Euroskepticism is back in fashion

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I've always been slightly more euroskeptical than most mainstream economics pundits.  It's not that I thought it precisely probable that the euro would break down, but I thought it quite possible, given the internal tensions.  As I wrote for The Economist many moons ago, the euro area is far from an optimal currency zone:


Even before the euro was adopted, in 1999, it was clear that neither the EU nor the 12-member subset that has joined the monetary union was an optimal currency area. Ideally, currency zones should be compact and homogenous enough to show little regional variation in business cycles--otherwise a one-size-fits-all monetary policy will leave some regions lingering in recession, while others grow so fast they overheat. Many argue that this is what is happening in Europe, where a few countries, like Ireland, are experiencing rapid growth while big economies, like Germany and Italy, stagnate.

There are ways to mitigate imbalances within big currency areas. Even America is not an optimal currency zone; its regions sometimes boom or shrink out of sync with the rest of the economy. But America has important features that temper the problems of unified monetary policy. Federal programmes act as automatic fiscal stabilisers, siphoning off tax revenues from booming areas and transferring them to ailing regions as unemployment insurance or health benefits for the poor. America's labour market is also highly flexible. This allows wages and prices to adjust downward, giving depressed regions a competitive advantage that can attract new companies and thus smooth out regional disparities. And workers in declining industrial towns frequently pack up and move across the country to find work; capital flows freely as well. Without these mitigating factors, people in depressed areas could easily be trapped in a cycle of stagnation.

In Europe, by contrast, few mechanisms exist to bring the euro area's widely divergent business cycles into sync. The ECB has been trying to chart a middle course between slow- and fast-growing countries while establishing its credibility as an inflation-fighter. The result has been a monetary policy that is too "hot" for some, too "cold" for others, and "just right" for almost no one.

The lack of adjustment mechanisms means that "ever closer union" is not just a glowing ideal; it is a matter of survival. Language and cultural barriers--not to mention wide differences in social insurance and retirement programmes--encourage workers to stay in their own country, no matter how bad the economy, closing off one of the easiest avenues of convergence. If Europe's economies do not drive forward towards a single market, with labour markets that are more flexible (and international), there is a growing risk that some of its members will eventually find the gulf between their economies and their monetary policies too wide to endure.

Unfortunately for euro-boosters, recent policy moves have all been in the wrong direction. Not only has the stability and growth pact, which was supposed to help force fiscal policies into rough alignment, been weakened. Progress has also stalled on measures to widen market access, such as the EU's services directive. And fierce public resistance to eroding generous worker and consumer protections has made governments unwilling, or unable, to implement the kinds of deep structural reforms that could help. 

Those fissures have been deepened by the current fiscal crisis.  Countries like Italy, Spain, and Greece benefited from their membership in the euro because they didn't have to pay a premium for currency risk.  Italy, for example, used to use serial devaluations as an export stimulus, shoring up manufacturing industries like furniture and clothes.  Unfortunately, while euro membership has lowered Italy's borrowing costs, and made some business transactions easier, its manufacturers have struggled to make themselves competitive with an appreciating currency.

Those sorts of difficulties are multiplying rapidly now:

Now, in the middle of the worst economic downturn since the euro's birth, a new view is emerging -- especially as the creditworthiness of Greece, Spain and Portugal, one after the other, has been downgraded. The view is that the balm of euro membership allowed these countries to gloss over serious economic problems that have now roared to the fore.

"Membership is not a panacea for a country's social and economic problems," said Simon Tilford, the chief economist at the Center for European Reform in London.

"In fact, there has been a huge divergence in competitiveness that shows up in massive trade imbalances," he said, comparing Greece with the wealthier euro countries. "While Greece may have been insulated from the risk of a currency crisis, there is also the risk of a credit crisis and a collapse of confidence in its solvency."

While sharing a currency with some of the mightiest economies in the world helped Europe's poorer nations share in the wealth, a boon during boom times, in hard times the rules of membership are keeping them from doing what countries normally do to ride out economic storms, including enormous spending.

So Germany, France and the Scandinavian countries are mounting billion-dollar stimulus plans and erecting fences to protect their banks. But the peripheral economies are being left to twist in the market winds.

If the global recession deepens, and both fiscal and monetary stimulus remain closed to the eurozone's problem children, eventually their governments are going to have to make a stark and ugly choice between leaving the euro zone, or standing idly by while their economies crater and the rioting spreads.

It will probably take only one exit to start a sizeable exodus.  Much of the benefit of eurozone membership for those countries comes from the perceived integrity of the zone.  Once one member has exited, creditors are going to take a long, hard look at the remaining members.

It would help the euro zone a lot if the commission acted more like a central government--stepping in to help floundering members before they're forced towards default or defection.  But the systems aren't there for that kind of action--and the EU's ponderous structure is deliberately designed to prevent rapid central action.

I still wouldn't put anything like a 50% probability on a defection.  But I'd say it's a lot more probable today than it was three years ago.

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Megan McArdle is a columnist at Bloomberg View and a former senior editor at The Atlantic. Her new book is The Up Side of Down.

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