Europe and the Euro

"It was – the article was written in 2007. I chose it because I thought it was important to include something on the topic of whether the euro area could break up, since this is what is currently on everyone’s minds. I think it’s accurate to say that this article is still the only semi-serious piece of scholarship on the issue. Alesina and Giavazzi asked if I would write on it for a project they were organising. So the idea that no one foresaw this possibility is not entirely right – my editors did. The commission forced me to sit down and think hard about scenarios. The conclusion I reached was that countries with serious financial problems – like Greece – and, equally, countries fearing that they would have to pay for those financial problems – like Germany – would both be extremely reluctant to abandon the euro. Doing so would be equivalent to abandoning the whole European project, which, for political reasons, I regard as bordering on the inconceivable. Also, if a crisis country abandoned the euro in order to reintroduce its own national currency with the goal of restoring its competitiveness, it would be creating more problems for itself than it solved. The more I contemplated scenarios of possible exits from the euro, the more I concluded it wouldn’t happen. Rarely does an academic have the privilege of a real-time test of his hypothesis. With the benefit of that test, I would now say that I was both right and wrong. I was right in that, yes, if the Greek government were to announce tomorrow that it had decided to reintroduce the drachma, it would precipitate the mother of all financial crises. Everyone would know that its intention was to depreciate the new drachma, so in the first minute everyone would rush to get their money out of the country, out of its banks, and out of its bond market. The result would be the biggest bank run and financial crisis the world has ever seen. This danger is a formidable deterrent to even contemplating going down this road. So I think the argument I made in 2007, that attempting to exit the euro area would be the equivalent of burning down your own house in order to find a way out, was exactly right. I was wrong in that – as Paul Krugman observed in 2010 – if the house is burning down anyway, then the normal advice not to play with matches loses much of its force. If there’s a run on your banking system anyway, then the deterrent to action no longer applies. If there’s a run on your banking system and you have to close down your banks and financial markets anyway, you may want to take that opportunity to reintroduce your own currency. I still don’t think that things will be allowed to get to that point, but I no longer attach a zero probability to a country exiting the euro – just a close to zero probability. Never say never, but I still believe that the euro is an example of a path-dependent historical process that is unlikely to be reversed. It’s worth observing that even in the midst of a crushing recession, a majority of Greeks are still in favor of keeping the euro. While Germany is the country that faces the fewest technical obstacles to exiting the euro, I think it faces, if anything, the most political obstacles. That’s why the Judt book and the Marsh book are important – both explain how the European project is central to the German political psyche. That’s the point. Every time the German public and press get upset about the prospects of another bailout, Mrs Merkel gives voice to their views. But then she backs down. In doing so she is, in effect, acknowledging how deeply invested Germany is in the European project. This response may seem odd in the midst of a rolling crisis, but on balance I still think that it was. I would have been happier, obviously, if more attention had been paid to domestic budget-making institutions so that euro-area governments wouldn’t have got into the mess they’re now in. But the last decade would also have been very difficult for Europe without the euro. There would have been chaos in foreign exchange markets after 9/11 , after the Madrid train bombings, and after Lehman Brothers. Things may have gone badly for the euro in the last four years, but they might have gone even worse for Europe in its absence. I’m still inclined to the view that the decision to go ahead with the single currency was right. It was doing so without at the same time pressing ahead with domestic reforms that was the mistake. And bad shocks might have come along in the interim. So if you wait and then get thrown off-course by disturbances to financial markets, you may never get to the destination. That depends on what you mean by a single market. We have a reasonably integrated product market between the US, Canada and Mexico, but we’re not going to have a single North American currency in my lifetime, or yours. But whereas integration in North America is limited to product markets, Europe’s extends to capital and labour markets. And the further integration extends, the greater the political problems that arise when currencies move. The distribution impacts are greater. So it’s not so much that a single market needs a single currency for economic reasons, as a single market needs a single currency for political economy reasons. Europe first experienced the problem when its agricultural markets began to be integrated and then exchange rates moved – all sorts of difficulties arose, and the problems only deepened after that. As integration became more extensive, the disruptions to people’s lifestyles and security that could be caused by a currency shift became more serious. The euro area is not an optimum currency area in the sense of the members experiencing the same economic shocks. Europe doesn’t have as much labour mobility as it might. It doesn’t have the kind of fiscal transfers that Professor Mundell, when he developed the theory, pointed to as important. But I don’t think that the question of whether a collection of states satisfying the optimum currency area criteria admits a simple yes or no answer. The US may be closer than Europe to satisfying Professor Mundell’s criteria, but even it falls short of being a true optimum currency area. Consider the limits of fiscal federalism in the United States. Look how the budgets of certain states are disproportionately constrained. Look at how the so-called sand states – California, Arizona, New Mexico and Florida – suffered much bigger shocks than the rest of the country in 2008 and 2009. The question is not whether Europe is an optimum currency area. It’s whether it comes reasonably close to that standard, and whether it will come still closer with the passage of time. I continue to believe that the end result of the crisis will be a more deeply integrated Europe. History tells us this. But history also tells us that it will take a long time to forge it. This interview was published in 2012"