Can the Euro Survive?
In recent months bonds issued by some “peripheral” countries in the Eurozone have fallen sharply in price, and have thus borne much higher yields than the bonds of the benchmark country in Europe, Germany. Does this have any implications for the future of the Euro? The answer of course depends on why it has happened. Was it the result of irrationality on the part of the private sector – irrational pessimism? Was it caused by idiosyncratic factors, specific to each country? Or does it reflect flaws in the design of the Euro itself?
Mass irrationality is always possible, and should not be dismissed out of hand. There was, after all, quite a lot of irrationality in the boom preceding the recent banking crisis. But this time is different. In the boom while many in the private sector were indeed irrational, some were not. And as for the public sector, by and large it too was fooled. But this time the private sector is of one view – there is something wrong in the peripheral economies that was largely produced by the design of the euro – and the public sector, while accepting that some of these economies have problems, does not concede that for them all, and defends the design of the euro as requiring at most a little tinkering.
Mass irrationality is unusual, so it is set aside for the moment, to consider whether there may be fundamental problems with the euro.
But these countries are all different
A perfectly valid objection to those who say there are problems with the design of the euro is to reply that the problems in the countries under threat are not all the same. But every person with a particular illness does not exhibit exactly identical symptoms. The problems in these countries’ bond markets, although produced by different proximate causes, may have common roots.
What are the proximate causes? These are summarised briefly, recognising that this does not do full justice to their complexity so as to allow rapid progress to the main arguments.
Greece has a lavishly financed public sector and low tax collections. Expenditure exceeded revenue, and there was no sign that revenue was going to catch up. Ireland’s banking sector had expanded rapidly, made terrible loans in the process, and these loans, when the government took them on to protect the country’s banks, nearly overwhelmed the government’s finances. Portugal experienced a tremendous private sector credit boom in consequence of low interest rates and relaxation in lending criteria, so that the private sector collectively seemed unlikely to be able to pay its debts. This threatened the banking system, and in combination with a downturn this threatened the government’s finances. And Spain was similar to Portugal, except that the private sector bad debts were particularly concentrated on property, both residential and commercial.
Despite these differences, there were also common factors. Joining the Euro enabled every one of these countries to borrow at interest rates almost as low as those for the core. And many of them had much slower rates of productivity growth in the private sector than did the core members of the Eurozone.
A Common Cause?
In thinking about whether there was a common cause behind these similar but far from identical problems it is useful to look back at the beginnings of the Euro. No doubt some saw it as a political project, a step towards Europe’s becoming a single country. For those, no economic discussion seemed necessary. But many others wanted to consider economic factors, either because they saw the project as an economic one purely, or because while they shared the goal of Europe’s becoming a single country they wanted to see if the separate countries were as yet ready to have a single currency.
The body of analysis brought to bear was Optimum Currency Area theory. This theory, first enunciated by Robert Mundell in 1961, can be neatly summarised as follows.
“The crucial tradeoff identified by Mundell is, according to my own textbook (McCallum, 1996, p 258) that ‘an extension of the area over which a single currency prevails enhances microeconomic efficiency but reduces the possibility of monetary policy responses to shocks (or conditions) that affect various sub-areas differently. The wider the area, that is, the greater are the efficiency benefits of possessing a single medium of exchange and medium of account, but the smaller the area, the greater are the possibilities of tailoring monetary policy to (temporary) local needs. Somewhere between one currency for the entire world and one for each country (or for each city, or neighbourhood…) lies the optimum.” (McCallum, 2003, p8)