Winner of the New Statesman SPERI Prize in Political Economy 2016

Thursday 18 July 2013

The Eurozone’s Founding Mistake

It really was predictable. Take away the ability to control national interest rates, and you create a potential for patterns of demand to diverge, leading to movements in competitiveness that would have to be painfully unwound later on. The good news was that you could use countercyclical fiscal policy to moderate these movements - an entirely conventional macroeconomic idea. But it was not what the architects of the Euro wanted to hear.

This is how my paper just published in Global Policy starts. So instead of countercyclical fiscal policy, we got an obsession with budget deficits and the possibility of fiscally profligate governments. Even with this obsession the Eurozone failed to spot its one member that was behaving in this way until it was too late. But in looking in the wrong direction, the Eurozone allowed just the kind of competitiveness imbalances to take place that fiscal policy might have been able to do something about.

This is not wisdom from hindsight. Before the Euro was established, I was among a large group of economists suggesting that fiscal policy should be used countercyclically by Eurozone members. That work continued after the Euro was established: here and here are just two examples. It had no impact on policy. There was a lot we did not foresee. It is particularly ironic that the first major asymmetric shock to hit the Euro area, that would cause these large competitiveness imbalances, was arguably a consequence of the creation of the Euro itself. But the point remains that a method of handling these things, which was entirely conventional in macroeconomic terms, existed and was ignored.

Now in saying this I find myself in the rather unusual position of disagreeing with Martin Wolf. He has argued (here for example) that a country like Spain could not have done more in terms of fiscal policy to counteract its housing boom. I have heard many others make the same point - you think Spain should have been running even larger surpluses? they ask incredulously. The answer is simply yes: by looking at fiscal surpluses you are looking at the wrong indicator. Here is what happened to consumer price inflation from 2000 to 2007.

Euro area average

Inflation was significantly above the Euro area average year after year. If the average inflation rate had been 10%, or even 5%, this might not have been a big deal, but when the inflation target was 2% or less, that makes reversing these trends very painful. Looking at budget surpluses during a property led domestic boom can be very misleading, as Karl Whelan argues in the case of Ireland.

There may be many reasons why the Eurozone ignored this advice. One was probably a belief among some that countercyclical fiscal policy was either ineffective or dangerous. (The ordoliberal logic on this has never really been spelt out, and it seems more like an article of faith.) Another was an almost mystical belief that the creation of the Euro would diminish the importance of asymmetric shocks or the extent of asymmetric structures.[1] Yet another was a view that the far greater danger lay in the reduced fiscal discipline that being part of the Euro would bring, and any countercyclical role would only encourage this ill discipline. Yet we now know (and I do not think anyone really foresaw this) that this last argument is completely wrong. Not having your own central bank means that market discipline on Euro members’ fiscal policy will be much greater, once it is understood that national default can occur.

I do not think this point has sunk in yet among many macroeconomists. The standard line, backed by academic papers, was that joining a common currency would reduce market discipline on fiscal policy. Yet that analysis ignored default, and the possibility of a bad equilibria generating a self-fulfilling crisis. Countries will not forget the events of 2010-12 in a hurry, so the danger now is that we have too much, not too little, market discipline influencing fiscal policy. 

Ironically, the architecture of the Stability and Growth Pact sent all the wrong signals. By stressing the dangers that individual countries might free ride on the Eurozone, it suggested that such actions might be in the national interest for any country that could get away with it. That is why attempts to control national budgets at the Eurozone level can be counterproductive as well as unnecessary. It is far better to build national institutions that can make sure countries develop appropriate fiscal policy which is in their national interest. In an ideal world the Commission might play a coordinating role, but given its current mindset it would be best if it just stayed out of the picture.

So while the details of the Euro crisis were not foreseen, the palliative medicine that would have made that crisis much more manageable was available, but those in charge decided not to take it. What turns this serious policy error into a tragedy is that policy makers continue to make the same mistake. The Fiscal Compact is exactly the opposite of what the Eurozone requires right now. (I have cited the Netherlands as a clear example of this.)

This makes me both optimistic and pessimistic about macroeconomics as a discipline. Optimistic because the subject has so much potential to do good: basic ideas, long understood, yet clearly not obvious to some, can help prevent disaster. (Those who claim that macroeconomics is the weak point of the economics family should take note.) Pessimistic because even when those disasters occur, the macroeconomic wisdom continues to be ignored.  

