January 28, 2019 — In Europe, twenty years ago this month, 11 long-standing national currencies disappeared and were replaced by the new single currency, the euro. Since then, the euro has had its successes and failures.
Let us review the experience of the euro’s first two decades. Where there were failures, to what extent were they the result of avoidable technical mistakes? Of warnings not heeded? Or were they the inevitable result of a determination to go ahead with monetary union in the absence of a political willingness to support fundamental changes necessary to make it work?
Three early successes
Three early successes are insufficiently remembered. First, the transition from individual currencies to the euro in January 1999 went very smoothly. It was not obvious ahead of time that this would necessarily be the case. Recall the European currency crises of 1992 and 1993 or more recent chaotic demonetizations elsewhere.
Second, the euro instantly became the world’s #2 international currency by virtually all measures of international use.
Third, the incentive of being admitted to the club led to favorable reforms in many aspiring member countries, particularly countries in Central and Eastern Europe that joined subsequently to 2002.
Seven failures
There have been perhaps more failures than successes. Consider seven failures.
- First was the problem of asymmetric or unsynchronized shocks. Many American economists, in particular, had warned beforehand that European economies lacked cyclical synchronization and the other key criteria for a group of countries to constitute an “Optimum Currency Area.” It is much easier to give up monetary independence if your economy’s needs are correlated with those of the countries that will be setting your monetary policy. It is also easier if you have alternative means of adjusting to shocks, such as if workers can move between regions or if cross-union fiscal transfers can cushion local impacts. European countries lacked these alternative mechanisms of adjustment compared, for example, to the 50 US states which share a common currency.
The warnings proved accurate. To take one example, the Irish in 2004-06 needed a tighter monetary policy than the European Central Bank was prepared to set, because they were experiencing a housing bubble and economic overheating. But of course they had given up the ability to revalue their currency or raise their interest rate. Conversely, during 2009-2013, Ireland needed an easier monetary policy than the ECB was prepared to set, because it was in steep recession. But it had given up the ability to devalue, print money, or lower its interest rate.
- Second were the large current account deficits of the periphery countries during the euro’s first decade. At the time, large net capital flows to the periphery were viewed as a sign of efficiency-improving financial integration. In retrospect, the imbalances were less benign, attributable in part to a rise in the periphery’s Unit Labor Costs relative to Germany’s.
- The third failure was high budget deficits and debt levels in some countries, with Greece as the most extreme example. The problem of moral hazard in national fiscal policy (i.e., the problem that fiscal discipline is eroded by the belief that the country would be bailed out in the event of a crisis) had not featured prominently in academic research. (The academic emphasis had instead been on the Optimum Currency Area criteria.) But pushed by German taxpayers who were worried that they would eventually be asked to bail out some profligate Mediterranean country, the European architects of monetary union correctly identified fiscal moral hazard as a central vulnerability. To their credit, they tried hard to address the problem. They adopted (1) the Maastricht fiscal criteria, including the requirement that countries must get their budget deficits below 3% of GDP; (2) the so-called “no bail-out clause”; and (3) later the Stability and Growth Pact, which made the fiscal requirements permanent.
The fiscal rules proved un-enforceable in practice, however. Virtually all euro members soon violated the 3% deficit rule, including even Germany. Governments repeatedly claimed that fiscal targets would be met in the future, assertions that could only be maintained via systematically over-optimistic growth forecasts. (Officials during the first decade never forecast that they would have a budget deficit in excess of 3% of GDP, even though they often ran such deficits in successive years. When the deficits did come in over the limit, the leaders could than attribute the shortfall to “unexpected negative shocks.”)
- Fourth, when periphery governments were suddenly able to borrow at miniscule sovereign spreads in 1999, relative to German interest rates, it was interpreted as good news. That the high-debt countries did not have to pay penalty interest rates, as indebted US states like Illinois have to do, should instead have been interpreted as a signal that the moral hazard problem had not been solved after all.
Many have labeled it a fatal failure not to have moved more of the function of fiscal policy to the supra-national level – a failing that became clear in the euro crisis and is as troublesome in Italy today as it was in periphery countries in 2010. (The same applies to banking regulation. A few European economists flagged correctly the need for pan-euro banking regulation if the project were to be successful. But that warning was ignored.) It is perhaps not fair to label these as “mistakes” — since political opposition to federalizing these functions would have been overwhelming in the 1990s, as it still is today.
In some other areas, however, the leaders really did score “own goals.”
- The ECB mistakenly raised interest rates in July 2008 and again, twice, in 2011, despite the global recession.
- When the Greek crisis emerged at the beginning of 2010, European leaders did not handle it well. They might have been able to contain the forest fire. Instead it spread.
Mistake #1 was the failure to send Greece to the IMF Brussels and Frankfurt thought that the history of EM crises was not relevant to a euro member. Mistake #2 was a refusal to write down Greek debt quickly enough, despite Debt Sustainability Analysis showing the debt/GDP path to be explosive even with stringent fiscal austerity. - The post-2009 emphasis on austerity — applied especially to Greece but to other countries as well — was a major mistake. More specifically, the troika (EU Commission, ECB and IMF) in 2010 under-estimated the fall in income that would follow from fiscal austerity in the periphery countries. Even leaving aside the economic cost of the recession and the political cost of associated populist anger, fiscal austerity did not achieve its financial goal of putting Greece and the others onto sustainable debt paths. To the contrary, the fall in GDP was greater than any fall in debt, with the result that debt/GDP ratios rose at accelerated rates.
Failures #3 and #7 together add up to a history of pro-cyclicality in fiscal policy. The combination of high spending in 2001-2007 and austerity in 2010-2018 made Greek fiscal policy one of the most highly pro-cyclical of countries in the world. Government spending in other periphery countries, too, has shown positive cyclical correlations. Fiscal pro-cyclicality of course exacerbates the amplitude of the business cycle.
Three more successes
One can conclude more optimistically with three further observations on the “success” side of the ledger:
First, some periphery countries, particularly Spain have gradually managed (via painful recessions) to bring their previously-uncompetitive unit labor costs back down.
Second, ECB President Mario Draghi warrants top marks for successfully walking the tightrope between the German need for discipline and the Mediterranean need for accommodation – most famously for the July 2012 press conference that contained the immortal sentence, that the ECB was “ready to do whatever it takes to preserve the euro.” It worked. The euro survived the crisis with all 19 members intact, contrary to some predictions in 2010 that Greece, for one, would have to drop out. Draghi will be hard to replace when his term expires this October.
Third, opinion polls in recent years show the euro to have achieved high popularity, supported by 64% of the public as of November 2018. So there is hope after all.
[This is an extended version of a column that appeared at Project Syndicate. Comments can be posted there or at Econbrowser.]