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The Tufts Daily
Where you read it first | Thursday, March 28, 2024

Nobel prize winner discusses economic policy in Eurozone

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–Sir Christopher Pissarides spoke on the the monetary and fiscal policies being used within the Eurozone as well as the status of the labor market today and during past crises.

Sir Christoper Pissarides, the winner of the 2010 Nobel Memorial Prize in Economics, gave a presentation yesterday afternoon on the current state of affairs in the Eurozone for the Department of Economics' 2014 Wellington Burnham Lecture. 

Pissarides' lecture began with an overview of the development of monetary and fiscal policies in the Eurozone and the deployment of the euro, given his interest in labor markets. He added that, in retrospect, some mistakes were made in the euro's introduction.

"I think we got some things terribly wrong in Europe," he said.

Policymakers in the European Union (EU) were unaware of the serious problems with the union of the currency at the time, according to Pissarides. He said that they will now have to "take some decisions which no one seems to be willing to take."

In looking toward the future, Pissarides said policymakers will have to reevaluate the types of policies that are really needed and examine what has happened within the Eurozone.

"Observing what's going on in Europe now has sort of provided evidence, which still hasn't been tested formally," he acknowledged.

In providing an overview of the Eurozone crisis, Pissarides began with the start of the currency union in the late 1990s, noting that "there was huge optimism here." Before the launch of the euro, the EU had pursued smaller steps of integration, with the biggest change coming in the 1980s with the declaration of the single market.

"The great European visionaries … saw the next step as the introduction of a single currency," he noted.

While many were excited about the prospect of integration and its benefits, the financial crisis in 2008 revealed a number of problems in the Eurozone economy.

"As it turned out, though, there is … disappointment now about that process,” Pissarides said.

The crisis impacted the whole union, but impacted some member countries more than others through high unemployment rates and loss of income, he added. Subsequently, the common belief has been that these problems were results of countries'  labor markets, but Pissarides explained that in his opinion, the fault lies with the macroeconomic policies pursued by the EU.

Given that the crisis began as a debt crisis, fiscal policies have targeted debt, rather than paying attention to what is happening in the labor market, such as unemployment, wage growth or taxation, he said. He explained that this pursuit of fiscal policy to reduce debt has provoked a crisis that is essentially a crisis of managing a common currency when the core criteria for a currency union are not satisfied.

Pissarides underscored the inflexibility of labor markets in Europe and the need for reforms, citing labor market reforms in the Unted Kingdom in the 1980s as an example.

"I do believe that reforms in European labor markets are essential," he explained, adding that such reforms will be vital for competition and adaptability.

"Although we do need reforms in the labor market, they’re not going to take us out of the current recession," Pissarides said.

Pissarides discussed the criteria for which the adoption of a common currency in an "optimal currency area" (OCA) will increase welfare and be economically beneficial, citing examples including the experiences of the United States and Germany after reunification.

"Countries that join the area should have similar economic structures and similar business cycles," he listed as the first criteria. He said this will enable countries can have a common monetary policy to suit everyone.

Pissarides added that there must also be both free labor and capital mobility so that imbalances in areas such as unemployment may be corrected. A third important reform, he said, was that the union should allow the possibility of fiscal transfers between countries, a controversial idea which rests upon solid ideas of partnership.

Examining whether the Eurozone satisfies these criteria, Pissarides noted that imbalances in labor mobility have not been corrected as Europeans have been unwilling to move  due to strong connections to their home countries. He added that the European Commission has objected to too much mobility and many countries with labor issues have experienced a drain of their most educated citizens.

"When there is labor mobility, the people who moved are the qualified professionals, they are not the workers who are unemployed," he said.

In regard to capital mobility, Pissarides explained that many people previously believed that capital would move to poorer countries because the return on investment is higher. In reality, the rates of return in countries such as Germany are higher than those in countries such as Greece, because there is more industry to back up new investments, productivity is higher and there is more demand. Institutions like the European Investment Bank have been unable to pick up the slack, Pissarides added.

"The money they have to spend is not nearly enough to correct imbalances," he said.

Finally, Pissarides explained that the EU has explicitly prohibited fiscal transfers. He noted that in currency unions such as the United States or Germany, fiscal transfers were allowed and ultimately necessary for economic growth. In the Eurozone, there hasn't been as strong of a connection between member states.

"No one feels European before they feel their own nationality," he noted.

Moving back to the first criteria of the OCA, Pissarides questioned the degree of similarity between Eurozone economies.

"When we first started forming this union in [the] 1990s, countries still looked like they were similar," he said, noting that they were all post-industrial service economies with around 20 percent industrial employment and interstate trade.

The most recent crisis has exposed a number of unanticipated differences between member states, especially in the large construction sectors of countries such as Greece, Cyprus, Portugal, Ireland and Spain, which saw large growth with their adoption of the euro, giving them unprecedented access to credit markets, according to Pissarides. This construction bubble burst, however, and these countries bore the brunt of the economic crisis, he said.

"The implication was that some of the countries got a much bigger shock than the other countries," he noted.

Unemployment therefore rose significantly in countries like Greece and Spain -- over 15 percent from 2007 to 2012 -- and the countries also experienced decreases in gross domestic product and real incomes, according to Pissarides. Instead of lower nominal wages causing increased employment, there was a decrease in aggregate demand, he said.

"What we’re seeing in fact is a recession shock that reduces aggregate demand and raises unemployment, and that’s followed by wage reductions that bring forth that fall in demand and raise unemployment further," he said.

Pissarides underscored that with a recession, the proper policy is not to fight it with deflation and negative shocks, particularly when a country is facing large debts.

"If you’re going to try to fight recession by increasing the debt burden and reducing aggregate demand, you’re not going to do it -- you’re going to get into a vicious circle," he said.

Although EU institutions have continued to focus on labor market reform, examining Ireland and Spain -- two countries with very different degrees of labor market flexibility-- one can see they nonetheless had very similar responses, and thus the fault cannot lie fully with the labor market, Pissarides said.

As a lesson, Pissarides explained that the optimal response is to look for expansionary policies, such as in monetary policy, to offset deflationary shocks.

Given the current restraints, Pissarides proposed debt forgiveness as the best solution to wiping out some of the debt, enabling debtor countries to start anew while taking control of their banking system to make sure the same issue does not arise again.