suffered reductions in their assets as a result of falls in the value of their holdings of Greek bonds, estimate by the IMF to amount to about €200 billion and the resulting reductions in their capital adequacy ratios are reported by the European Banking Authority to be in need of recapitalisation. It is evident that, without large-scale recapitalisation, the proposed restructuring of the Greek government's debts would result in multiple bank failures.

Internal devaluation

Since it is not open to eurozone governments to increase the international competitiveness of their countries' products by devaluation, some have sought to do so by measures to reduce the costs of production, for example by reducing the tax wedge that raises the cost of labour to employers above the take-home pay of employees. The same objective may be served by the downward pressure on wage rates brought about by increases in unemployment resulting from fiscal adjustments designed to restore sustainability.

Exit from the eurozone

Departure from the eurozone would enable a country to monetise its debt, and would offer the prospect of an increase in competetiveness resulting from a currency devaluation. However, according to a study by UBS economists, the benefits to a country like Greece would be overwhelmingly outweighed by costs. It would also result in mass sovereign and corporate default, a major increase in the cost of capital, and the collapse of its banking system (the first-year cost of its departure was later estimated to be 40 to 50 per cent of GDP. ). The economic commentator, Anotole Kaletsky, has argued that the "seemingly impossible" solution of a German exit might become inevitable, and would be much less disruptive than a Greek expulsion because it would not trigger bank runs in countries, but would enable a devalued euro to be managed on less austere principles. But the UBS economists estimate that departure of Germany would lead to a first-year loss to its economy of 20 to 25 per cent of GDP.