The euro will mark its twentieth anniversary in 2019. Is this a cause of celebration and congratulations? Or a case of a well-intentioned policy gone awry? Ashoka Mody in his new book , EuroTragedy: A Drama in Nine Acts, offers an account that shows that the joint currency was flawed from the outset, and has been further weakened by poor policy choices.
Mody, a distinguished research economist at the IMF for many years, is currently the Charles and Marie Robertson Visiting Professor in International Economic Policy at the Woodrow Wilson School at Princeton University. His book is a combination of scholarship and storytelling, as Mody analyzes the background of the euro, its evolution and future prospects. He does a wonderful job in portraying the European figures who advanced the monetary union, often in the face of public indifference or opposition. At the end, he is deeply pessimistic about the viability of the common currency and its impact on the European economies that use it.
The decision to introduce the euro was based on political aspirations, not economic need. The history begins with the European Coal and Steel Community formed in 1951 by France, Germany, Italy, Belgium, the Netherlands and Luxembourg. This was followed in 1958 by the formation of the European Economic Community, a common market and customs union for the same six nations. These associations sought to bind together the economies of Europe, which had been shattered by two world wars and the Great Depression. However, national sovereignty over domestic policies, particularly taxes and government expenditures, was asserted by the leaders of the member countries from the very beginning.
The next step took place in 1969 when French President Georges Pompidou called for a European monetary union. Pompidou was motivated by a desire to end the chronic devaluations of the French franc against the German mark. Despite skepticism over the feasibility of a common currency, West German Chancellor Willy Brandt , whose main priority was the reunion of both halves of Germany, gave a tentative endorsement, based on an understanding that there would be “harmonization” of fiscal policies. But this was a conditional agreement, and the terms were left undefined. The consequences of that ambiguity have bedeviled the implementation of the euro to the current day.
Denmark, Ireland and the United Kingdom joined the original six nations in 1973, and more joined in the 1980s. The formation of the European Monetary System in 1978 to fix exchange rates amongst these nations was a step on the road to a monetary union. The currency crises of 1981 and 1982, however, showed the risks in such integration, and for much of the 1980s further progress seemed stalled. Mody tells well the story of the change in the position of Germany’s leader Helmut Kohl, who sought to unify Europe after his own country came together in 1989. Kohl’s endorsement ensured that there would be sufficient support amongst European leaders for the euro. Kohl, however, never overcame the doubts and concerns of German policymakers and business leaders over how a common currency would affect Germany itself. The Germans were particularly wary of the possibility that they would be required to come to the assistance of other less credit-worthy members.
In addition to German concerns about its responsibilities, there were flaws in the design of the euro. Those countries that join a monetary union lose the ability to use national monetary policy to stabilize their national economies. In theory, this vulnerability can be offset by fiscal transfers from a central source to the areas affected by asymmetric shocks that the union’s central bank does not address, much as the U.S. federal government can allocate funds to areas in emergency. But such a redistribution mechanism was never established for the Eurozone, in large part due to opposition from Germany and other members. In addition, domestic fiscal policy is constrained by the Stability and Growth Pact (SGP), which puts a limit on budget deficits of 3% of GDP. Since an economic contraction lowers tax revenues, a government facing a recession will already be in danger of violating the SGP mandate, and therefore cannot increase its own spending to counter the downturn.
In addition to this fundamental flaw, the viability of the euro has been hampered by the policies of the European Central Bank (ECB). The ECB has a single mandate: maintain price stability. The limitations of that charge became quite clear during the global financial crisis, but were amplified by the unwillingness of ECB President Jean-Claude Trichet to acknowledge the depth of the crisis and formulate an adequate response. Federal Reserve Chair Ben Bernanke was much more aggressive in responding with unconventional policy moves such as Quantitative Easing. This timidity was compounded by premature calls for fiscal austerity during the slow economic recovery.
The Greek debt crisis amply demonstrated the division within the Eurozone over what obligations member governments have to come to the aid of another member in fiscal distress. Mody believes that Italy now poses the biggest current threat to the structure of the Eurozone. That country adopted the euro in the belief that it would act as a “vincolo esterno,” an external constraint that would impose sound policies on a fractious political system. But a common currency cannot improve low productivity growth due to poor governance and institutions.
The protracted pace of the recovery in Italy from the global crisis has frustrated its citizens, who have turned to populist parties—the Northern League and the Five Star Movement—that were once seen as fringe movements. The parties have dropped their opposition to the euro because of public sentiment. But the new government is determined to proceed with its fiscal plans, which include a flat tax rate and a universal income. The resulting deficit would violate the European Commission’s fiscal rules and raise Italy’s debt burden. The current public debt/GDP ratio of 131% is exceeded within the Eurozone only by that of Greece. While an Italian exit from the European Union seems impossible, the Italian government and the European Commission each seem determined to make the other side move first towards a compromise in an international game of chicken. In such circumstances there is ample opportunity for miscommunication and misunderstanding. Given the size of the Italian economy, any rupture could be catastrophic.
Mody is not anti-European. Indeed, he calls for a renewal of the European identity of a group of nations that compete in the “marketplace of ideas,” and together form a European Republic of Letters. But the euro has not fostered that identity, and in is based on an inherent flaw:
“The original conundrum remains. A single monetary policy for diverse countries cannot operate effectively without a mechanism to share risks in crisis conditions. Eurozone leaders cannot agree to a risk-sharing mechanism based on a democratically legitimate political contract. Under pressure during the crisis years, they agreed on technical agreements to share risks. These arrangements can be undone politically at an inopportune moment.” (Mody, p. 385)
Mody’s book provides an important lesson: policies imposed by political elites that are not endorsed by the public who are supposed to benefit from them have weak underpinnings. A crisis uncovers the flaws in the institutional architecture, and these exacerbate the impact of the crisis. The resulting tragedy affects everyone, not just those who promoted a solution to a problem that did not exist.