Why the Euro Isn't Worth Saving

A currency union for states this wildly different turns the most important economic lessons from the 20th century on its head.


[Reuters ]

Pop quiz, hotshot. You're the prime minister of Spain. It's 2005. Unemployment is at a two-decades low. Housing prices are booming. You're worried that they might be booming too much. You want to put a brake on the economy. You also hope to build up a rainy day fund for any possible bust. How big a budget surplus should you run?

If you've been following the biggest economic debate the past half century, you might think this question is besides the point. Haven't we learned that monetary policy, not fiscal policy, is the best way to manage the economy -- with the possible exception of when short-term rates are at zero? We have. But the irony of Europe is that a defective currency union reverses this logic. When one central bank sets interest rates for different countries with different economic needs and different budgets, it's fiscal policy that matters most. There's no other way to stabilize the economy.

Welcome to life in a suboptimal currency area. After all, countries that share a currency also share monetary policy. If they don't share fiscal policy too -- that is, there is no centralized treasury -- they can get into trouble. Just ask Europe. But as Christian Odendahl at The Economist points out, this also means that each individual country's fiscal policy becomes a much, much more important economic tool than it would otherwise be. Let's think about why this is, and what it says about the future of the euro.

As previously mentioned, monetary policy is usually the first, best, and only policy tool to stabilize the economy. It's quicker and more efficient than government spending. (Anything that cuts out Congress is usually a good idea). But all of that changes when it comes to the ECB. At best, the ECB runs a one-size-fits-one policy. Interest rates make sense for Germany, but not really for anybody else. At worst, the ECB runs a one-size-fits-none policy. Interest rates don't make sense for anybody: They're too low for Germany, but too high for Spain. So, rather than stabilizing the economy, monetary policy actually destabilizes the economy. The booms and busts both get bigger. It's left to each country to use government spending to temper both.

Which brings us back to our original question: How big should Spain's surpluses have been during its housing bubble days? In retrospect, they should have been huge. The logic is that less government spending would have helped cool its overheated economy. The bubble might not have been quite as bad. But only quite. And, again, this was necessary because of the euro. Spain couldn't just raise interest rates to slow down its economy because Spain couldn't raise interest rates. 

It shows us how unworkable the euro is in its current form. Not that the crisis hasn't already shown us that many times over. It would have required something approaching inhuman clairvoyance -- or at least Michael Burry-level clairvoyance -- for Spain to have run "big enough" surpluses in the mid-aughts.  If Spain's government had been that prescient, they may as well have shorted themselves. Now, I'm being a bit facetious, but let's remember: this wouldn't have "saved" Spain. Even counter-cyclical fiscal policy during the boom only would have ameliorated the subsequent slump. Spain would still have a competitiveness problem today. Unemployment would almost certainly still be disastrously high.

I'm not breaking news when I tell you that Europe doesn't have the institutions it needs to make the euro work. If it did, there wouldn't be a crisis. Unfortunately, Europe's leaders aren't making much progress on these larger issues. People often say that the costs of a euro breakup would be astronomically high. They are certainly right. But the costs of living with the euro? They're already astronomical.