It’s time to consider a two-speed euro
The collapse of Lehman Brothers three years ago triggered a financial crisis and brought the world economy to its knees. In recent months, there has been a fear that a collapse in the euro zone might have equally damaging consequences.
In recent months, the combination of excitable markets and ineffective politicians has seen the euro crisis spread. While the core of the euro zone led by Germany has been strong, the economies on the periphery have suffered badly, with recession and rising debt. Worries about default in Greece and a failure to resolve the problem has seen Spain and Italy dragged into the mess.
This led European leaders to gather in Brussels for another crisis summit on July 21st. The outcome was a deal that pulled the euro zone back from the brink and which eased immediate pressure on Greece. More government money was provided, and the private sector participated, ensuring a sharing of the burden. Despite this, the latest deal does not solve the underlying economic problems in the euro area.
In my view, a two-speed euro has always seemed the most natural scenario for the euro zone. Perhaps now is the time to consider it seriously. It would allow euro zone countries to stay committed to the project while trying to address the need for economic growth in the countries on the periphery, particularly Greece, Portugal, Spain and Ireland.
The problems inflicting the euro zone should not have come as a surprise. Since its inception, the euro has faced multiple economic challenges. These issues have always been met by a solid political commitment to make the project succeed. Just as those outside the euro area should not under-estimate this political commitment, it would be wrong for politicians in the euro zone to under-estimate the economic pain ahead for many countries as they try and remain in the common currency area.
In monetary terms, one size does not fit all. The interest rate for one region or country may not be the same as for another. Indeed, the recent decision by the European Central Bank to raise policy interest rates, driven by the solid core economies of Germany and France, will likely compound the problems for the periphery.
Thus, as has been widely recognised, a central Treasury is necessary in order to fund fiscal transfers from the core, or the richer regions, to the periphery, or those in most need. Yet even a central Treasury may not be enough.
I wrote as long ago as 1997 that a historical analysis shows that no monetary union of large sovereign nations has survived without becoming a political union. That, ultimately, may be what is necessary for the euro to survive. But this is not going to happen yet.
The challenge is that in the core economies such as Germany, things are seen differently. In terms of the Economic and Monetary Union (EMU), the view there is that the MU part, or monetary union, has worked well. In contrast the E, or the economic aspect, has failed. Thus the core sees the need for the periphery to make the economic adjustment needed.
Hence the tough conditionality asked of the likes of Greece and Portugal, among others, in return for any help from the centre. The central aspect of this are the measures to make the periphery more competitive, through austerity and supply side policies. In short, the Greek economy needs to become like Germany’s – an almost impossible task.
Austerity is the last thing the periphery economies need now. They are already in a hole, and are being asked to dig deeper. What is the solution?
Under the present set-up it is for the public and the politicians in the core to decide whether to sustain huge fiscal transfers to the periphery. Where the boundary between the core and periphery is has never been clear, but in recent weeks Italy has moved towards the periphery.
The euro’s current problems justify completely the UK’s decision to stay outside, and set policy to suit its own domestic needs. In contrast, countries in the euro area don’t have this flexibility.
I doubt very much that the periphery will be able to sustain the economic pain under the present set-up. Facing recession and already high youth unemployment, they are being expected to adopt austerity measures. It will not work and, instead, it will impart a further deflationary bias into their economies. Debt figures will stay high, not justifying the economic pain being inflicted upon domestic populations.
A two-speed system may provide the solution. The core can stay in the fast lane. Their economies are in better shape. They could form an optimal currency area, where the costs of staying in a monetary union are minimised, and the benefits of the European free-trade area maximised. They also will not need to go on writing blank cheques for the periphery.
There are clear benefits for the periphery from being in a slower lane. Although the politicians there may not see it as such, they should ask themselves: what will allow their economies to stay committed to the euro project while being able to receive a necessary boost to growth?
The periphery needs a competitive boost, in much the same way the UK benefited in recent years from the sterling’s massive devaluation. They also need this in a way in which they can stay realistically committed to the euro project. Going at their own speed is necessary and safer for their own populations.
How would it work? With a two-speed euro, the European Central Bank would remain in place. There would be two currencies and two rates, one at a discount to the other. Over a realistic period, say fifty years, the aim may be for achieving parity between the two currencies.
Interest rates would be different, with higher policy rates now for the fast-speed zone, based on present conditions, and lower policy rates for the slow-speed zone.
Every scenario for the euro faces huge obstacles. There is a genuine possibility it will not survive in its present format. Trouble is: leaving the euro is hard even if a country wanted to. Replacing the euro with your own currency cannot happen overnight. And if people and the markets thought this was imminent there would likely be a rush of money out of the country and a run on banks.
In some respects, the periphery are damned if they stay in the euro. Thus the disruption caused by moving to any new set-up, while painful, may be seen as a necessary step towards eventual economic recovery. After all, the need for growth is the key issue.
The immediate benefit to the periphery is that the member countries would receive an immediate competitive boost from a weaker currency. Initially the market might view this as an admission of defeat and demand higher rates, but over time these would be expected to fall, particularly if the ECB gave support to the slow-lane’s currency. Such lower rates would help the economies in the periphery.
The fear of default would be replaced by the reality of growth. After some initial uncertainty, yields in the slow-speed zone would likely fall as economies start to recover and debt dynamics improve. Austerity would not need to be rushed.
Of course, some say this can’t happen as treaties would need re-writing. But that would seem the least difficult thing to do in the current circumstances.
The question for the euro zone is whether any new approach taken can reignite growth while still keeping the euro project alive. A multi-speed euro, with different countries going their separate ways would not achieve that objective; a two-speed system might.
By Dr. Gerard Lyons – Chief Economist and Group Head of Global Research at Standard Chartered Bank
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