I think we all agree on this, the question is that in the nation state the tax benefits from the faster growing regions are distributed to those who grow more slowly. But again I think we are all agreed that tax revenue going to Brussels and then being shared out would be a political ‘no-no’.

Here in Spain Catalonia wants the right to raise the revenue and then pass an agreed portion of it on, and you should see the row that this is causing.

“I’d be hard pressed to think the markets would price French or Italian debt lower than German debt, despite all of Germany’s problems.”

This is the whole point, this would be the automatic stabiliser: those countries would have to pay more for their debt so there would be less temptation to get into systematic debt. Lets be clear here: we are not talking about cyclical fluctuations, we are talking about a long term tendency to endebtment. As I am flagging, for some of the countries running high deficits we are as near to an economic boom as we are going to be in the foreseeable future.

“Compared with following Frankfurt with no voice in policy and continuing to pay a risk premium, the maintenance of the eurozone is almost by definition a good deal for all of the non-German members.”

OK this is certainly true, so we could add it to Oliver’s earlier point, which was:

“there’s a level of differences in desirable interest rates at which changing money in international transactions is cheaper than having a bad interest rate.”

Oliver II, courtesy of Doug, could be the idea that you can offset the disadvantage of losing your monetary policy with the fact that you can get yourselves into debt very cheaply. (Incidentally this has also happened to individual Spanish consumers, but that’s coming in another post).

The point is that the plus signs on both these values – savings in currency transaction costs, and interest savings on debt – could be fairly small compared with the loss of GDP produced by being away from your optimum output operating level. And remember, as I tried to indicate this is a kind of ‘compound interest’ problem as the years go by.

I don’t think it can be long before someone does a modeling exercise (maybe they already have, let me know if you see one) comparing achieved GDP with the GDP which would have been accumulated by running a national monetary policy with (say) a 2% inflation target. My guess the resulting difference would be big and important.

“I talk to a reasonably large number of entrepreneurs in biotech”

It’s just a guess, but I can imagine a reason for this. Biotech start-ups contract labour. Most of the reforms are directed to those who want to shed labour, and want to do it more cheaply. It’s about time scales. Shedding labour has a high initial cost. Maintaining the person in employment is cheaper in the short run, but may be grossly inefficient over time.

This is not a big transfer in global terms, though as its distribution is weighted towards poorer regions (structural funds) and States (cohesion fund) it can be significant to them in terms of % of their local GDP. (The new member states for example, will get roughly 4% of GDP in transfers).

But – in a nutshell – it is hardly on the scale of transfers within member states, where the automatic stabilisers of unemployment benefits, regional policies and the like, are much more significant.

I fully agree that it is just not reasonable (or desirable) to envisage much bigger transfers at the EU level. This would be a political nightmare. The squabbling is bad enough as it is.

But how big a constraint is the loss of a national monetary policy? This is where the pro-euro argument can be refined: There are two points related sometimes made:

1. If a member state is regionally diverse then a national monetary policy does not necessarily help much as shocks will tend to have regional, not country sized effects, and a national monetary problem does not get round this. So the empirical issue is: how much more homogenous are member states than the euro zone as a whole?

2. If the real problem is one of slow and fast growing regions rather than fast and slow growing member states, then tranfers within member states may be an adequate adjustment mechanism, so the lack of an EU wide instrument may not be a real problem.

Although I see the point in these arguments, I am sceptical, and tend to buy into your concerns about the problems the euro zone faces.

First, from Mitterrand’s endorsement of the franc fort policy forward, monetary policy for what will become euroland is effectively made in Frankfurt. The Bundesbank sets its rate, and very shortly after, the other central banks follow it up, down or sideways. (The Bank of England is the exception, as it is today.) At that point, the other states have the market risk of a nominally independent monetary policy, i.e., the markets are not 100% certain they will follow Frankfurt and thus charge a bit more. But the other states have very little practical benefit in practice, as they cannot move separately from Frankfurt without paying even higher risk premiums.

That might be different today, though I’d be hard pressed to think the markets would price French or Italian debt lower than German debt, despite all of Germany’s problems.

Compared with following Frankfurt with no voice in policy and continuing to pay a risk premium, the maintenance of the eurozone is almost by definition a good deal for all of the non-German members.

My argument here is analogous to my argument with the folks who say an orderly delay would have been better in 98-99. Maybe, but the situation in the market was such that you could have had either order or delay, but not both. Here, euroland without the euro would still have interest rates set in Frankfurt but without any of the positive offsetting effects discussed above. They may be smaller than the transfers in the US, but they are more explicit than they would be without the euro.

