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.


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.