by Dirk Ehnts, Econoblog101
It is only the beginning of 2013 but it seems like the world economy will face another year full of downside risks. One of those risks lies with the euro zone. It seems that politicians have reacted to the subsiding panic in financial markets by falling back into idleness. However, solving the financial problems by offloading all credit risk at the ECB is not a long-term solution and what is even more important: there is still mass unemployment in some EMU members. Believing that the market would cure the remaining problems in the euro zone is mistaken. Not even Mundell (1968) would say that. In his paper on Optimum Currency Areas he writes (my highlighting):
In a currency area comprising different countries with national currencies, the pace of employment in deficit countries is set by the willingness of surplus countries to inflate. But in a currency area comprising many regions and a single currency, the pace of inflation is set by the willingness of central authorities to allow unemployment in deficit regions.
This willingness has been high. It is interesting to note that according to Mundell, unemployment in deficit regions is the result of discretionary central bank action. Of course we are now in the liquidity trap so even if the ECB would be willing to inflate it probably couldn’t. Fiscal policy would be needed to get the economy out of the slump, according to the Mundell-Fleming model. In Spain, expansionary fiscal policy is used now as president Rajoy has increased the duration of unemployment benefits. This is not the first expansionary fiscal policy that the troika seems to allow: in September 2012, the plan PIVE gave car buyers a €1,000 discount under certain conditions.
Is there a policy shift in the making away from austerity?