The euro is as much a political exercise as economic. The Eurozone is probably not an OCA, so its existence can largely be attributed to noneconomic factors. How will it fare in the future?
a. Euro-optimists
Euro-optimists make several points: (1) The euro has already been fairly successful. (2) The zone itself will encourage further integration, so the cost of the euro will fall over time—although there is little evidence for this. (3) They have faith the ECB will continue to be independent and be successful in maintaining price stability. (5) The euro is increasingly being used as a reserve currency by other countries. (6) Following Monnet, they argue that Europe has no imaginable political future without a common currency.
The euro project must be understood at least as much in political terms as in economic terms. We have seen how the OCA criteria can be used to examine the logic of currency unions, but in the case of the EU these are not the whole story: Europe does not appear to satisfy the narrow definition of an optimum currency area. In contrast, some of the most important criteria for the survival of the euro may relate to the non-OCA criteria that were included in the Maastricht Treaty. How well can the euro hold up in the future? Even after the crisis, both optimistic and pessimistic views persist.
Euro-optimists For true optimists, the euro is already something of a success: it has functioned in a perfectly adequate way (apart from a crisis that has troubled many other countries too) and can be expected to become only more successful as time goes by. More countries are lining up to join the Eurozone. Even if there are costs in the short run, the argument goes, in the long run the benefits will become clear.
Optimists tend to stress that the OCA criteria might be self-fulfilling. In the long run, they believe the euro will create more trade in the Eurozone. It may also create more labor and capital mobility. They downplay the risk that shocks will become more asymmetric, or at least think this will be outweighed by greater market integration. This will enhance the Eurozone’s claim to be an OCA. Since the euro is only a few years old, data are scarce, and these claims can be neither proved nor refuted decisively at present. However, the little evidence we have suggests that although labor mobility has not changed much, goods and services trade in the Eurozone is rising (even if no faster than outside) and that capital market integration has perhaps improved even more dramatically, as measured by the increase in cross-border asset trade and FDI flows in the Eurozone.16
Optimists also tend to believe that the ECB will prove to be a strong, credible, independent central bank that can resist political interference or the temptation to print money for the sake of expediency. On paper, the ECB certainly has such characteristics, with a very high degree of independence compared with other central banks. Again, the costs of a common currency may be large in the short run, but as long as the ECB can deliver on its low-inflation target, the optimists reckon it will, in the end, command the respect of the peoples and politicians of the Eurozone.
At a global level, optimists note that the euro is increasingly becoming a reserve currency for foreign central banks, a vehicle currency for trade, and is now the dominant currency used in international bond markets. These developments show the market’s confidence in the currency and also augur well for the future, since trade and financing costs may be expected to fall as the euro becomes more widely used around the globe.
Finally, like the “father” of the European Union, Jean Monnet, the optimists believe that the adoption of the euro, like entry to the EU itself, means “no going back”: there is simply no imaginable political future for Europe apart from union. Neither the euro nor the EU has exit mechanisms. Perhaps such an idea was inconceivable to the institutional designers. For true believers, the EU project ultimately rests on a deep belief in the political logic of the process and in a presumed common destiny for the peoples of Europe. For them, the great crisis and economic suffering of the present are not a major concern: even if there are large costs to be shouldered in the short run, optimists believe that the long-run gains will make it all worthwhile.
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Martin Wolf argues in 2013 that the euro is temporarily out of danger, but surveys problems that threaten its long-term survival.
b. Euro-pessimists
Euro-pessimists make several points: (1) The euro is not making much impact on the level of trade. (2) Labor mobility will remain low. (3) There is popular resistance to further integration. (4) Without political support, the main reason for the euro’s existence disappears. (5) There is evidence of asymmetric macroeconomics shocks within the EU. (5) What if countries run fiscal deficits? They can’t inflate or devalue themselves, so they might start lobbying for inflation, which would undermine the credibility of the euro. (6) The recent crisis reveals the monetary and fiscal tensions of imposing a monetary union over a continent with so many economic, political, cultural and linguistic differences. These tensions will both reduce economic growth and create policy conflicts if the euro survives, or they will lead to the dissolution of the Eurozone.
c. Summary
The political dimensions of the euro may trump purely economic ones. However, the expansion of the Eurozone weakens the OCA case for the euro and makes the ECB’s governance more complicated. There is a risk of a clash between the fiscal needs of governments and the policy goals of the ECB. Many Europeans remain unconvinced that the euro is desirable. It is still an experiment.
As the Eurozone crisis continued into 2013, Martin Wolf of The Financial Times summarized the dismal situation.
Is the eurozone crisis over? The answer is: “yes and no”. Yes, risks of an immediate crisis are reduced. But no, the currency’s survival is not certain. So long as this is true, the possibility of renewed stress remains.
