Tuesday, January 17, 2012

Is the Euro Good for Europe?

If this essay were for an economics exam, I would fail. I say this so no one thinks I forgot my economics – accuse me of heresy but not of ignorance. Economic theory and practice says that the Eurozone is a big mistake. I disagree. Here’s why.

The Economics of the Euro

The economics case against the Eurozone rests on a theory called optimum currency area (OCA) which says that countries should share a common currency only if: (a) they have labor and capital mobility; (b) they have synchronous business cycles; and (c) they can move money from one region to another, preferably through a fiscal union. The Eurozone is not an OCA since it fails most of these conditions.

In an optimum currency area, a country gives up the right to have its own currency and to conduct its own monetary policy. As a result, countries can be trapped in the wrong monetary policy and the wrong exchange rate. In the mid 2000s, the European Central Bank’s monetary policy was fitting for Germany but not for Spain. Thus money was too cheap in Spain and that helped fuel a housing bubble. Similarly, a dear euro made goods and services from the periphery less competitive in the global market, fueling current account deficits. Instead, a country with control over monetary policy can avoid such pitfalls – it can change interest rates and it can devaluate its currency.

This makes sense, but not fully. The syllogism assumes (a) that we know what the optimum monetary policy is and (b) that having control over monetary policy is better than not. On the first assumption, one need only think about the United States and its love affair with Alan Greenspan’s magic wand. In retrospect, it is clearer that his loose monetary policy helped fuel a housing bubble than helped trigger our current crisis (not by itself, of course). The chief instrument by which monetary policy operates – interest rates – is just one lever to manage an economy that is too complex for one lever alone. Monetary policy can be powerful indeed – but it can also be powerless and it can also be wrong headed.

On the second assumption – control over monetary policy is better than not – the economics profession is itself divided. Monetarists will say that managing an economy through interest rates is silly. More mainstream, there is a growing consensus that good monetary policy is aided by “independence” which is effectively saying that good monetary policy requires some control but not too much. Implicit in that assumption is that monetary policy can be managed well if managed apolitically. In truth few states can claim some perfect balance – and as the case of the United States shows – even when the economy seems in balance, it may not be. In fact, in many countries, monetary policy is often a disaster, producing nothing more than chronic inflation. That central bankers can guide an economy the way a conductor guides an orchestra is an idea that our crisis should have deflated. Some humility please.

Implicit in OCA is the idea that monetary policy and exchange rates are “good” adjustment mechanisms. Economies are bound to veer off course and the invisible hand brings them back in harmony. That is why economists like flexible exchange rates: they are self-corrective. But a flexible exchange rate is just one way for a country to adjust from disequilibrium. Think of Greece’s tourism industry, for example. Tourism in Greece is plagued by myriad structural problems that have led to a massive decline in net receipts. Now assume that Greece drops the euro and returns to a (devalued) drachma. The price of a trip to Greece will fall and more tourists will come. Success, right? Well, it depends. Are our hotels cleaner? Will our ferries be on time? Will our waiters be more professional? Will ships be able to actually dock on islands? Probably not. A devalued currency may price the service more accurately, but it does not upgrade the service. What you need instead is structural reform. And if you need structural reform, why do you need a new currency? You don’t.

Therefore, we have to think about the euro versus its alternatives: monetary policy may not be tailored to each economy’s specific circumstances but it can offer more stability than monetary policy conducted at the national level, especially for countries that cannot achieve monetary stability by themselves. As for exchange rates, a country does lose a self-corrective mechanism, but the “correction” is a superficial correction. The correction works if you assume that the underlying economy functions well and that there are no microeconomic distortions. So often this is not the case.

OK, the economist will respond, but didn’t the “straightjacket” of the Eurozone help trigger our current crisis? Yes and no. The crisis was due to a miscalculation of risk: markets lent money to Greece and to Germany for the same price because they assumed they were the same. Were they right to do so? Yes and no. Technically, national debts are national debts. But in truth some of these debts turned out to be European debts. Richer Eurozone members have stepped in to help. At this heart, this was a market failure with markets not pricing sovereign risk correctly. It was aided by the existence of the Eurozone in two ways: bond yield convergence led people to think that Eurozone debt was the same; and the absence of exchange rate risk led markets to be less diligent when lending money (usually emerging markets face both exchange rate risk as well as solvency risk – in Europe, one of the two risks was absent which meant lower premiums).

