Decoupling and the Euro

There is a considerable debate about whether the Eurozone has broadened and deepened enough to have become less dependent on the US economy (the ‘decoupling’ hypothesis). The recent decline in stock prices in major European economies (with, in places, greater losses than in the United States, where the financial problem originates) rebuts this hypothesis. But there is the possibility that the Eurozone may not slow down as much as is expected this year. And the stubbornness with which the ECB refuses to cut interest rates, which if it turns out to be right, would show that there is something going on, albeit a partial decoupling. Could this be related to the existence of the Euro? Wolfgang Munchau hypothesizes what would have happened without the Euro:

To see how much has changed over the past 10 years, just imagine what would have happened if there had been no euro. The European financial markets would have remained fragmented. Italy would have devalued its lira a long time ago. Spain would probably have announced a devaluation of the peseta right after the recent elections as the depth of its housing crisis became more and more apparent. Portugal and Greece would have devalued three or four times by now. President Nicolas Sarkozy of France might have been tempted to devalue the franc against the D-Mark shortly after his election. Today, the German, Benelux and Austrian economies would have been crippled by a super-hard D-Mark, guilder and shilling, which would have risen not only against the dollar, but also against the franc, the peseta and the lira. The US downturn would have brought havoc to the European economy – as it used to in the past.

Those who hold the view that currency crises are generated by fundamentals would argue that, in the past, Southern European countries had to devalue because of high budget deficits or high unemployment rates that required monetary interventions. But there are those who hold the view that crises can be self-fulfilling and contagious. And the Euro is more than just the sum of its parts:

A size effect. The euro area is a large and increasingly integrated economic union that is less prone to external shocks simply because it is larger. In other words: if the euro area is more than the sum of its parts, it dependency on the rest of the world would be less than the sum of the dependencies of its parts.

Improved monetary policy. The inflation targeting framework of the European Central Bank assures an anti-cyclical policy response if the euro area was hit by a symmetric shock, for example an exchange-rate shock. An appreciation of the euro could easily be compensated by lower interest rates. In the pre-EMU period, most EU currencies were tied to the D-Mark, with German policy often not optimal for the other countries.

Improved fiscal policy. Despite the many criticisms, especially by academic economists, the stability and growth pact has introduced a counter-cyclical fiscal policy in many countries for the first time. If the euro area was hit by a big external shocks, the automatic stabilisers have the effect to soften the blow.

It is however difficult to imagine decoupling on the real side of the economy while there is such high contagion on the financial side (Ehrmann, Fratzscher and Rigobon show that events in the US account for 26% of the variations in European asset prices). One explanation is that the real economies only correlate with a lag, which is why the Eurozone has not slowed down as much yet (which makes me wonder here if a Model of Overshooting à la Dornbusch could – or has been used to – explain the excessive gyrations in the financial markets). Another is that we are in Neverland, an a-typical financial crisis whose ending is yet to be foretold. Here is Jacques de la Rosiere:

This crisis is a-typical. Contrary to the financial shocks of the 80s and 90s, the present turmoil did not come from emerging markets. It took place in the United States, the most prosperous country in the world, and originated in the mortgage subprime market (one of the most risky) and it spread out worldwide leading investors to loose confidence and to rush towards safetier instruments. This process has practically dried out liquidity on a number of credit markets considered, most often wrongly, as dangerous.