On another track, growth really does seem to be the problem in some large euroland economies. If I knew for sure what was keeping down German growth, I’d be raking it in as a consultant, or lobbying like hell in Berlin. For example, I talk to a reasonably large number of entrepreneurs in biotech, and I have almost never had someone tell me the much-maligned labor laws are a significant problem. And I ask quite explicitly on a regular basis. I dunno.

It is also, btw, the more or less pragmatic conclusion of Eichengreen in the linked paper.

My opinion however differs from this. In a modern nation state – US, France, Germany eg – there are a series of policies which operate to guarantee what is called ‘territorial integrity’. Roughly speaking this normal means less populated areas have per capita more political clout, and that richer areas subsidise poorer ones in the name of ‘national solidarity’.

In principle this is fine, but there are limits to how far this can go. I think I am right in saying that the German constitution places limits on redistribution between the various Lander (please correct me someone if I am wrong here).

In Spain at the present time there is a furious row going on about this since Catalunya – one of the richer regions – pays a disproportionate price, and is finding that its growth capacity is falling behind other regions (which are benefiting from the transfers) in part due to the fiscal burden.

Now my point here is that if these problems require a *delicate* balancing act within any given nation state, how much more difficult would this be to apply across states, especially were there is no inbuilt correction pressure on the net-recipient (the free rider problem).

Just imagine the row there would be in the UK if it were to join the euro and then find that as a high growth country it was to be required to fund a growing deficit in relatively low growth Greece and Italy.

Of course it is intelligent to have a general policy to assist the relatively poorer EU economies catch up with the relatively richer ones: but the structural funds already exist to do this, and the objective here is different.

“Instead all members are required to maintain a balanced budget over the economic cycle.”

This is actually the current obligation, but as we can see it isn’t working out. As I keep flagging last year was a record global growth year, that may be the best it’s going to get. We may now be near the top of the cycle, and most euroland economies (and of course the US, the UK and Japan) are heavily in deficit. So what exactly is going to happen when we enter the bad times?

The central problem for several euro zone economies is that the trend growth line my have sunk so low that it is virtually impossible to distinguish boom from recession.

But a similar, if not better, solution would be to devolve fiscal control. This is roughly the ?-solution, with the important proviso that there are only minor transfers from/to the centre and also that significant restrictions are placed on the member-states’ discretion.

Now, consider the following: the ECB has its inflation target as a guarantee to the markets, but the Stability and No Growth Pact goes. Instead all members are required to maintain a balanced budget over the economic cycle. If Ireland (say) is booming and testing the inflation target, it can apply the fiscal brakes – if state X is recessing, it can Keynes away.

Alternatively you could perhaps have a pan-European budget target; deficits in one to be balanced by surpluses elsewhere. But this would be problematic in the event of a continent-wide recession (or boom), and would be politically difficult as the surplus state would no doubt be infuriated at effectively subsidising the deficit state.

“on the verge of going through a very rocky patch”.

This is hard to say at present. Remember the euro is high at the moment precisely because the dollar is weak. Since at the Federal Reserve they are unlikely to do anything to unduly strengthen the dollar (this is another issue) this seems to put a short term ‘cap’ on the upward movement of interest rates there.

The Japanese – struggling away with deflation – would undoubtedly fiercely resist any strong rise in the yen, and the Chinese yuan, as I have been suggesting, just isn’t strong enough to plug the gap.

So in the short term at least the euro is likely to remain strong by default.Of course all this is playing with fire, since the situation is far from stable.On the SGP I don’t know whether it’s ‘loosening’, ‘trashing’, or simply de-facto abandonment. We’ll have to wait and see, but my feeling is its a gonner.

Listening to Trichet’s webcast yesterday was a rather depressing affair. I hadn’t really twigged how attached he still is to the old mantra of ‘providing a firm anchor for inflation expectations’. Of course inflation needs to be kept under control, but this shouldn’t become an obsession which blinds you to changing realities.

The euro zone generally is in a strong cycle of disinflation. That this should be the case after what is probably the strongest year of global growth ever recorded is rather alarming. At some point global growth will slacken and then disinflation could become, in some cases, outright deflation: Germany would be the prime candidate here. This also seems to be Eric Chaney’s view in the piece you link to:

“With real interest rates already at zero and fiscal policies more or less frozen, reflation is unlikely to come from policy makers. On the other hand, wage moderation has turned into wage deflation in several regions, starting with Germany, where this is a necessary but extremely painful adjustment. The conclusion: Europe is doomed to remain in this stag-disinflation world for a long period of time, the risk being that disinflation could turn into outright deflation if the risk scenario I alluded to earlier became a reality.”

When Chaney refers to real rates at zero he is talking about a comparison between the *average* harmonised rate and the 2% ECB funds rate. I’ve already indicated my opinion of this specific comparison, but I agree with Chaney’s main point.

On the euro and the accession states I am working on a post right now .