Factual evidence since the start of the global financial crisis in 2008 shows that the Euro area members face strong challenges to attain simultaneously internal (employment and output) and external (balance of payments) balance. The lack of policy or market mechanisms designed to attain both balances is a weakness in the architecture of the currency area that has been identified since the 1960’s but that are still waiting for a viable solution. The southern Euro-members, given their common internal and external positions, should push for comprehensive and rational mechanisms that can help the achievement of the dual rebalancing.
In this brief talk, my aim is to elaborate an argument for a stabilization fund financed by a flexible mix of VAT and payroll revenues that can perform the role of an adjustment mechanism.
The first part of my presentation presents a narrative of the necessary and sufficient conditions that have been identified for a functioning currency area. This first part highlights some of the conditions identified in the economic literature and how they depend on the hypotheses presented in each specific study. The key message of the first part is that the above hypotheses do not always reflect empirical regularities but that sometimes they reflect beliefs. The idea that the market-based mechanism of internal devaluation, basically a decrease in nominal wages due to an increase in unemployment, would be a sufficiently rapid adjusting mechanism within the Eurozone has been proven wrong, at least in its “rapid” qualification.
The second part of my presentation presents two episodes relating to currency realignment, i.e. the mechanism that existed in the smaller European Union during the European Exchange Rate Mechanism (ERM). These episodes show that imbalances were difficult to resolve even when EU members maintained their own currency. Finally, the third part presents a proposal to explore an adjustment mechanism for the euro area members.
The mechanism is not new as far as it builds on the several existing proposals for a Common European Unemployment Insurance and are also present in the case of the less ambitious European stabilization fund. The novelty of the proposals consists in the financing of the fund with a flexible mix of VAT and payroll taxes. This financing scheme builds on the results that neutral budget tax swaps between VAT and payroll taxes can mimic the effects of currency realignment. The mix should be adapted to the relative position of each euro member in order to allow him to perform a fiscal devaluation or a fiscal revaluation, i.e. a fiscal realignment, while letting the stabilization fund help to achieve the internal balance objective.