The best indicator of revived confidence is the decline in interest-rate spreads between sovereign bonds of vulnerable countries and German Bunds. Irish spreads, for example, were just 205 basis points on Monday, down from 1,125 points in July 2011. Portuguese spreads are 465 basis points, while even Greek spreads are 946 basis points, down from 4,680 points in March 2012. Italian and Spanish spreads have been brought to the relatively low levels of 278 and 362 basis points, respectively. [1 basis point = 0.01 percentage points.]
If all members of the eurozone would rejoin happily today, they would be extreme masochists. It is debatable whether even Germany is really better off inside: yes, it has become a champion exporter and runs large external surpluses, but real wages and incomes have been repressed. Meanwhile, the political fabric frays in crisis-hit countries. Anger at home and friction abroad plague both creditors and debtors. Behind this improvement lie three realities. The first is Germany’s desire to keep the eurozone intact. The second is the will of vulnerable countries to stick with the policies demanded by creditors. The third was the decision of the European Central Bank to announce bold initiatives—such as an enhanced longer-term refinancing operation for banks and outright monetary transactions for sovereigns—despite Bundesbank opposition. All this has given speculators a glorious run.
Yet that is not the end of the story. The currency union is supposed to be an irrevocable monetary marriage. Even if it is a bad marriage, the union may still survive longer than many thought because the costs of divorce are so high. But a bad romance is still fragile, however large the costs of breaking up. The eurozone is a bad marriage. Can it become a good one?
A good marriage is one spouses would re-enter even if they had the choice to start all over again. Surely, many members would refuse to do so today, for they find themselves inside a nightmare of misery and ill will. In the fourth quarter of last year, eurozone aggregate gross domestic product was still 3 per cent below its pre-crisis peak, while US GDP was 2.4 per cent above it. In the same period, Italian GDP was at levels last seen in 2000 and at 7.6 per cent below its pre-crisis peak. Spain’s GDP was 6.3 per cent below the pre-crisis peak, while its unemployment rate had reached 26 per cent. All the crisis-hit economies, save for Ireland’s, have been in decline for years. The Irish economy is essentially stagnant. Even Germany’s GDP was only 1.4 per cent above the pre-crisis peak, its export power weakened by the decline of its main trading partners.
What, then, needs to happen to turn this bad marriage into a good one? The answer has two elements: manage a return to economic health as quickly as possible, and introduce reforms that make a repeat of the disaster improbable. The two are related: the more plausible longer-term health becomes, the quicker should be today’s recovery.
A return to economic health has three related components: write-offs of unpayable debt inherited from the past; rebalancing; and financing of today’s imbalances. In considering how far all this might work, I assume that the risk-sharing and fiscal transfers associated with typical federations are not going to happen in the eurozone. The eurozone will end up more integrated than before, but far less integrated than Australia, Canada or the US.
On debt write-offs, more will be necessary than what has happened for Greece. Moreover, the more the burden of adjustment is forced on to crisis-hit countries via falling prices and wages, the greater the real burden of debt and the bigger the required write-offs. Debt write-offs are likely to be needed both for sovereigns and banks. The resistance to recognising this is immensely strong. But it may be futile.
The journey towards adjustment and renewed growth is even more important. It is going to be hard and long. Suppose the Spanish and Italian economies started to grow at 1.5 per cent a year, which I doubt. It would still take until 2017 or 2018 before they returned to pre-crisis peaks: 10 lost years. Moreover, it is also unclear what would drive such growth. Potential supply does not of itself guarantee actual demand.
Fiscal policy is contractionary. Countries suffering from private sector debt overhangs, such as Spain, are unlikely to see a resurgence in lending, borrowing and spending in the private sector. External demand will be weak, largely because many members are adopting contractionary policies at the same time. Not least because it is far from clear that the competitiveness of crisis-hit countries has improved decisively, except in the case of Ireland, as Capital Economics explains in a recent note. Indeed, evidence suggests that Italian external competitiveness is worsening, relative to Germany’s. Yes, the external account deficits have shrunk. But much of this is due to the recessions they have suffered.
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Meanwhile, the financing from the ECB, though enough to prevent a sudden collapse into insolvency of weak sovereigns and the banks to which they are tied, required rapid fiscal tightening. The results have been dismal. In a recent letter to ministers, Olli Rehn, the European Commission’s vice-president in charge of economics and monetary affairs, condemned the International Monetary Fund’s recent doubts on fiscal multipliers as not “helpful”. This, I take it, is an indication of heightened sensitivities. Instead of listening to the advice of a wise marriage counsellor, the authorities have rejected it outright.
