A Predictable Crisis
Europe’s single currency was bound to break down.
Jun 14, 2010, Vol. 15, No. 37 • By MARTIN FELDSTEIN
The current crisis of the European single currency was an accident waiting to happen. The adverse consequences of imposing a single currency on a disparate group of countries were initially hidden by the short-run advantages that the weakest countries enjoyed when they adopted the euro in 1999—and by the favorable global economic conditions that prevailed until 2008. But we now see very serious problems affecting both individual eurozone countries and the overall single currency system.
Many economists warned of these dangers even before the euro was adopted. (My own analysis, first published in the Economist in June 1992, predicted many of the problems that I will spell out here.) The euro’s political proponents did not understand the likely adverse economic consequences of its adoption, or even care about them. They wanted the single currency as a way of achieving stronger political cohesion in Europe, going beyond the free trade agreement of the European Union toward a full political union.
A country that retains its own currency is certainly not guaranteed problem-free growth and low inflation. There is no substitute for monetary and fiscal discipline and for sound financial regulation and supervision. Even with the best of country-specific policies, problems will occur. But accepting membership in a single currency system exposes a country to four basic problems that would otherwise be avoided.
First, a single currency means a single monetary policy, denying individual countries the chief means of dampening business cycles and reducing the unemployment caused by declines in local spending. A monetary policy that is best for the eurozone as a whole will be excessively easy in some countries, causing house price bubbles that eventually collapse with substantial damage to individual wealth and overall employment.
Second, a common currency means that every eurozone country has the same exchange rate, preventing the natural rate adjustments that maintain national competitiveness when there are different trends in productivity and demand. Germany has an enormous trade surplus because of the strong growth of its labor productivity and because of the rapidly rising demand for German equipment in countries like China. If Germany still had the mark, the currency would have appreciated in response to these developments. The rise in the mark would have limited the trade surplus and, by lowering the cost of imported products, would have raised the real incomes of German workers. Similarly, the decline of Greek productivity relative to that of other countries would have caused the Greek drachma to decline, preventing Greece’s enormous trade deficit. It was obvious before the euro was adopted that such chronic trade problems would arise and persist.
Third, membership in the currency union encourages countries to have large fiscal deficits. When a country with its own currency issues large amounts of government debt, the financial markets gradually raise the interest rate on that debt and may also cause the value of the currency to decline. These market responses are a warning that the deficit is becoming excessive. But because eurozone members borrow in euros, the excessive deficit of any one country has only a very small effect on the total supply of euro bonds and therefore on the overall interest rate and euro exchange rate. Until the risk of default by Greece (and others) became substantial, the markets regarded all euro denominated government bonds as essentially equal, implying very small interest differentials among the eurozone countries. As a result, Greece could (and did) borrow large amounts with impunity.
Fourth, the lack of a country-specific exchange rate makes it very painful to reduce excessive fiscal deficits, something that many of the eurozone countries must now do. The large cuts in government spending and large increases in tax collections necessary will reduce the GDP of those countries and cause substantial unemployment. If the countries were not members of the eurozone, they could allow the values of their currencies to fall at the same time. The resulting increase in exports and reduction in imports would raise GDP, reducing the decline in economic activity caused by the fiscal contraction and helping to maintain employment.
In the years before the introduction of the euro, the common reaction to this critique was: Why should Europe not be able to operate with a single currency when the United States, an equally large and equally diverse area, is able to do so? There are four fundamental differences that allow the United States but not Europe to overcome the problems associated with a single currency.
First is the mobility of labor. The rise in the unemployment rate in an individual U.S. state or region in response to a decline in demand for local products is limited because people are quick to move to other parts of the country where jobs are more available. Powerful forces in Europe preclude the development of labor mobility. The most obvious of these is language. But even within a single country like Germany, strong regional allegiances impede the flow of workers from one part of the country to another. Union memberships, pension systems, and religious differences also impede cross-border mobility.
