Europe () - The world’s greatest macroeconomic imbalances are not between the U.S. and China, as many believe, but within the not-so-united states of Europe.
This is just one result of the currency and competitive distortions caused by what German Chancellor Angela Merkel calls the “common destiny” of economic and monetary union. Destabilizing European current-account imbalances will need to be eliminated, sooner or later, by splitting up the euro area into a creditor and a debtor group.
The euro creditors formed around Germany would need to accept a trade-weighted appreciation of 20%. In the export sector, this might trigger wailing and gnashing of teeth, but consumers and importers would profit greatly through a marked improvement in the terms of trade. This would be a constructive European contribution to alleviating one of the largest sources of global economic uncertainty.
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The solution of splitting up the euro EURUSD +0.06% into weaker and stronger constituents has been put forward by many people (including me) over the past year or so, but has always been rejected as unworkable and unworldly. Now, realization seems to be drawing nearer — a conclusion of the grotesque turmoil in the international bond markets.
As is now glaringly evident, the single currency has been a sadly inadequate device to bridge economic and structural divergence in the euro area. A combination of a substantial currency undervaluation in creditor nations in the North and a deleterious overvaluation for the troubled Southern debtor states means the euro’s valuation is not right for anyone.
In the first category we see large surpluses in international trade and an inflation rate turning up because of relatively dear imports.
In the second group the opposite happens: Current-account deficits are persisting in spite of sustained deflationary policies needed to curb years of excess.
According to the International Monetary Fund, last year no fewer than seven European countries registered similar or higher current-account surpluses, measured by gross domestic product, compared to China, Japan and Russia. They include three members of EMU: Germany, the Netherlands and Luxembourg. In the group we also find Denmark and Sweden, outside the euro bloc but with currencies that have been relatively strong but are still undervalued, as as well as the two “special cases” Norway and Switzerland.
All with a current-account surplus of over 5% of GDP, compared to 3.6% for Japan, 4.8% for Russia, 5.2% for China.
It is highly unlikely that this untenable situation can be defended by unlimited expansion of the European Central Bank’s balance sheet. Without a tough European political consensus and the associated guarantees of creditor country taxpayers, the ECB can’t be expected to carry out more than smoothing operations on the bond markets.
The euro has failed to overcome its sternest test. Creative, politically ambitious action toward splitting up the euro is now needed to end the ordeal. Before the baptism of fire becomes a fireball.
