Why the euro failed

Trading fiscal responsibility for unity.
Trading fiscal responsibility for unity.
Image: Reuters/Dado Ruvic
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The euro—the single currency shared by nineteen European nations— is unique in human history.

Never before has a group of countries created a brand-new currency that they would share with one another. Some idealists have seen this uniqueness as a virtue, as the harbinger of a better future world in which nations cooperate on a wider range of economic and political decisions. In due course, a political union might emerge; national parliaments would give increasing authority to a European parliament, which would make decisions for everyone. With this vision, almost half a century ago, European nations began exploring the idea of a single currency. Such a single currency, their leaders said, would bring greater prosperity and greater political unity.

At the time, Europe had a lot going for it. The wounds of World War II were receding into the past. Europeans had made another war unthinkable. They had learned to “fight across conference tables” rather than on battlefields. They had opened their borders to allow greater trade with one another. None of this had been easy. They had wisely taken little leaps in the dark to slowly leave behind the shadows of two great wars fought earlier in the 20th century, and they had learned to rely on one another’s goodwill. They were rightfully proud of their success.

At that point, the essential historical purpose—to build the best human defense against another European war—was largely fulfilled. The question was how best to use the space opened up by this peace parenthesis. The task that lay ahead was to build on the liberal values that European citizens  had come to cherish. To create an open society. To enable competition for ideas. To foster creativity and prosperity.

At The Hague in December 1969, European leaders, possibly unknowingly at first, took another leap in the dark: they set about creating a single currency. The thinking was that businesses and travelers would save the costs of exchanging currencies, and so they would trade more and travel more within Europe. Furthermore, with a European central bank, the euro zone would have a uniform monetary policy, which governments of member nations could not bend toward their purposes. Hence, to prevent domestic inflation and to promote domestic growth, the governments of all the countries would have to be fiscally responsible. Countries using the single currency would also need to coordinate their economic policies. And as they learned to cooperate, peace would be even more firmly established.

Despite the economic and political crisis of the euro zone over the past decade, some continue to believe in this vision.

In fact, key decision makers came very quickly to understand the dangers of the leap they were taking. They understood that the benefits of easier transactions within Europe were small. What they possibly did not think clearly about is an economic proposition that comes as close to a theorem as economics can have. In a classic 1968 paper, Milton Friedman, one of the foremost economists of the 20th century, explained that the main function of monetary policy is to help minimize a macroeconomic dislocation—to prevent an economic boom from getting too big and reduce the time that an economy spends in a recession.

Monetary policy, Friedman insisted, cannot help an economy raise its long-term growth prospects. And, here was the kicker: if monetary policy is badly implemented, it can cause lasting damage and can, hence, reduce long-term growth prospects. Like a “monkey wrench” thrown into a machine, ill-chosen and ill-timed monetary policy frustrates normal economic functioning. By going down the route of monetary union, European leaders were making it more likely that European monetary policy would throw monkey wrenches into their economies.

European leaders may not have been aware of Friedman’s near-theorem on the proper role and limits of monetary policy. They should have been aware that a single currency could not deliver economic prosperity. And they were surely aware that Italy and Greece had always bucked economic directives from European authorities, and thus these countries were unlikely to meet the standards of economic management needed to accompany a single currency, a single monetary policy.

European leaders also knew that the promised political gains were illusory. Although they often repeated the mantra of “political union,” they knew they would not give up their own tax revenues to provide meaningful help to other nations in distress. They knew that the risk of economic conflicts of interest was real. And economic conflicts would create political conflicts. From the moment the single currency was proposed in 1969 to its introduction in 1999, validations of these forewarnings recurred. Again and again. But the risks were downplayed, and alternative viewpoints were deflected.

The essential flaw of the single currency was elementary. In giving up their national currencies, euro zone members lost important policy levers. If a member country went into recession, it would not have a currency it could devalue so that its businesses could sell abroad at lower US-dollar prices in order to boost exports and employment. The member country would also not have a central bank that could reduce its interest rates to encourage domestic spending and stimulate growth.

This basic flaw creates acute difficulties as soon as the economies of countries that share the currency diverge from one another. If the Italian economy is in trouble and the German economy is humming along, the common interest rate set by the European Central Bank (ECB) will be too high for Italy and too low for Germany. Thus, Italy’s economic troubles will persist, and the German economy will get even more of a boost. It is in the nature of the single currency that once member economies begin to diverge from one another, the common interest rate will cause the divergence to increase.

These elementary problems considered, economists concluded by the late 1960s that if the single currency were to have a chance—any chance at all— there would need to be significant fiscal transfers from the humming countries to those that were in the dumps. In a single-country, single-currency customs union such as the US, states receive more funding from the federal budget; also, residents of states hit hard by recession pay reduced federal taxes relative to the residents of states that are less seriously affected. When such benefits are provided, no one fusses about them, because under the current political arrangement (the US), they are legitimate. Indeed, some US states, such as Connecticut and Delaware, make large permanent transfers to states such as Mississippi and West Virginia. Economists thus concluded that for the euro leap into the dark, a common budget under a single fiscal authority would be needed.

If Europe wanted to go down this route, national parliaments would need to take back seats; they would mainly transfer resources to a common budget. A European finance minister reporting to a European parliament would use funds from a common European budget to stimulate the economy of the troubled country and thus shorten its recession. Fiscal transfers would not guarantee success, but without them, this was a dangerous venture.

From day one, however, it was clear that the Europeans would never be willing to agree on a common budget. The Germans were understandably worried that if they agreed to share their tax revenues, they would become the financier of all manner of problems in the rest of Europe. Thus, a common budget to smooth the path to the United States of Europe with the euro as its common currency was politically off the table.

Although they described the project in grand terms, Europeans set about creating an “incomplete monetary union,” one that had a common monetary policy but lacked the fiscal safeguards to dampen booms and recessions. Within this incomplete structure, conflicts involving the conduct of monetary and fiscal policy were bound to arise.

To be clear, such conflicts arise even within nation-states. But within a nation, political procedures are typically in place to achieve some resolution. In the European single-currency project, there was no political contract for how the conflicts would be resolved. When financial crises occurred, there would be no mutually acceptable way to resolve them. Some countries would “lose,” and others would “win”; the “winners” would become “more equal” than the others. Divergence among countries would increase, and the monetary union would become even more unmanageable. The incomplete monetary union contained the seeds of its own breakup.

To make matters worse, breakup of the incomplete monetary union would be extremely costly. If a country exited during a crisis, its domestic currency would depreciate rapidly, and the country’s government, businesses, and households would need to pay their euro (or dollar) debts in their depreciated currency. Many would default. Especially if the country was large, the defaults could set off panic, leading to more exits from the euro and a widening circle of financial mayhem.

Why did Europeans attempt such a venture that carried no obvious benefits but came with huge risks? How did they reconcile its obvious contradictions? How did these contradictions play out once the euro was launched? Where has Europe ended up?

There is an overarching answer to all these questions. European leaders had little idea why and where they were going. And as it has been said, if you don’t know where you are going, you end up someplace else. Despite their idealistic vision, Europeans ended up someplace else. As could be expected, that someplace else has not been a good place. The euro has hobbled many of its member countries. It has created bitter division among Europeans. If  Aristotle were alive today, he would see how “eminently good and just” men and women enacted the EuroTragedy, “not by vice or depravity,” but by “error or frailty.”

Excerpted from EuroTragedy: A Drama in Nine Acts (Oxford University Press). Copyright 2018.