David K.H. Begg, Gianluigi Vernasca-Economics-McGraw Hill Higher Education (2011)

29. 7 The economics of the euro
The idea was correct but the sums were wrong. The original US calculations are relevant to a world in
which state incomes are uncorrelated with each other. In practice, the correlation is quite high.
Hence, when one state slumps and gets help from Washington, many other states are slumping and also
getting help. But this increases US government debt and means every state has to pay higher future taxes.
But an individual state could have done that on its own, without membership of the federal 'mutual
insurance' club. It could have borrowed in the slump to boost its own fiscal spending, and paid it back later
when times were better. Making allowance for this, US states are probably insured by nearer to 10 cents in
the dollar than 40 cents.
However, the Stability Pact may have prevented individual EMU countries behaving in this way, by
restricting their ability to borrow in bad times. In fact, over time the Stability Pact was interpreted more
flexibly, having greater regard for the effect of temporary cycles in temporarily reducing tax revenue.
Even before the financial crash, the most powerful eurozone members, Germany and France, were not
penalized for exceeding the 3 per cent ceiling. Once the crash took place, and the world followed the lead
of the UK and US in opting for huge fiscal deficits to stave off even worse reduction in aggregate demand,
budget deficits soared in the eurozone as elsewhere.
By the start of 2010, the eurozone therefore faced a number of fiscal challenges. First, to what extent could
the reputation for fiscal prudence be restored? Second, how could acute differences in the outcomes of
different member states be resolved without having a common fiscal policy? Third, could the possible
bankruptcy of individual member states be prevented? As in all questions of redistribution, the fortunate
have to be willing to pay for the unfortunate. In part, the definition of a workable nation state is a grouping
of citizens across whom the common bond is sufficiently large that the rich agree to be taxed (a bit) to pay
for the poor. During 2010 German voters made it pretty clear they were not excited about paying for
Greece or Portugal. The less fiscal support such countries obtain, the more they may be driven to restore
their monetary autonomy by leaving the eurozone altogether.
Irish deflation
II
Irish unions agree to link pay rises to efficiency, reported John Murray Brown in the Financial
Times (30 March 2010), following a deal between the government and public sector trade
unions. In exchange for the avoidance of compulsory redundancies, unions agreed to flexible work practices
and possible pay cuts as well.
The objective of the policy was two-fold. The direct effect was to tighten fiscal policy by shrinking public
spending. During 2008-10 Irish fiscal policy was tightened by 6 per cent of GDP. Ireland aims to have reduced
its budget deficit from 12 per cent in 2008 back to the Stability Pact target of 3 per cent of GDP by 2014.
The second effect of the policy is to reduce the price level in Ireland. If nominal wages are reduced, and prices
then fall, Ireland's competitiveness will increase even within the eurozone. Domestic wage and price reduction
is a substitute for nominal exchange rate depreciation.
In the December 2009 budget, public sector workers took pay cuts from 5 per cent for people earning below
€30 000 to 10 per cent for those on higher incomes. This was on top of a pension levy in February 2009 that
reduced take-home pay by 5 per cent.
Suppose Irish prices and wages each fall by 10 per cent. How much poorer have Irish people become? The answer
depends on the openness of the Irish economy. If imports were only 10 per cent of the size of GDP, real wages
would be reduced only a little since most goods are produced domestically and their prices have fallen by the
same percentage as nominal wages. Conversely, if imports are 90 per cent of the size of GDP, then the nominal
wage cut is matched by a price cut on only the 10 per cent of goods produced and consumed in Ireland, and
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