The second difference is that wages are much more flexible in the United States than in Europe. A fall in demand for the products of a U.S. region causes a decline in local wages. That lowers production costs in that region which in turn dampens the fall in sales of the affected products and induces a more general increase in the demand for labor in the region. Such wage flexibility reduces the need for expansionary monetary policy. The flexibility is reinforced because wages in the United States are set by individual employers with none of the national or industry-wide wage bargaining seen in Europe and because less than 10 percent of the private sector labor force is unionized.
The third important difference between the United States and Europe is that income taxes are primarily collected by the central government in Washington while in Europe the equivalent taxes are paid to the individual national governments. Each dollar’s decline in the GDP of a particular U.S. state causes a fall of about 30 cents in the taxes paid from that state to Washington, an automatic fiscal policy that helps to stabilize local output and employment.
The final difference is that each U.S. state has a constitutional rule preventing sustained deficits. State constitutions also prohibit using borrowed funds for operating expenses. Debt financing is limited to spending on infrastructure. Some states accumulate surpluses to use in years of reduced revenue; others allow operating budgets to be balanced over a two-year period rather than in a single year. But the net impact of the constitutional rules is to prevent the kind of massive deficits and debt at the state level that have occurred in individual European governments. Even California’s budget deficit is now only 1 percent of its state GDP.
Despite the fundamental problems, the first decade of the euro was quite successful. The operational transition from national currencies to the euro was smooth. The European Central Bank (ECB) resisted political interference and achieved a very low target rate of inflation—less than 2 percent. The new currency was widely accepted by international investors, causing the value of the euro to rise relative to the dollar and other currencies.
The success was due not only to the very favorable global economic environment but also to the immediate benefits enjoyed by those countries that had previously had high inflation and to the gradualness of the cumulative adverse effects of a single monetary policy and a fixed exchange rate.
For Greece, Italy, and other countries that had previously had high interest rates because of a tradition of high inflation, joining the euro caused sharp declines in interest rates. That induced substantial increases in public and private borrowing that financed spending that stimulated economic activity. But the accumulated effect of that borrowing is the large deficits and debts that now face Greece, Italy, Ireland, Portugal, and other eurozone countries.
The ECB’s management of monetary policy for the eurozone as a whole created excessively easy monetary environments for some countries. More specifically, in the early years of the euro, when the economies of Germany and France were relatively weak, the ECB kept interest rates low in order to stimulate demand in those countries. The resulting easy monetary conditions led to housing booms and house price bubbles in Ireland, Spain and other countries that eventually burst. The collapse of housing construction in those countries contributed to a sharp rise in unemployment rates.
The individual countries joined the eurozone at exchange rates that at the time were considered appropriate to balance imports and exports. But Germany’s productivity grew more rapidly than productivity in other eurozone countries, its wage increases were limited by tough public and private policies, and the demand for its high-tech products was stimulated by the very rapid growth of China and other Asian countries. As a result, Germany now has a current account surplus of 5 percent of GDP. At the other extreme are countries like Greece in which wages have grown relatively fast despite slower growth of productivity and of export demand, leading to a Greek current account deficit of 7 percent of GDP. These countries will now be forced to accept large reductions in wages and incomes in order to shrink their trade deficits, a very much more painful way to achieve real devaluations than would be possible with an adjustable exchange rate. Differences in productivity trends and in global export trends mean that this will be a recurring problem.
Shrinking the large fiscal and trade deficits may be unacceptably painful. It is not clear that democratic governments will tolerate years of decline of GDP and of real personal incomes. In the end, those governments may choose to default on their debts through a formal restructuring or by substituting new and less onerous debt for existing bonds. If the pain involved in regaining and sustaining a competitive real exchange rate is too large, they may choose to leave the eurozone so that they can devalue.
The creation of the single currency eurozone has been an ambitious, politically motivated experiment. Many of the problems that have now occurred as a result of abandoning country-specific monetary policies and individual exchange rates were anticipated by economists but ignored by politicians. It remains to be seen whether the political pressure to continue building a more centralized federal Europe will induce the eurozone countries to continue to accept these adverse economic consequences.
Martin Feldstein, chairman of the Council of Economic Advisers under President Reagan, is a professor at Harvard University.