Euro-Doom Is Fantasy, Why the Currency Won’t Collapse
When the euro was being created, the economics profession split into three groups -- enthusiasts, opponents and realists -- that predicted wildly different costs and benefits for the project. By 2007, when the young currency was thriving, the enthusiasts declared a premature victory. Now it’s the turn of the opponents, and they are, of course, wrong.
I say “of course” because currencies are meant to exist for centuries. Their performance cannot be judged after five or 15 years. It’s understandable that people who felt a strong prejudice for or against the euro’s existence should feel the itch to make a point when things turn their way, but the point is bound to be misleading, and intentionally so. The reality, however, is that changes in the broad flow of history, which the euro certainly was, require a much longer view. If you want to prove your case early, you need to abuse the data.
Consider the growth performance of four relatively small and comparable European countries, two of which are in the euro area (Finland and the Netherlands), and two of which (Sweden and Switzerland) kept their own currencies. With the right tricks, you can use the experience of these four countries to prove what you will about the euro’s viability. One trick is to choose the right period from which to draw your data. Another is to normalize the data on a particular year to create the impression that you want to project.
Chart A covers the period 2001-2011, which is convenient if you wish to show the euro’s failure, because in that period Sweden and Switzerland largely outperformed the Netherlands. But doing so ignores the very relevant fact that Sweden and Switzerland underwent their own housing-price bubbles, complete with banking crises, in the early 1990s. Chart B shows that since those crises, these two non-euro economies have struggled to make up the ground they lost. Switzerland, in particular, failed massively in this respect.
Add in Finland, a euro-area member that underwent a similar crisis in the 1990s, and the problem becomes clear. A comparison of Finland with fellow Nordic country Sweden suggests that adopting the euro made no difference at all to economic performance. The correct conclusion is that selecting countries and years is simply not an acceptable way of building an argument. There may be a case against the single currency’s viability, but it has to be based on firmer ground.
There is such a case, plain for all to see, and it’s fiscal indiscipline. A monetary union cannot last if fiscal discipline is not respected in every member country. Once individual countries give up their monetary policies, their public debts are effectively issued in a foreign currency, as Paul de Grauwe has shown. A government that has allowed its debt to become so large that it loses market access must be either helped or allowed to default.
Help can be in the form of inflation, loans or even grants, from other governments or the common central bank. The problem with help is that it generates perverse incentives, otherwise known as moral hazard. So once fiscal indiscipline has occurred, there are only bad options. And, indeed, here we are. But what does this failure mean?
The view of many euro opponents is that because the euro area has failed to establish fiscal discipline, the project is now doomed. There is no doubt that fiscal discipline has been lost, but that does not mean the problem can’t be fixed. In fact, the governments involved believe that it can be fixed, right now.
Show of Faith
Bearing responsibility for the explosion of public debts (more than 80 percent of gross domestic product in France and Germany, for instance), policy makers now exhibit a zealot-like faith that the necessary discipline can be established over the next two or three years. As they impose austerity on countries that lost market access and are in a recession, they make matters worse, of course, but more ominously they also show they still fail to grasp that fiscal discipline is a long-run concept.
The reality is that a few years of surpluses or deficits hardly tell us anything about fiscal discipline. Thus the zealots, who are broadly part of the euro-enthusiast group, provide the euro’s opponents with a solid argument: namely, that the euro area is unable to deal with its own flaws. This case, however, is not made loudly by the euro’s opponents because they fear they might be listened to, and that the euro area would end up fixing its most glaring flaw. (They should relax, the euro has many other failings, some potentially lethal, but now is not the time to list them).
That the euro area suffers from flaws is nothing particularly damning. It is a complex undertaking and the real surprise would be to have it 100 percent right the first time. This is where history comes into play. The euro will survive if the flaws are eventually fixed, but we’ll probably have to wait a few years or decades to know.
Everybody likes to refer to the U.S. as the model of a successfully assembled federal system. Yet the U.S. went through a succession of state defaults until 1840, at which point the federal government mustered the courage to put an end to bailouts. True, a handful of states defaulted after this watershed, too, but by then fiscal discipline had been firmly established as a requirement of dollar membership. It’s worth remembering that 1840 was 50 years after the creation of the Union, which itself was almost dissolved at the time of the Civil War. So the mighty U.S. dollar’s success wasn’t so instant or smooth, either.
The euro’s opponents also tend to suggest that sovereign default will be followed by an exit from the euro area. Many euro enthusiasts do the same, though for the opposite reason. The opponents hope a default will lead to an exit, proving the currency’s failure. The enthusiasts hope that fear of an exit will prevent a default. But what is the link that leads from default to exit? There is no legal procedure for a country to leave the single currency, nor for the other countries to eject a defaulting country. There is no economic logic, either.
People note that defaulting countries usually undergo a deep currency devaluation, which helps greatly in recovering growth and re-establishing fiscal discipline. This is indisputably true. Defaulting within a monetary union is bound to be more painful than when the currency can be devalued, as the American states now understand well enough to have themselves adopted stringent fiscal rules. But “easier” does not mean necessary, or sufficient. The short-term benefits of leaving the euro would soon be eroded by inflation, which eventually would have to be fought. Exiting would also create a particularly arduous breakup of all contracts denominated in euros, with massive wealth redistribution.
This is where, one more time, a historical perspective is needed. A country does not join a monetary union for a few years, when it is convenient and benefits accrue, only to leave once some of the fully predictable costs occur. Like a marriage, monetary union is for the long term, in sickness and in health. Of course, some marriages do end up in divorce, but there is nothing automatic about it. This is why the euro is ultimately a political decision. Economists can point out costs and benefits, but they can’t estimate them with any remotely credible degree of precision.
All that we do know about monetary unions is that the costs will strike sporadically, while the benefits will accrue drop by drop over the duration of the currency’s existence. This is why the presumption is that, as in any good marriage, over the long term the benefits must outweigh the costs. In the case of the euro, the honeymoon is certainly over, but it’s far too early for a breakup.
(Charles Wyplosz is a professor of economics at the Graduate Institute of International and Development Studies in Geneva. The opinions expressed are his own.)
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