[1] If anything, formation of a currency union should allows greater national specialisation, which of course has the opposite effect.  


  1. Some people outside the mainstream did foresee the euro crisis in detail. See:

    1. I see all four of those cited in that article and who warned of the coming Euro problems were leading MMTers. (Punches air with right hand.)

    2. This comment has been removed by the author.

    3. Peter Kenen, as a founding father of Optimal Currency Area (OCA), correctly predicted the correct mechanism of the euro's collapse all the way back in 1969.

      Peter Kenen in his own words:

      "The third implication pertains to the need to use national fiscal policies to cope with the imperfect fit between the single monetary policy of monetary union and the needs of its individual members. At one time, I believed that a monetary union should be accompanied by some sort of fiscal union. Indeed, my 1969 paper on OCA theory said so and made two related points.

      First, the income-based federal tax system in the United States cushions the effects of expenditure-switching shocks, because it leads automatically to fiscal transfers from households and firms in prosperous regions to households in firms in depressed regions. Second, this method of cushioning the effects of shocks is clearly superior to either built-in or discretionary stabilisation at the regional level. Interregional transfers via the federal fiscal system are not likely to have large effects on the fiscal stance of the federal government. Therefore, they are not likely to cause significant changes in stocks of government debt. If instead regions or states had to conduct contra-cyclical fiscal policies, those in depressed regions would have to borrow and issue debt, and they might find it hard to do that when faced with long-lasting shocks."

      The paper Kenen is referring to is "The Theory of Optimum Currency Areas: An Eclectic View", in Mundell and Swoboda (eds), Monetary Problems of the International Economy, Chicago University Press, 1969.

      Krugman has cited Kenen as the prophet of eurodoom on his blog no less than six times:

    4. Before this 'who predicted what' thing gets out of hand, please note that I am not saying that the Euro idea was always doomed, or that the only thing that would work would be a fiscal union. In fact, I argue in the paper I reference that a fiscal union right now would be a bad idea. What I am saying is that a monetary union might well work if it includes countercyclical fiscal policy set at the national level, alongside OMT.

  2. Re those inflation figures for Ireland, Spain, etc that Prof. Simon gives, as far as I can see, the reduced competitiveness of periphery countries that that caused is not being reversed despite the severe deflation currently being imposed on the periphery. At least that seems to be the case given the figures here:

    So my conclusion is that the Euro might as well be abandoned, unless I’ve dropped a clanger somewhere.

    1. Ralph - While numbers for relative unit labour costs tell a similar picture to the CPI for the loss of competitiveness up to 2007, I think they give a more optimistic view of what has happened since. But I have not really investigated why there is this difference.

      On the MMT thing, I guess what I'm saying is that if countercyclical fiscal policy had been there from the start, the Eurozone would have worked much better. Would MMT people have agreed with this, and if not, why not?

    2. Simon,

      I don’t think MMTers have any brilliant ideas on the EZ. Bill Mitchell keeps railing against high unemployment in the periphery and advocates fiscal stimulus here:

      Warren Mosler (who made a large fortune out of bond trading) has his own quirky “Mosler bond” solution, which I don’t understand. See:

      But it strikes me that any sort of stimulus for the periphery, desirable as that would be on social grounds, just slows down the rate at which the periphery regains its competitiveness.

  3. So national political authorities should control national inflation? Two objections:
    1. the very reason we created central banks, independent of political influence, was because we did not trust political authorities to do the job of controlling inflation appropriately
    2. in a currency union, controlling your own national inflation is not sufficient: you can well keep your inflation at 2%, but if another member pushes its inflation to, say, 1% (as Germany did, measured with GDP deflator), we will still see large imbalances, so there is a co-ordination problem.
    What do you think?

    1. If you keep your inflation at the standard/average rate you will remain competitive relatively speaking (providing that is the only factor that influences that, which of course it is not). In your example you will get less competitive vis-a-vis Germany but more competitive vis-a-vis the rest.

