The euro area today consists of a competitive, moderately leveraged North and an uncompetitive, over-indebted South. Its main macroeconomic challenge is to carry out the adjustment required to restore the competitiveness of its southern part and eliminate its excessive public and private debt burden. This paper investigates the relationship between fiscal and competitiveness adjustment in a stylised model with two countries in a monetary union, North and South. To restore competitiveness, South implements a more restrictive fiscal policy than North.
We consider two scenarios. In the first, monetary policy aims at keeping inflation constant in the North. The South therefore needs to deflate to regain competitiveness, which worsens the debt dynamics. In the second, monetary policy aims at keeping inflation constant in the monetary union as a whole. This results in more monetary stimulus, inflation in the North is higher, and this in turn helps the debt dynamics in the South.
Our main findings are:
- The differential fiscal stance between North and South is what determines real exchange rate changes. South therefore needs to tighten more. There is no escape from relative austerity.
- If monetary policy aims at keeping inflation stable in the North and the initial debt is above a certain threshold, debt dynamics are perverse: fiscal retrenchment is self-defeating;
- If monetary policy targets average inflation instead, which implies higher inflation in the North, the initial debt threshold above which the debt dynamics become perverse is higher. Accepting more inflation at home is therefore a way for the North to contribute to restoring debt sustainability in the South.
- Structural reforms in the South improve the debt dynamics if the initial debt is not too high. Again, targeting average inflation rather than inflation in the North helps strengthen the favourable effects of structural reforms.
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Marcel 12th August 2012
I'm really getting tired of these Italians who want to keep borrowing even if they can't afford to pay the interest (they shouldn't be borrowing, then) or French who want other countries to bail out its future bankrupt welfare state.
Don't think the French model is bankrupt? Maybe you should look up the meaning of 'contingent liabilities'. France will be knocking on Germany's door for a bailout before the decade is over.
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Val Samonis 3rd August 2012
I have been proposing Neuro and Seuro Zones (with floating or dirty floating between them) for a very long time now; I think this is the only solution under the circumstances of persistently prevailing substantial differences in competitiveness/productivity between the North and the South of Europe!
Well into the future, the two Zones might be ripe for merging.
Tertium non datur.
Val Samonis
Vilnius-Warsaw-Toronto
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Val Samonis 26th October 2012
Even more evidence for choosing my Neuro/Seuro solution and branding other proposals (so far) nonsolutions!
Neurozone would be like Canada, and Seurozone like the USA; we have working models!
Regards,
Val Samonis
Toronto-NYC-Vilnius
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Jean Pisani-Ferry 31st July 2012
Culturalist prejudices die hard. They even make some readers strangely blind. We are NOT advocating a relaxation of the ECB price stability mandate. We are advocating that it sticks to it. Strictly.
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P. Schneider 30th July 2012
I am not surprised that a French and an Italian economist advocate high inflation. Unfortunatedly for them, there is the Maastricht treaty which pledges the ECB to price stability. What a pity...
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