The Eurozone crisis in perspective

The crisis facing the Eurozone today is in someways inevitable given the impossibility of managing a monetary union without some form of fiscal union and a fully committed central bank.

To put the folly in its true perspective, let's compare the different Indian states to Eurozone members. Imagine 28 independent countries federate into a single country with a single monetary policy. All the countries embrace a single currency, rupee, and all monetary aggregates, including the interest rates, are harmonized across all states. Trade barriers have been brought down and there is unrestricted cross-border trade across states.

However, both the central bank, the Reserve Bank of India (RBI) and the central government at New Delhi will not make monetary and fiscal transfers to help any state if it runs into economic problems. All taxes are levied by the states and they refuse to allocate a share of their tax revenues to the central government. Driven by moral hazard concerns, the RBI is traditionally averse to monetary accommodation and banking bailouts.

In this context, consider this scenario. Maharashtra and Tamil Nadu are booming. In contrast, Uttar Pradesh and Rajasthan are experiencing a deep recession. The later two have a serious competitiveness problem, since their wages have been driven up by a positive economic shock. In this period, both state governments have indulged in populist fiscal profligacy and run up massive debts, including from neighbouring states and their banks. Both now stand at the verge of sovereign defaults.

Further, when the the states form the monetary union, the initial conditions of the different states vary widely. The economies of Uttar Pradesh and Rajasthan are uncompetitive in relation with Tamil Nadu and Maharashtra. The former have much lower labor productivity, though wages and prices remain more or less the same. There are also critical structural imbalances in these two states and they also suffer from high fiscal deficits.

There is more. Even as Rajasthan and UP struggle, the increasingly competitive states of Maharashtra and Tamil Nadu prosper, partly by increasing their exports to Rajasthan and UP, and in the process, atleast partially, displacing local production and driving out local jobs. Clearly, Maharashtra and Tamil Nadu are, atleast partially, prospering at the expense of Rajasthan and UP. So what is the way out for these two struggling states?

If Uttar Pradesh and Rajasthan were independent countries with their own currencies and interest rates, they would have responded to such a supply shock by either devaluing their currencies or lowering interest rates or both. They may even have welcomed a bout of moderate inflation to reduce the real debt burden and narrow the gap in labor costs. The objective in all these cases would have been to lower real wages and costs and thereby increase competitiveness and investments. Now that these states are part of a monetary union, they do not have access to these traditional options.

In the real world, India is a monetary and fiscal union. Faced with such a situation, the central government will invariably step in with fiscal transfers (packages, as they call it politically!) and restructure their loan books with help of the RBI. The central government will be committed to ensuring that even a solvency crisis will be averted. Sure, tough conditions will be imposed and the state will be forced to implement reforms that will help improve its competitiveness.

The only strategy to restore economic strength in these two states without compromising on the monetary union is for the central government to step in and provide fiscal transfers to these states and the RBI to open liquidity windows and ensure that the credit tap is kept open. Simulataneously, the two states will have to undertake structural reforms to increase their medium and longer term competitiveness. It has to be hoped that these measures will buy adequate time to restore the health of both the state economies.

Replace Rajasthan and UP with Greece and Italy, Maharashtra and Tamil Nadu with Germany and France. The problems facing Eurozone economies today are not much different. In this context, in an FT op-ed, the former British Prime Minister, John Major had this observation of Eurozone economies locked in Germany's embrace,

The powerful German economy is still locked within the same currency as weaker economies. She racks up huge trade surpluses within the eurozone while others have comparable deficits. Since Germany has an estimated 30 per cent currency advantage within the euro, this seems likely to continue. It is undesirable and unsettling.

In a sensible world, the southern states would devalue to become competitive – but they cannot. They are locked in a single currency. And because they cannot devalue their currency, they must devalue their living standards and promote reforms to enhance efficiency. This will take years. Meanwhile, wages must fall, unemployment will rise and social unrest will increase. The severity of this medicine may not be bearable in a liberal democracy.

His solution is similar to what India is today,

It must become a fiscal union; a union of transfer payments to off-set regional disparities; or it must shrink. The latter option – essentially expelling Greece – has political consequences. There is no mechanism to do it. What would Greece’s future be? Would she remain democratic in the chaos that might follow? Pushing Greece out is not a risk-free option.

Nor is a transfer union. Germany would hate it and transfer payments would institutionalise inefficiencies. That leaves fiscal union as the most likely destination. But it has huge political consequences. It implies a far greater level of integration, and is an escalator to a federal eurozone. This may be sensible economically, but it is profoundly undemocratic. It would drive voters and decision-makers dangerously far apart. More top-down Europe imposed by a remote elite could provoke a powerful antipathy.