The previous post of the same title focused on the economics underlying the painful, protracted adjustment deal underway with the euro zone crisis in Europe. With relative calm restored in the wake of the ECB’s Long-Term Refinancing Operation (LTRO) and Greek debt swap, this might be a good time to step back and examine the origins of the euro zone to better understand how things got to where they are today.
The architects of the euro zone fashioned a new monetary structure for Europe for the noblest of reasons: to purge the scourge of warfare from the European continent. It is hard to argue with that. (And, yes, I am reminded of an old adage of the road to somewhere being paved with good intentions.) But, given the disruption witnessed over the past couple of years, particularly the rekindling of age-old national prejudices, the question that must be asked is: did the architects of the euro pursue policy contrary to self-interest, or contrary to the advice available at the time?
In other words, do their actions satisfy Barbara Tuchman’s definition of folly?
The key here is whether Europe satisfies the conditions of an optimal currency area (OCA). The literature on this subject is vast, but the basic idea is to identify the conditions under which a particular monetary policy for one is appropriate for all countries. These conditions include countries that share similar characteristics and face similar shocks – identical countries, confronted by the same shock, would respond identically to the same monetary conditions. This is, clearly, fairly restrictive. A less demanding condition is that the various members are characterized by a high degree of wage and price flexibility. Because such economies respond quickly to external shocks through real-side adjustment (i.e., wages), the impact of monetary policy and its role in stabilizing or facilitating adjustment to shocks is lessened. Alternatively, countries marked by a high degree of factor mobility (capital and labour) between them could be contenders for an OCA, since excess demand/supply in one country would elicit flows of capital and labour to/from other members.
So, how did Europe measure up on these criteria?
By most measures, it didn’t. There were large differences in the economies of the “core” and the “periphery” – differences that have become blindingly apparent in the past two years. Moreover, wages and prices were relatively rigid; these rigidities account for Great Depression era levels of unemployment that are currently observed in some members of the euro zone. And, while important measures were taken to ensure capital mobility and financial integration between members, labour was less mobile owing to differences in language and local affinity.
I have no doubt that the architects of the euro zone understood that its members did not constitute an OCA. And I suspect they recognized that the people of Europe were unlikely to agree to the structural reforms that are required to transform Europe into an OCA by increasing labour mobility and wage and price flexibility. But their thinking might have been that, by pursuing monetary union, the costs of not following through on structural reforms would be so great, the status quo bias would be broken. Over time, such reforms would lead to changes in economic structure as the various members converge on the conditions for an OCA. This is consistent with the Bayoumi and Eichengreen result that the French desire for monetary union was driven by politics; not economics.
Of course, there was a risk that some shock would come along before this process of convergence had been completed. It was a gamble, they realized, but one worth taking to advance the European ‘project.’
As a result, Europe has a monetary union between sovereign nation states at fundamentally different levels of economic development and competiveness, many of which are struggling with high public debt and a lack of policy instruments to deal with declining growth. The only way out for these countries in crisis is through the process of “internal devaluation” implemented through structural reforms. In crisis conditions, people may indeed accept structural reforms. But, then again, they may not, particularly if the costs of persevering are considered too great and those that could help ease the pain are unwilling to do so.
It is similar to a situation in which architects have designed a beautiful new addition. The renovations are nearly completed — except, say, for the roof. Winter has arrived, and there is a dispute over who will pay the costs of completing the renovations.
Shouldn’t there have been an agreement on the nature of the job and the terms of payment before ground was broken? Who do we hold accountable for the disruption that has already occurred and for the greater disruption that might yet come?
The challenge now is to build the institutions that are required to better spread risk and facilitate adjustment. But institution building within sovereign states is a lengthy process, requiring political consensus. Building trans-national institutions that bind independent, sovereign states in a crisis – “not letting a crisis go to waste,” as Rahm Emanuel observed – is even more challenging. It requires a shared vision of the future and a modicum of trust. And, as Eichengreen argues, Europe’s problem now is a lack of trust.