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The Euro: Beware of What You Wish For

For all the seven long years since the signing of the Maastricht treaty started Europe on the road to that unified currency, critics have warned that the plan was an invitation to disaster. Indeed, the standard scenario for an EMU collapse has been discussed so many times that it sometimes seems to long-time eurobuffs like myself as if it has already happened – perhaps because it is modeled on the real crisis that afflicted the European Monetary System back in 1992.

Here’s how the story has been told: a year or two or three after the introduction of the euro, a recession develops in part – but only part – of Europe. This creates a conflict of interest between countries with weak economies and populist governments – read Italy, or Spain, or anyway someone from Europe’s slovenly south – and those with strong economies and a steely-eyed commitment to disciplined economic policy – read Germany. The weak economies want low interest rates, and wouldn’t mind a bit of inflation; but Germany is dead set on maintaining price stability at all cost. Nor can Europe deal with "asymmetric shocks" the way the United States does, by transferring workers from depressed areas to prosperous ones: Europeans are reluctant to move even within their countries, let alone across the many language barriers. The result is a ferocious political argument, and perhaps a financial crisis, as markets start to discount the bonds of weaker European governments.

Well, here we are, right on the brink of the creation of "euroland", and it is now clear that none of the problems EMU critics have warned about will arise, at least for a while. Indeed, it turns out that Murphy was wrong: not everything that can go wrong, does…

-Paul Krugman, 1998

Twelve years from now I am sure someone will be able to pull up an equally embarrassing quote from me – I guarantee you. But, quite frankly, Krugman was wrong on this one (Hat tip TR).  The Euro crisis that everyone anticipated long ago has finally arrived and the institutional structure of the Eurozone is inadequate to deal with it. Krugman now gets that and is singing a different tune.

The Euro-zone is NOT the United States of Europe, and that is actually much of the problem (see reader comments at the end of this post). Ryan Avent has a good post over at the Economist’s Free Exchange blog about this.  He says:

A number of economic writers have been making the point that one of the reasons the euro zone is struggling is because it’s not an optimal currency area. Business cycles have differing impacts across the euro area, which lacks the necessary fiscal institutions to cushion the blow in places hit relatively hard. Paul Krugman makes this point in his most recent column, in which he explains how federal government transfers across states fill in the gaps left by the common monetary policy. States that are struggling more receive more in transfers from the federal government, which prevents, say, California from suffering from a dramatically worse recession than the rest of the country, of the sort that would generate Greece-like complications.

This story is correct, but it’s not the whole story. As Greg Mankiw writes today, another key to American success is the thinness of state borders. The differences across American states, in terms of language and culture, are far smaller than those between European nations. Americans can discuss their nation’s inter-regional cultural variation at length, but the fact is that a suburb in Pennsylvania is very similar to a suburb in Georgia, which is very similar to a suburb in California. The language is the same (if not the accent), the television programmes are the same, the structure of the educational system is basically the same (high school is high school, college is college), and so on.

I don’t want to overplay this point because there are all sorts of scary stories emerging from U.S. states and their budgetary woes. I anticipate defaults in US states much as we are going to see in the Eurozone. But, clearly, Europe is very differentregarding heterogeneity. Greece is night and day to Germany compared to the differences between Georgia and California. So at a minimum, Europe needs an institutional framework to deal with the inevitable political fallout from a deep recession and the monetary and fiscal constraints inherent in the single currency.

I gave you the example of Slovakia a few days ago. Here’s a country contributing only 800 million euros of a 110 BILLION euro package and they have the ability to torpedo the whole thing if they so choose. I think this is absolutely ludicrous. But there is something fundamentally wrong with forcing politicians to conduct bailouts of foreigners during a period of domestic economic woe. You really are asking for problems – and yes, Murphy’s law does apply here.

If the Europeans can get through this crisis with the Euro still intact, they are going to need to think long and hard about ways to pre-fund fiscal transfers during the good times rather than waiting and worrying about bail outs during the bad times. If they don’t at least learn this lesson, the euro-zone is not going to last.

