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A Predictable Crisis

Europe’s single currency was bound to break down.

Jun 14, 2010, Vol. 15, No. 37 • By MARTIN FELDSTEIN
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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.

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