Therefore, this crisis was only incidentally caused by the Eurozone. In a properly functioning market, Greece and others would have found it progressively more expensive to raise debt and would have been forced into corrective action earlier. That they were able to postpone this reckoning for so long is the true failure here. It is also a failure that the market is unlikely to repeat – not because markets are “wise” but because the underlying assumption (all Eurozone debt is the same) has been shattered beyond repair.

Now replay the years since 2000 without the Eurozone. First, profligate countries would have faced debt trouble sooner and might have been forced to change course. Second, countries such as Spain could have resorted to tighter monetary policy to burst a housing bubble – but it also possible that Spain would have failed in that task the way the United States did. And third, countries such as Greece and Spain would have seen the value of their currencies decline, more likely accompanied with higher inflation but not necessarily structural reform. In this scenario, the only definite positive is that fiscal correction could have come sooner. But the freedom to print money and adjust exchange rates – it questionable how much these would have helped versus the current path which puts greater onus on microeconomic reforms.

In truth, there is nothing sacred about the euro, or, for that matter, any currency. Currencies are what you make of them: you can have good monetary policy and you can have bad monetary policy regardless of who is conducting it. That is why policymakers, including the IMF, now judge fixed exchange rates on a case by case basis. Does Greece need the euro to have monetary stability? Of course not just as Switzerland doesn’t need the euro. But in practice, the only time when Greece had monetary stability has been when it was either in the Eurozone or trying to get into it. The only result of independent monetary policy was more inflation and a progressively devalued drachma. So much for independence.

For a big country such as Germany, the euro is not necessary to achieve stability, which is why Britain can live without the euro with no problem. For bigger countries it’s often a wash, while for smaller countries it often provides the monetary stability that they have been unable to achieve on their own. But this is, after all, a political project so one needs to weigh the occasional economic problems (which, as I have argued, are exaggerated) versus the political benefits. What are the political benefits?

The Politics of the Euro

To answer that, we need to ask a bigger question: what is the point of the European Union? Simply put, the EU has three interlinked and mutually reinforcing goals: peace, prosperity and power. To achieve these goals, it develops institutions and interaction among its member states. So what does a common currency do for these goals? Here, we need to distinguish between two questions: was it a good idea to set up the euro? What happens to Europe if the common currency fails?

Let’s start with the second question because it is easier. If the euro fails, the European project will have suffered a massive setback. Two decades of European integration will be almost undone, and the acrimony that will accompany this failure will take very long to contain and heal. Finger-pointing – “who destroyed the euro?” – will dominate European politics for years if not decades. Distrust towards Germany, France, and the European bureaucracy more broadly will delay if not invalidate other parts of the European agenda. European politics will require a serious leadership effort to recover, and even then, a backlash against the migration of sovereignty to Brussels might undo a number of initiatives.

What about setting up the euro? Did the euro help Europe achieve peace, prosperity or power? Europe aims at peace both directly (by aligning defense policies through bodies such as NATO) and indirectly (by creating institutional structures that offer alternative dispute resolution approaches than war). If peace were the only goal, Europe could have stopped integrating a long time ago. Integration and conflict can come in tandem: integration gone bad, or integration without proper political cohesion and consensus, can produce discord and conflict. One is often reminded that the path to integration in the United States came with a very bloody civil war. Many (failed) states have found that integration can create tension and generate centrifugal forces that tear a polity apart. The euro will help peace if it succeeds and undermine peace if it fails. Not much else we can say about that.

What about prosperity? It is impossible to test the counter-factual: how will economies have performed in the 2000s without the Eurozone? But I have sketched some thoughts above. The peripheral economies would have gotten into a fiscal crisis sooner, and because they would have done so at lower debt levels, they would likely have faced milder crises.

Otherwise, many peripheral countries could have ended up where they were before the Eurozone: a land of devaluation and inflation. Naturally, a country here and there could have changed like Ireland did. But is it not clear that such an outcome would be more likely in the Eurozone than outside of it. Insofar as life outside the Eurozone would have been crisis prone, perhaps reform could have come earlier. But small crises don't produce reforms – long and long-lived ones do.

In all likelihood, smaller countries benefited from the monetary stability of the Eurozone and that aided their prosperity, even though it allowed them to live beyond their means for longer than would have been possible had there been no Eurozone. The euro served as the economic equivalent of the acquis communautaire – an anchor for smaller and institutionally weaker states to cling on. For the bigger economies, it is not clear that the Eurozone allowed Germany to accomplish something that it could not have done so by itself with the Deutsche Mark. It is hard to see how Germany is more or less prosperous as a result.