About 

Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty years of business experience. He is also a regular economic and financial commentator on BBC World News, CNBC Television, Business News Network, CBC, Fox Television and RT Television. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College. Edward also writes a premium financial newsletter. Sign up here for a free trial.

18 Comments

  1. Abhishek says:

    The European Union is a wonder that it functions at all. Common monetary policy without a common fiscal policy is a contradiction which will ultimately burst

  2. Carmeloc04 says:

    so far keynesians and monetarist policies have proved that are not the appropiate to solve this crisis around the world, just panacea. I think that that heterogeinity is a more important obstacle that not having a common fiscal policy. No need to invent new formulas for transfers I think, just keep the old maastricht rules. The markets should know that those countries not complying will be expelled from the euro zone so the access to credit markets will be harder to get for those countries and riskier for investors.

  3. ds says:

    States of the European Union and US States are similar in that they are both financially constrained, but the two groups have substantially different obligations to their constituents. California does not have to pay out Social Security and Medicare, maintain an army, build highways, etc. Greece must do all of this, and yet still has to fund itself in a manner similar to California. At this level of government involvement, it is incredibly difficult, if not impossible, for Greece to serve the public purpose and remain ‘fiscally responsible’ at the same time.

    I understand there are cultural/political reasons which serve to distinguish Euro States from US States, but the real difference right now is that even though California and Illinois are fiscally constrained, there is an unconstrained higher authority — the Federal Government — who provides the lion’s-share of essential public services in these states. In Europe there is no such higher authority who is either unconstrained or aids in the provision of public goods.

    This is also why I think the possibility of a Euro member nation default is substantially higher than a default of a US state. A successful bailout of the ‘piigs’ requires collective action from the other member states; so, as noted in the post, Greece needs the help of France, Germany, Slovakia, etc. But if California were on the brink of default, they would not have to appeal to Texas, Kentucky, etc. for help — they can simply ask the Federal Government. After all of the financial bailouts, there is no way the Federal Government would allow a state to default on its bonds.

    In my mind, the only way the Euro can survive in the long run is if the member states allow for a supra-national authority responsible for the funding of a large share of public services such as military, roads, schools, pensions etc. This is where the cultural/political differences come in. Would the Euro nations ever accept a supra-national authority with taxing/spending powers? I doubt it.

    • A good distinction!

    • pebird says:

      ds: I 2nd Marshall’s comment – very good points. No one measures trade balances between California and Georgia. Edward – this is a great set of posts on the Eurozone you have put up over the last few (days/hours?!). Great work!Also, give Krugman credit for being right for 10 years – that’s a lifetime achievement award in economics.

      • Agreed, give Krugman credit. You never say where he was wrong. It seems to me he was spot on and a good example of how economists can be useful.

      • Krugman was too sanguine about the design flaws of the Eurozone from the start. Giving credit here is akin to giving the Fed credit for lowering interest rates repeatedly during the Greenspan tenure. Sure, things did not go pear-shaped from the word go,. However, the Euro has failed its first real test for exactly the reasons Eurosceptics believed it would.

        Krugman poo-poos this argument:

        “Nor can Europe deal with “asymmetric shocks” the way the United States does, by transferring workers from depressed areas to prosperous ones: Europeans are reluctant to move even within their countries, let alone across the many language barriers. The result is a ferocious political argument, and perhaps a financial crisis, as markets start to discount the bonds of weaker European governments.”

        This is essentially what happened. So at the first sign of a deep downturn in the south we see that the Eurozone cannot handle “asymmetric shocks.” Where was Krugman right?

  4. John Haskell says:

    The bottom line is that countries that don’t share a language shouldn’t share a currency. And even some times when they share a language. Imagine how insulting it would be to be told that we needed to merge the US and Canadian dollars or the War of 1812 would break out all over again. Well that is the “logic” behind the Eurozone. No wonder it is failing.

    As for who counts or who doesn’t count the trade balance between states, the counting isn’t the issue. People certainly count how much you have borrowed vs. your income. You can’t run a trade deficit without borrowing. Or am I the only person who has noticed this.