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Is the EMU sustainable in its current form?

Interview mit Hans-Werner Sinn, Goldman Sachs - Economics, Commodities and Strategy Research, 16.05.2013, Nr. 12, S. 8

Hans-Werner Sinn is President of the Ifo Institute and Professor of Economics and Public Finance at the University of Munich. He has published on numerous topics pertaining to the German economy and the Euro area crisis, among other topics. Below he shares his vision for a more flexible Euro area that allows struggling Euro area countries to temporarily exit and devalue.

Allison Nathan: Is the EMU sustainable in its current form?

Hans Werner Sinn: I don’t think so. Some countries are way out of line in terms of their competitiveness. In the early years of the euro, the euro project itself emboldened investors to flock to Southern Europe for only slightly higher interest rates. In Greece and Portugal, the government borrowed to pay higher wages; in Ireland and Spain, it was the private sector which borrowed to buy real estate, fueling a construction boom and a real estate bubble. In the end, these economies were inflated through the cheap credit from abroad. The credit-financed wage increases went far beyond productivity increases and deprived these countries of their competitiveness. That seemed possible as long as private credit continued to finance the spending. But when the American crisis swept over to Europe in 2007/08, all of a sudden this turned out to be a problem, because investors began shying away from the Southern countries. Private credit had to be replaced initially by the printing press and ultimately by the open rescue operations of the Euro area governments. The Euro area taxpayers have ended up footing the bill for both kinds of funding.

For these countries to return to health within the EMU, they must reduce their prices to the competitive level. But that path is rather steep. It is estimated that some countries would require a real devaluation of 20% relative to the Euro area average. For others, it is more in the range of 30%. That would be very difficult to achieve, because prices tend to be sticky downwards for various reasons: the unions would likely object, and because of high debt levels, a cut in prices and wages would likely drive many households as well as firms into bankruptcy.

Allison Nathan: What would make the EMU sustainable?

Hans Werner Sinn: The solution is either inflating the core of the Euro area to make the periphery competitive or, if the core does not want that or if the ECB does not succeed in doing so or is legally constrained to do so, then it would be better for countries whose path towards competitiveness is too long to exit the EMU, devalue and possibly return to the Euro area after some years at the new exchange rate. Wishful thinkers see Keynesian deficit spending as a solution, but that would just be a painkiller that slows down or prevents the realignment of relative prices, while it exacerbates the debt problem. Given the catastrophic development of unemployment rates in the Euro area, I suggest a two-tier Europe in which countries with competitiveness problems have the option to temporarily exit and devalue. Such a system provides more flexibility at the edges and would allow countries to realign their effective price levels in an orderly way, rather than through catastrophic unemployment. I insist that these exits should be orderly, with the other Euro area countries helping the exiting countries with critical imports and with stabilizing the banking sector. And the ECB should help carry out a pegged floating strategy that avoids extreme exchange rate volatility. Once the exiting country has regained its competitiveness and undertaken the necessary reforms, it would have the option to return to the first tier and re-adopt the euro. The current situation for some populations is desperate inside the euro. I think we have no choice but to look for alternative solutions such as this one.

Allison Nathan: What kind of disruption would such exits present to the Euro area as a whole?

Hans Werner Sinn: Of course, before an announced or expected exit, turbulences of the Cyprus type would occur, accompanied by capital flight out of the exiting country. So, if you can’t manage to pull off the exit and adoption of the new local currency over a weekend, capital controls as in Cyprus would be required. To facilitate the process and further reduce capital flight I would give the existing euro bank notes in the country to the people who hold them. Thus, new domestic bank notes can be printed later and gradually replace the euros. Once the exit has taken place you can immediately lift the capital controls. I don’t want to say that there would be no problems. There would be problems. But I find them minor relative to the other problems that arise if we continue along the current path, which will lead to a clash between taxpayer rescue fatigue and the southern populations' austerity fatigue.

Allison Nathan: Which countries do you think should exit?

Hans Werner Sinn: That is up to the countries themselves, but Greece clearly has a huge competitiveness problem and, with youth unemployment at 70% and total unemployment at nearly 30%, it will obviously have difficulties surviving in the Euro area. You can of course provide the country with further public credit; it has already received the equivalent of 160% of its GDP and is about to receive another 30%. But that does not create jobs. It just ensures that people will not have to starve despite the high rate of unemployment. Cyprus is also vulnerable. And Spain and Portugal are potentially also at risk.

Allison Nathan: Is exit the only solution? Would structural reforms enable a workable EMU in its current makeup?

Hans Werner Sinn: All reforms in the respective countries, be it labor market reforms, infrastructure improvements, productivity increases, etc., have to lead in the end to real devaluation if they want to be successful. Something like an open devaluation has to be mimicked inside the Euro area through a process of differential inflation or even deflation, and this requires austerity. But austerity has its limits because, as I already mentioned, prices are sticky downwards. You can squeeze countries a lot and the prices will not actually come down. After almost six years of crisis, the process of realignment of goods prices has not yet taken place, with one exception: Ireland. Ireland has cut its prices relative to the rest of the Euro area by 15% from 2006 until now. Why? Because they underwent a very, very harsh austerity program given that no one was willing to help them in the first two years of their crisis. All of the other troubled countries came into their crises simultaneously after Lehman; Ireland came into the crisis two years before. After Lehman, the crisis countries were able to find a market majority in the ECB council that would allow them to alleviate their pain by printing the money they could not borrow; before Lehman there was no one alleviating the pain. So Ireland had to help itself and it worked its way out of its biggest problems. So that tells us that austerity is a possibility, within limits, but it is very painful, and for some countries too painful, in my view. If a country has strong unions that are well organized, unlike in Ireland, the resistance to wage cuts is much stronger. Also, the path towards equilibrium will be much longer for some countries than it was for Ireland. Ireland had a much lower current account deficit before the crisis than, say, Portugal and Greece. So even with Irish-type austerity programs they would not be competitive.