What about power? Here we, again, have to separate two ideas. First is whether the European Union as a whole is more powerful; and second, whether individual states are more powerful. The emergence, if only briefly, of the euro as global reserve currency offered Europe as a whole some of the "exorbitant privilege" conferred to the United States by the dollar. But it is really hard to isolate "currency" as a source of power. Assume two identical European economies - one has a single currency, the other has 17. Which one is stronger? Perhaps it is the one with a single currency, but only because it seems to have a greater ability to unify and leverage its power. Either way, this is almost impossible to judge. When it comes to intra-EU power, the biggest change has been to place the management of money as a pre-eminent goal of the European Union and, as a result, enhance Germany's role due to its reputation for sound macroeconomics. Did Germany need the Eurozone to become Europe's pre-eminent state? Probably not. But it did help solidify its position.

The most obvious political consequence of the euro is that it furthered European integration. There is a sense in Europe (a) that integration has to move forward or else and (b) that more integration and more unity are inherently good. I happen to disagree with both of these propositions. The imperative for “more integration or else” is a self-inflicted one: institutions should be judged by how well they perform the functions they are meant to perform, not whether they have ever expanding writs. And unity is an over-appreciated virtue. Discord and tension can be revitalizing, provided they remain in check – a little competition never hurt anyone.

Europe has no greater symbol than the euro. It is the symbol of a peaceful, prosperous and powerful Europe - although more recently it has come to symbolize the continent's woes. A European may not feel as cool as an American can knowing that the dollar will be welcomed in any corner of this earth. But Europeans can glance inside a wallet and find a daily reminder that they inhabit a common economic space with 300 million people and that they are part of a grand political and economic experiment. And that's a remarkable feeling for anyone who can imagine what Europe looked like 70 years ago.


  1. ""Europe has no greater symbol than the euro""
    And you say that after your country has been led into desperate straits by its adoption of the Euro. What a ghastly lickspittle you are.

  2. Excellent! Also touching ;) .. no seriously, fully agree.

  3. @John, I don't think that Greece's crisis was caused by the Eurozone so I don't see any tension between stating that the euro is Europe's greatest symbol and, at the same time, feeling bad about how this crisis is affecting ordinary Greeks.

  4. once again, congrats: your article rightly disputes a lot of disparencies going around right now on what could have happened if the euro never was. Excellent work! Although I confess that I cannot agree on your point on unity: yes a little competition never hurt anyone, if these anyones were prone to finding a solution; in the case of the EU, the more competition we have the more time it takes for a decision to be made. And the EU's slowness in reacting has been -rightly- greatly critiqued concerning the handling of the current crisis, and of every eurocrisis before. Prove me wrong, but I believe that a more integrated Europe would no doubt be more effective administratively; provided that this integration did not equal an another book of regulations but instead an actual rapprochement of national regulations.

    And John, for God's sake, Greeks are the first to admit that the country was heading the wrong direction regardless of the euro. As Nikos said, the adoption of the euro just delayed (or accelerated depending on the commentator) the emergence of Greece's deep structural problems. And anyway, instead of looking back, it would be well in our own interest to look forward and try to create a better future and a functional state at least for the next generation.

  5. Thanks Evelina :-) Your point is well taken - except, I am not sold on the idea that a more unified Europe could have done better. That view presumes that there is a "right" course that could alleviate the crisis - and that this course is different than the muddle through that EU leaders have adopted so far. That's not a view I share - I believe that Europe faces a multilayered crisis and that there is no obvious solution that addresses all the aspects of the European crisis. And that Europe's current balancing act, though inelegant and often messy, does represent the best course of action. But I realize that I am a tiny minority when it comes to this issue!

  6. An interested readerJanuary 24, 2012 at 6:42 AM

    I agree with you and seriously don't think you are a tiny minority, at least there are many people in Europe sharing your view ;)

    And you mention very important points:

    - The reasons for the current crisis differ: government profligacy (esp. Greece, Portugal), mortgage crisis (Spain, Ireland), structural flaws of the monetary union, lack of reforms during the last 10 years and decreasing competitiveness (Italy and many others)
    - More European integration is required. But at the same time, system competition must be allowed so that we are able to recognize our own mistakes and to see what others do better. Europe needs common goals, but differend ways to achieve them must be allowed. It would be horrible if European nations aimed at standardizing everything, which I fortunatelly perceive as impossible anyway (e.g. different cultures)

    Thanks for your excellent blogg!


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