Martin Feldstein
The Little Currency That Couldn't
The euro should now be recognized as an experiment that failed. This failure, which has come after just over a dozen years since the euro was introduced, in 1999, was not an accident or the result of bureaucratic mismanagement but rather the inevitable consequence of imposing a single currency on a very heterogeneous group of countries. The adverse economic consequences of the euro include the sovereign debt crises in several European countries, the fragile condition of major European banks, high levels of unemployment across the eurozone, and the large trade deficits that now plague most eurozone countries.
The political goal of creating a harmonious
The initial impetus that led to the
The primary political motive for increased European integration was, and may still be, to enhance
The
A DEATH FORETOLD
Long before the euro was officially introduced, economists pointed to the adverse effects that a single currency would have on the economies of
Here is why: when a county has its own monetary policy, it can respond to a decline in demand by lowering interest rates to stimulate economic activity. But the ECB must make monetary policy based on the overall condition of all the countries in the monetary union. This creates a situation in which interest rates are too high in those countries with rising unemployment and too low in those countries with rapidly rising wages. And because of the large size of the German economy relative to others in
The tough anti-inflationary policy of the ECB caused interest rates to fall in countries such as
The result was rapidly rising ratios of public and private debt to GDP in several countries, including
Before the monetary union was put in place, large fiscal deficits generally led to higher interest rates or declining exchange rates. These market signals acted as an automatic warning for countries to reduce their borrowing. The monetary union eliminated those market signals and precluded the higher cost of funds that would otherwise have limited household borrowing. The result was that countries borrowed too much and banks loaned too much on overpriced housing.
When, in early 2010, the markets recognized the error of regarding all the eurozone countries as equally safe, interest rates began to rise on the sovereign debts of
A different market dynamic affected the relationship between European commercial banks and European governments. Since the banks were heavily invested in government bonds, the declining value of those bonds hurt the banks. The banks then turned to their governments to protect their depositors and other creditors, thus magnifying the original problem. In
THE EURO ON LIFE SUPPORT
By the fall of 2011, several European countries had debt-to-GDP ratios that were high enough to make default a serious possibility. Sharp write-downs in the value of their sovereign debts are not a feasible solution because they would do substantial damage to European banks and possibly to banks and other financial institutions in
European political leaders have proposed three distinct strategies to deal with this situation. First, led by German Chancellor
But the plan to increase the banks' capital has not worked, because banks do not want to dilute the holdings of their current shareholders by seeking either private or public capital, and so instead they have been raising their capital ratios by reducing their lending, particularly to borrowers in other countries, causing a further slowdown in European economic activity. Nor can the EFSF borrow the additional funds, since such a move is opposed by
The second strategy, advocated by
The third strategy is favored by those figures, such as Merkel, who want to use the current crisis to advance the development of a political union. They call for a fiscal union in which those countries with budget surpluses would transfer funds each year to the countries running budget deficits and trade deficits. In exchange for these transfers, the
This transfer arrangement has already happened with
The situation in
Even if a more general write-down of Greek debt were to cut
To achieve a sustainable path,
Cutting the interest bill in half and simultaneously balancing the rest of the budget would reduce the ratio only very slowly, from 150 percent now to 145 percent after a year, even if no payments to bank depositors and other creditors were required. It is not clear that financial markets will wait while
The situation in
TRADING PLACES
Even if the eurozone countries reduced their large budget deficits and thereby alleviated the threat to the commercial banks that have invested in government bonds, another problem caused by the monetary union would remain: the differences among eurozone members in terms of long-term competitiveness, which leads to sustained differences in trade balances that cannot be financed.
During the past year,
If
But since
But limiting the growth of Greek wages would address only further deterioration of Greek competitiveness in the future. Stopping a further decline in Greek competitiveness would not correct the existing annual current account deficit of nearly ten percent of GDP that
THE TEMPTATION OF DEVALUATION
The alternative is for
Even though
The value of the new drachma would fall relative to the euro, automatically reducing real wages and increasing Greek competiveness without requiring
Withdrawing from the eurozone would of course be difficult and potentially painful. The announcement that
Another serious problem for
The primary practical problem with leaving the eurozone would be that some Greek businesses and individuals have borrowed in euros from banks outside
But as the experience of
Looking ahead, the eurozone is likely to continue with almost all its current members. The challenge now will be to change the economic behavior of those countries. Formal constitutionally mandated balanced-budget rules of the type recently adopted by
(AUTHOR BIO:
- Will the Euro Survive 2012?
- The Failure of the Euro
- Italian Prime Minister Calls For Unity to Save the Eurozone
- The New Old Europe
- Brussels Agreements Increase German Role in EU
- Council of Europe: The Soft Power Twin
- Greece: Default and Exit
- Greece's Unlawful Immigrants in Dangerous Hands
- Cyprus Gas Discovery Raises Political Stakes
- Politics Return to Russia
- Russians United against United Russia
- 2011 in Review: The World and the Balkans
- The Double Dilemma Facing Weaker National Economies
- German Chancellor Warns Financial Crisis Solution Will Take Years
- Bank of England Warns U.K. Banks that Eurozone Crisis Poses Biggest Threat
- Major Economies Headed for Slowdown
- Is the National Security Complex Too Big to Fail?
- Troubled Spain Elects New Leadership
- What Happens if Italy's Economy Collapses?
- Europe's Crisis and the Radical Right
- Is Europe Over?
- Europe's Crisis: Beyond Finance
- Uncertainty Rises as Eurozone Crisis Deepens
- Balkans: EU Will Help But Countries Must Reform
Copyright 2012 Council on Foreign Relations, publisher of Foreign Affairs. All rights reserved. Distributed by Tribune Media Services