      If you donot have an own CB you need other institutions and other methods as a consequence of that. And these will likely be less effective than an own CB. But it is the only way to control national inflation in a monetary union set up like the EZ.
      And yes it all confirms that political authorities usually do a crap job on that and that the reasons why it is moved to CBs were pretty good ones. And yes it is another fundamental weakness of the EZ set up, it leaves the control of relative inflation with the political authorities,(who usually do a crap job on it as here confirmed as basically nothing was controlled). It is they only alternative possible, well next to doing nothing what has happened here.

  4. I would have said that we created independent central banks so that inflation control came with lower opportunity cost. Do the facts support a view that UK governments could not be trusted to control inflation when it became excessively high (begging the odd question there)? I think that on the whole they did (pre-1997) but sometimes at enormous cost to the real economy.

  5. Joe Stiglitz called the current Eurozone "an automatic destabilizer".

  6. The EZ was set up with probably as main principle the 'no bail out clause'. It was the only way it could be sold to the respective populations in the North at that time.

    If one would start from scratch from there it would mean that the member countries should have adopted changes in their fiscal monetary (what was left) and bankregulation policies to accommodate the change in the set up of its monetary system. Adjust unbalances asap and often in another way. RE bubble, simply by eg making borrowing for purchase more complicated or expensive or via taxation.

    This was not done. The rules, including the no bail out were seen as basicaly dead. Plus politics especially in the South lived by 'apres nous le deluge' rules, as already expected in any pub in the North of Europe.

    The question comes up if adjusting policies to fit the EZ set up would have made membership very attractive. Anyway the South went for low interest rates and international status. The latter as they always have seen themselves and were seen by top league countries as well, as second league at best.
    Gambling on the de facto abolishing of the no bail out rule was a high risk move. This is stuff that goes over popular platforms in countries that have to come up with the bacon. And you donot need a crystal ball to know that that would be difficult.
    Plus gambling that nothing would happen of course. Effectively pure adolescent (the state of institutional development they were/are in) behaviour. Looking for the borderline and being astonished when thing end bad.

    You have to be very careful with things as a monetary union member (with no transfer possibilities). No overborrowing by the state or anybody else. No overexposed (RE mainly, but also dodgy Southern countries as the bookkeeping rules are so beneficial) banking sector. Watch your inflation, competitiveness, borrowing abroad, etc.
    It simply didnot happen.
    React faster as the alternative instruments are more limited and often less effective.

    And the North being totally naive believing that it would be managed well in the South (while all indicators were pointing in another direction) and it would not cause them problems anyway because of the no bail out clause.

    Some loose remarks.
    -Not understanding that non-printing countries can go bust is simply naive and clumsy (with eg Latino American CBs going bust (because of USD loans).
    -Hard to see if now rules can be fabricated that makes the thing work in the future.
    -Hard to see that the South keep going for 'so called' austerity for a decade or 2 more.
    -Hard to see the North going for permanent transfers. If it will lead to official spending (not Off BS stuff like now) requiring cuts at home (because dome other brilliant EU legislation) the party ill get really started.
    -Hard to see the North and the South becoming much more compatible so that disasters are less likly to occur.

    The EZ set up (well a set up very similar to the EZ) worked well between Germany, Holland, Austria and a few others even with a lot less rules and possibilities. Simply because of compatibility. Compatibility is clearly an important issue. Northern countries worked from the gentlemen's agreement concept, that worked as said. With the South a similar arrangement is not possible. As every frequent visitor of a North European pub could have told you.

  7. Great article!

    Great comments!

    Thank you!

    (Un)Fortunately might be deeper than just MacroEconomics Knowledge!

    In Portugal Carlos Carvalhas (former leader of Communist Party), Ferreira do Amaral (Socialist Area) and Miguel Cadilhe (former Finance minister, right win) all of them warned about the EURO. The second was specially strong with the point "Another was an almost mystical belief that the creation of the Euro would diminish the importance of asymmetric shocks or the extent of asymmetric structures."

    Then and I still think EURO is a good public good!

    What is failing is the defective system to make collective decisions on larger communities of homo sapiens sapiens!

  8. This article is only addressing one half of the picture - it's simply missing the other half, the key point that explains most of the problems that the euro periphery is currently undergoing.

    Yet Paul Krugman did underline it recently; on July 6 he referred the:

    "...De Grauwe point, which was imperfectly grasped in 2003 - the crucial importance of having your own central bank as lender of last resort for sovereign borrowing".