Allison Nathan: There are rising concerns economies in the EMU, such as France. Can France make the necessary adjustments to be successful within the Euro area? Hans Werner Sinn: It is estimated that France needs a real devaluation of 20% relative to the average of the Euro area. That is quite a bit, but it is manageable. It is on the order of magnitude of the devaluation Germany carried out from the time the euro was announced in 1995 at the Madrid Summit until Lehman. A decade ago Germany was the sick man of Europe, struggling under its own euro crisis, which outside Germany was hardly noticed. The pressure on policymakers became sufficient to push through wage restraint that was large enough to ultimately restore the economy to health. It was not popular with the German Left at all, but only a left-wing politician – Chancellor Schroeder – could do it. Still, he lost his job over his reforms. Today he is hailed as a hero. Everyone now acknowledges that these reforms were right. So I think the French situation is not hopeless. France can regain competitiveness with German-type reforms, but not with the kind of policies that the French Left has just declared in a pamphlet, through growth measures by which they just mean Keynesian deficit spending. Those measures would be counterproductive. They are painkillers that help for the moment but prevent the structural adjustments in relative prices from being undertaken.

Allison Nathan: What will force France to embrace reforms, especially given that markets have been very forgiving?

Hans Werner Sinn: More economic pain.

Allison Nathan: Has the OMT program done more harm than good?

Hans Werner Sinn: It has helped the investors. It has calmed the financial markets. But it should have alarmed the taxpayers of Europe. Basically the ECB has said to investors: “Don’t be afraid. Before a country goes bust I will buy the government bonds out of your portfolios and put the losses on my books at the expense of Europe’s taxpayers, since they will have to compensate for the decline in our distribution of profits to their respective treasuries.” This is a redistributive measure of dubious value. In my opinion, calming financial markets cannot be the ultimate goal of public policy because, after all, capitalism lives from the uncertainty that makes investors cautious. The sleepless nights investors spend in optimizing their portfolios by avoiding risks and investing prudently is the driving force of capitalism, and if you help investors sleep well by giving them taxpayer guarantees, they will be pleased, but it will not necessarily improve the allocation of resources. This is just a deferment of the problems and not a real solution. Calming the markets is not the same as stabilizing the real economies. Market-calming actions actually conflict with real stabilization. First, if you calm the markets you keep the asset prices above their equilibrium. The result is that private investors will not come to, and even shy away from, the country in question because they will be afraid that market prices might return to equilibrium, in which case they will lose money. Second, by alleviating the pain of austerity, you keep wages and prices above their market clearing level and preserve the structural current account deficits affecting these countries. And third, calming the markets leads to a revaluation of the euro, which undermines the competitiveness of the crisis countries even further.

Allison Nathan: Could a Eurobond that would mutualize debt across the Euro area be part of a solution?

Hans Werner Sinn: No. I remind you of the early years of the United States of America, when Alexander Hamilton mutualized the American states’ debt, believing this would cement the union. But in fact a few decades later this mutualization turned into a catastrophe, because the states – expecting the debt to be again mutualized – borrowed excessively; a credit bubble developed that burst in 1837, driving most of the American states into bankruptcy. What Hamilton called cement was in fact an explosive. And the establishment of debt-sharing through Eurobonds would require another treaty. Eurobonds are strictly ruled out by Article 125 of the Maastricht Treaty, which states that the Euro area is not a mutual insurance operation between countries but just an area with a common unit of account for international transactions, where if a country over-borrows it has to go bust and the solution has to be found in bail-ins at the expense of the country’s lenders.

Allison Nathan: How difficult would it be to change the treaty?

Hans Werner Sinn: It would require a complicated ratification process by the parliaments of all member countries, and such ratification would need to be unanimous. Previous treaty changes suggest that this could take several years, and I believe that the likelihood of passage by all countries of the Euro area is very low. Some countries such as Germany will also require a national referendum. Given the current political climate in Germany, I see no possibility for a majority. The new (euroskeptic) political ‘Alternative for Germany’ would prosper.

Allison Nathan: What should Germany be doing right now in terms of trying to promote a workable EMU?

Hans Werner Sinn: Definitely not continuing along the old path, which has already brought an enormous assumption of liability for Germany. Germany has been accused of favoring austerity, but the opposite is true. Austerity is being imposed by the markets. The countries in difficulty can’t borrow at market rates and need public intervention through the ECB or the ESM in order to bring down their interest rates. Ultimately, the still-solvent European countries are footing the bill, the largest contributor being Germany. We are talking about an overall public credit volume in the Euro area, including the extra ECB refinancing credit measured by the Target 2 balances, of €1.2 trillion, of which Germany shoulders the largest chunk. Should the euro collapse, Germany would stand to lose about €550 billion. No country has mitigated austerity as much as Germany has, and still it gets all the blame for austerity.

Allison Nathan: Should Germany exit the euro?

Hans Werner Sinn: Why should it? The euro as such is a worthy European integration project, and has much merit. If Germany exits, the euro is dead, because the whole purpose of the euro was to take away the Bundesbank’s interest-rate setting power. And if Germany exits, there would again be a dividing line between France and Germany, and the political reason for having the euro would be destroyed. So I am very strictly against such a solution.

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