Those who believe the eurozone’s trials are now behind it must assume either an extraordinary economic turnround or a willingness of those trapped in deep recessions to soldier on, year after grim year. Neither assumption seems at all plausible. Moreover, prospects for desirable longer-term reforms—a banking union and enhanced risk sharing—look quite remote. Far more likely is a union founded on one-sided, contractionary adjustment. Will the parties live happily ever after or will this union continue to be characterised by irreconcilable differences? The answer seems evident, at least to me. If so, this unhappy story cannot yet be over.
Source: Martin Wolf, “Why the euro crisis is not yet over,” Financial Times, February 19, 2013. From the Financial Times © The Financial Times Limited 2013. All Rights Reserved.
Euro-pessimists For true pessimists, the preceding arguments are not convincing. Market integration will not radically change because the impact of the euro on (already high) intra-EU trade levels will be small. Because cultural and linguistic barriers will persist, labor migration will be limited and held back even more by inflexible labor market institutions in most countries. In all markets, regulatory and other frictions will remain.
Moreover, there is resistance to further economic integration. In 2005 an EU directive to liberalize services proved unpopular in many countries and contributed to the failure of referenda on the proposed EU Constitutional Treaty in France and the Netherlands. In many countries, the implications of a single market in all dimensions (goods, services, labor, capital) are only now being dimly understood. Governments and the Commission disagree about how far the process should go.
If integration stops for lack of political support, a key economic rationale for the euro unravels. If political support for the EU stalls, then the political logic is weakened. If some countries press ahead for a closer, more highly integrated union of countries while others stand aside, the sense of a common destiny among all EU nations will be undermined.
On the other key OCA criterion, pessimists note that there is often wide divergence in the countries of the Eurozone. Low-growth, low-inflation countries tend to want looser monetary policy. High-growth, high-inflation countries tend to want tighter monetary policy. If different countries desire very different policies from the ECB, tensions may rise and governments may lose respect for the ECB’s independence.
The euro could also be threatened by fiscal problems. The rules say governments cannot lobby the ECB for low interest rates or high inflation to make their debt payments lower or to reduce the real value of their debts, nor can they urge a weaker euro to promote growth. But as history has typically shown, governments tend to trump central banks and will push them around if times get tough. Pessimists note that the Maastricht fiscal rules have evaporated and the Stability and Growth Pact has been emptied of meaning. If some states lobby for loose money, more fiscally prudent or inflation-averse nations will object, and the resulting fight will cause uncertainty and undermine the credibility of the euro. As the fiscal problems of countries mount after the 2008 crisis and double-dip recession in 2011–13 these tensions may rise.
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Prior to the crisis, the ECB was continually voicing its concerns about fiscal dangers, but with seemingly little effect on member states’ behavior. For example, in November 2005 the ECB asserted its power to deny Eurozone banks the right to use government bonds as collateral if those bonds’ credit rating fell too low; but as soon as this vow was put to the test after the 2008 crisis, the ECB caved in and continued to lend against peripheral country government debt of declining quality to prevent crises. The ECB then joined in the fiscal rescue of May 2010 by pledging to fund part of the rescue program, thus stepping farther away from its “no bailout” position. In 2012 the ECB said it would do “whatever it takes” to save the euro, launching the Outright Monetary Transaction bond-buying program, which has yet to be deployed. However, the extent of the Outright Monetary Transaction commitments, their terms, and the conditions under which they will be undertaken remain unclear, and such bond-buying programs are still viewed by some policy makers with suspicion, especially in Germany.
As the crisis drags on, pessimists see no end to the monetary and fiscal policy tensions inherent in trying to impose a monetary union on a region with too many economic, political, cultural, and linguistic differences. At best, even if the euro survives, pessimists believe the region will suffer slow growth and ongoing internal policy conflicts. At worst, the tensions could cause the breakup of the Eurozone into blocs or the reintroduction of the former national currencies.
Summary On the upside, the political dimension of the EU might yet carry the day in the long run, despite current setbacks; in the medium run, the OCA criteria might turn out better than one might think; and even if they don’t in the short run, the Eurozone can still survive and function, a workable albeit economically costly currency union.
On the downside, EU enlargement undercuts the OCA logic in the short run and could make the ECB’s governance more cumbersome and make resolution of conflicts more difficult. As the member states of the Eurozone cope with severe fiscal problems, there is a significant risk of a clash between the fiscal goals of the governments and monetary goals of the ECB; and should the current crisis intensify (e.g., should any member country default or desire to leave the euro) the project would be in uncharted waters.
What do the people think? The results of successive Eurobarometer polls indicate that at the best of times only about 50% to 60% of the citizens of the Eurozone have thought that the euro has been beneficial. In some countries that figure is higher, in some lower. Since the crisis began, support has fallen from even these lukewarm levels, especially in the hard-hit peripheral countries. The euro remains an experiment—its arrival did not mark the end point of European monetary history, and its long-run fate is not entirely certain.
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