The Magazine

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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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.



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