The Euro: Views from the trenches

This post gathers in one place material that could be helpful for those that wish to have a view of the “long march” of the “Euro project” and how many of the problems that have developed over time had been considered years before it came into being.

The first, which can be construed as an example of “bad timing” – “The euro: It can’t happen, It’s a bad idea, It won’t last – US economists on the EMU, 1989 – 2002” – is a “slap in the face” of those Americans that were critical of the single currency. It was written by Lars Jonung and Eoin Drea in January 2008, just before the “flood gates” opened up!

Abstract: The purpose of this study is to survey how US economists, those with the Federal Reserve System and those at US universities, looked upon European monetary unification from the publication of the Delors Report in 1989 to the introduction of euro notes and coins in January 2002.

Our survey of about 190 publications shows (a) that academic economists concentrated on the question “Is the EMU a good or bad thing?”, usually adopting the paradigm of optimum currency areas as their main analytical vehicle, (b) that they displayed considerable skepticism towards the single currency, and (c) that economists within the Federal Reserve System had a more pragmatic approach to the single currency than academic economists, focusing on the design and operations of the new European central bank system.

We find it surprising that economists living in and benefiting from a large monetary union like that of the US dollar were so skeptical of monetary unification in Europe. We explain the critical attitude of US economists towards the single currency by several factors: first, the strong influence of the original optimum currency area theory on US analysis, leading to the conclusion that Europe was far from a optimal monetary union, second, the implicit use of a static ahistoric approach to monetary unification, resulting in the failure to see monetary unification as an evolutionary process, third, the failure to identify the problems with alternative exchange arrangements other than a single European currency, and fourth, the misleading belief that the single currency for Europe was primarily a political project that ignored economic fundamentals, thus dooming the single currency to disaster.

The second, one of the pieces mentioned in Jonung´s and Drea´s article, is Martin Feldstein´s 1997 article originally published in Foreign Affairs which had the cover title of “The Euro and War”:

According to Martin Feldstein, Professor of Economics at Harvard University and President of the National Bureau of Economic Research, the Economic and Monetary Union could lead to conflict and eventually even to war. Instead of increasing intra-European harmony and global peace, the shift to EMU and the political integration that would follow would be more likely to lead to increased conflicts within Europe and between Europe and the United States.

The reasons, according to Feldstein, are that there would be important disagreements among the EMU member countries about the goals and methods of monetary policy and the European Central Bank

Especially the German stringent anti-inflationary policy and the French political interventionism could lead to disagreements. The tension between countries that are more concerned about unemployment than inflation and countries which remain adamant about fighting inflation could be exacerbated whenever the business cycle raised unemployment in a particular country or group of countries.

A politically unified Europe would make it easier to enforce policies that would reduce structural unemployment but EU countries would also become collectively less able to compete with the rest of the world. The result would undermine the entire global trading system and create serious conflicts with the United States and other trading partners.
Since not all European nations would be part of the monetary and political union, there would be conflicts between the members and nonmembers of Europe, including the states of Eastern Europe and the former Soviet Union.

Furthermore, without the ability to use monetary policy to offset a decline in demand, governments would want to use tax cuts and increases in government outlays to stimulate demand and reverse cyclical increases in unemployment,. But the ‘Stability Pact’ tells governments that they cannot run fiscal deficits above three percent of GDP after the start of EMU. The most likely outcome of the shift to a single monetary union would therefore be the growth of substantial transfers from the EU to countries who have high unemployment rates. This would require a significant increase in tax revenues collected by the EU (a bigger EU-budget). The debates about how large the transfers should be and how the taxes should be collected would definitely lead to a lot of irritation and conflict according to Feldstein. The attempt to form a common military and foreign policy would be an additional source of conflict because they differ in their national ambition and in their attitudes and projecting force and influencing foreign affairs.

The monetary union is based on France’s aspiration for equality with Germany and Germany’s expectation for hegemony. Both vision drive their countrymen to support the pursuit of the project and both would lead to disagreements and conflicts when they could not be fulfilled. Smaller countries would also get frustrated as the union expands with at least six more countries of Eastern Europe. Current EU voting rules will give way to weighted voting arrangements in which the larger countries will have a predominant share of the votes.

A critical feature of the EU in general and EMU in particular is that there is no legitimate way for a member to withdraw. But if countries discover that EMU hurts their economies they might want to leave. The devastating American Civil War shows that a formal political union is no guarantee against a intra-European war.

The third is an article just published by the Center for European Reform. It confirms many of the worries by the early cementers and critics of the project. From the conclusion:

When the euro was launched, critics worried that it was inherently unstable because it was institutionally incomplete. A monetary union, they argued, could not work outside a fiscal (and hence a political) union. Proponents of the euro, by contrast, believed that a currency union could survive without a fiscal union provided it was held together by rules to which its member-states adhered. If, however, a rules-based system proved insufficient to keep the monetary union together, many supporters assumed (as faithful disciples of Jean Monnet) that the resulting crisis would compel politicians to take steps towards greater fiscal union.

Eurozone leaders now face a choice between two unpalatable alternatives. Either they accept that the eurozone is institutionally flawed and do what is necessary to turn it into a more stable arrangement. This will require some of them to go beyond what their voters seem prepared to allow, and to accept that a certain amount of ‘rule-breaking’ is necessary in the short term if the eurozone is to survive intact. Or they can stick to the fiction that confidence can be restored by the adoption (and enforcement) of tougher rules. This option will condemn the eurozone to selfdefeating policies that hasten defaults, contagion and eventual break-up.

If the eurozone is to avoid the second of these scenarios, a certain number of things need to happen. In the short term, the ECB must insulate Italy and Spain from contagion by announcing that it will intervene to buy as much of their debt as necessary. In the longer term, however, the future of the euro hinges on the participating economies agreeing at least four things: mutualising the issuance of their debt; adopting a pan-European bank deposit insurance scheme; pursuing macroeconomic policies that encourage growth, rather than stifle it (including symmetric action to narrow trade imbalances); and lowering residual barriers to factor mobility.

6 thoughts on “The Euro: Views from the trenches

  1. Marcus,
    Just to let you know I’m reading all that you have put together here. I wish my daily walks were as pleasant as the one at the top of your post!

    • Becky- The premise – Liquidity Trap – is fallacious. So all the neat arguments put forth by KS are just that. “Neat”. We can be “certain” that if, for example, an NGDPT was credible, interest rates would rise and the economy would start moving UP.

  2. Speaking of liquidity traps, David Glasner has Krugman all upset today, so I’m going back now to read what he wrote that made Krugman say this,”I suspect that a lot of time and effort has been wasted because smart commenters like Glasner “knew” that Keynesians were crude thinkers using mechanical approaches – leading them to spend several years laboriously arriving at the same conclusions people like me”!?
    http://krugman.blogs.nytimes.com/2011/11/16/irving-maynard-and-me-wonkish/
    This is a lot more fun than learning about (fallacious) liquidity traps in a classroom.

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