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.
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