Business Standard

Alok Sheel: Euro zone's impossible trinity

The European Union had a basic flaw: monetary integration without fiscal union

Related News

The economic and monetary union of the had a basic flaw: monetary integration without fiscal union. This flaw was derived from the “impossible trinity” embedded in the Mundell-Fleming equation. According to this equation, a country can have only two of the following: an open capital account, a stable and monetary independence.

While several developing countries, including India, have at times tried – with little success – to get around this impossible trinity, countries have mostly adopted different solutions to this equation. Thus, the United States has an open capital account, but a floating exchange rate (India’s solution largely resembles this model with a big BUT). has adopted a stable exchange rate, independent monetary policy but a closed capital account. The solution to the equation was to have a fixed exchange rate, an open capital account, while it sacrificed monetary independence.

Given the solution adopted by euro zone countries, fiscal balances needed to be kept in check because there was no lender of the last resort. This was done by setting a budget deficit limit of three per cent of the for each country, and public debt limit of 60 per cent of the GDP. This was critical. Though countries are expected to keep fiscal deficits and public debt within prudent limits for sustainable growth, they can never be held hostage by the market because the can always step in to buy government debt by printing money. It is for this reason that credit rating agencies assign the highest ratings to sovereigns for debt repayable in their own currencies, while they rely primarily on macro-economic fundamentals in rating external debt.

Since euro zone countries, including Germany, did not have this central bank backstop, it is intriguing that credit rating agencies assigned risk-free status to the sovereign debt of these countries, instead of basing them on macro-economic fundamentals. Economists and the International Monetary Fund (IMF) also seem to have missed this fine distinction between domestic debt and external debt: the domestic debt of euro zone countries had some features of external debt, as a result of which they could be held hostage by markets, as appears to be happening at present. Had such a distinction been made, the ratings assigned to the weaker euro zone countries would have been so calibrated as to make it difficult for them to run up such high levels of euro-denominated public debt.

What also seems to have been missed was the “impossibility” of the holy trinity attempted by the European Maastricht Treaty: a currency union with “no bailout, no exit and no default” in the event of the public debt of a euro zone country becoming unsustainable through a market revolt.

It is perhaps because this second, but related, impossible trinity was not highlighted by economists, the and even rating agencies that markets were lulled into pricing the sovereign domestic debt of all euro zone countries on an equal footing as risk-free, despite vastly differing macro-economic fundamentals. In hindsight it is now clear that:

(a) If there was to be no bailout and no exit, a country might have to default on its debt since it could not inflate its way out through the printing press.

(b) If there was to be no bail out and no default, a country might need to exit to regain monetary independence to enable it to honour its debt obligations through a depreciated new currency that its central bank could print at will; and finally,

(c) If there was to be no exit and no default, a country would need to be bailed out, through either budgetary support from other countries (such as through the European Financial Stability Facility) or the common central bank (the European Central Bank or ECB) acting as lender of the last resort.

The impossible trinity attempted by the Maastricht treaty now threatens to bring down not only the euro zone but also the global financial system, unless one of the three nays is abandoned. This alone would rectify the fatal flaw in the Maastricht Treaty, short of full fiscal and monetary – which effectively means political – integration for which European civil society is not quite prepared yet. And Germany would not allow the to become a printing press without such integration — for good reasons.

The writer is a civil servant Views are personal

Read more on:   
|
|
|
|
|
|
|
|
|
|
|

Read More

Abheek Barua: Post-policy blues

In spite of the RBI's rate cut and the Centre's reforms, any recovery will only be half-hearted

Most Popular Columns

A K Bhattacharya

A K Bhattacharya: Why CEOs are less jubilant about Modi
A K Bhattacharya

Industry leaders were not as gushing with praise for the government of Mr Modi as would have been expected

Andy Mukherjee

Andy Mukherjee: Go easy, RBI
Andy Mukherjee

Cutting interest rates now would have few risks, and several benefits

Avirup Bose

Avirup Bose: A case of 'consumer unfriendly' brands
Avirup Bose

Consumer goods companies that boycott discounted sales of their products by e-tailers could be liable for scrutiny by the competition regulator for restricting free trade and customer choice

Advertisement

Columnists

Akash Prakash

Akash Prakash: Debunking two worries
Akash Prakash

Are India stocks over-owned? And are they too expensive?

R Gopalakrishnan

R Gopalakrishnan: Coping with technophobia
R Gopalakrishnan

Innovators must recognise that there will be opposition to their innovation, but they must listen carefully to the concerns of those who oppose ...

Nick Wingfield

Nick Wingfield: Now, anyone can buy a drone. Heaven help us
Nick Wingfield

With the price of drones falling, the machines have emerged as central characters in stunts from the puckish to the criminal

Back to Top