    This is the element that the periphery threw out in 1999, when it joined the ill-advised monetary union.

    And of course, the usually excellent Krugman could have put it even better if he had added something like this: "long before De Grauwe, the post-keynesian school known as MMT had already grasped the crucial importance of keeping your own central bank as lender of last resort; indeed, it's a fundamental tenet of their school - that was, until recently, sadly absent from the mainstream".

    1. "...that was, until recently, sadly absent from the mainstream."

      I gather you don't consider Henry Thornton (1802), Walter Bagehot (1873) or Milton Friedman and Anna Schwartz (1961) to be mainstream.

  9. Was the euro a disaster waiting to happen? Maybe. But is it really about fiscal policy?
    Avoidable mistakes have been made and the euro had the bad luck of being born during an epic credit and housing boom (not just in the euro area) and the Lehman moment.
    What if the following would have been different:
    - Countries with higher than 60% debt would not have been allowed eurozone entry, as stated in the Maastricht treaty. This would at least have prevented the currently troubled countries Italy and Greece access.
    - Housing booms would have been identified by central banks, economists and politicians, and counter measures would have been taken to cool them down. This would have saved Spain and Ireland.
    - less overleveraged banks and more understanding of the risks these pose with policy makers and economists. This would have prevented the current zombie banks.
    - better understanding of the international interconnectedness of financial system and the risks of this, potentially preventing the Lehman moment.

    Would a system shock, that the euroarea can't handle, even have been possible if all of the above would have avoided? And even if it would have happened, maybe debt default would have been possible for troubled countries, as for example now with Detroit in the US.
    Would fiscal policy really be needed for the euroarea under these different conditions?

    1. I'd argue the Eurozone itself added to the epic credit and housing boom. The Euro is not a neutral variable by any means, as your words "bad luck" seem to imply.

    2. non eurozone countries like the UK and USA had a similar credit boom, housing bubbles, overleveraged banks, highly indebted consumers etc.
      And many more countries in the world, we all turned Japanese.

  10. Simon, I agree that there existed a fiscal policy so tight that it could have offset the impact of the capital inflows which financed the boom in the Spanish non-tradable sector. But the fiscal surplus would have had to be enormous.

    It is inconceivable that the Spanish authorities would have been able to sustain such a surplus, particularly when many Spanish people denied that the boom was unsustainable (as I well remember). The argument made was that the high growth of real wages (and so high inflation) was due to economic catch-up. (The argument was obviously false: productivity growth in Spain was very low before the crisis.) Much the same applies to Ireland.

  11. Countercyclical fiscal policy might have worked, however, if it had been combined with more aggressive control over the credit system.

    When the UK was thinking of joining, I argued that we would have to adopt Germany's credit curbs. Otherwise, eurozone monetary policy would work through the UK economy and so prove massively destabilising.

    As it was, eurozone monetary policy definitely worked through the Spanish economy. It is worth noting that if the much tighter fiscal policy Simon envisages had been adopted by Spain, aggregate eurozone demand would have been quite a bit weaker. The ECB would then presumably have adopted a more aggressive monetary policy. It is interesting to consider where precisely the impact of that policy would have fallen.

  12. The problem is one of trying to limit the problems associated with monetary trends and these didn't start with the Euro.
    Countercyclical Fiscal may help, but it seems to me that this and the other levers that economists have are not up to the job. It's like taking a exuberant labrador pup off the leash and then trying to control him with whistles.
    The pup is Big Finance, whose activities directly affect the money supply and the answer is to put them back on the leash.
    As I have opined before, the Euro should have been created as a true fiat currency, whose only purposes would be to act as a medium of exchange and for private parties to hold as savings - the original purposes of a currency. There should be no central bank, no interest rate debates. A monetary fund would produce and direct the distribution of new monies in line with economic growth but keeping inflation near zero (I am not convinced by this 'some inflation is good' business; it only works within it own frame of reference).
    Internal inflation due to debt increases - whether through housing booms or Govt borrowing - would be met with a local freeze on the distribution of new money, so there I suppose is your fiscal element; but it would be as much an incentive towards good behaviour. There would be Bretton Woods-level controls on money leaving the zone and other measures against game playing by investors.
    A monetary utopia, run in the interests of people and businesses, rather than banks.

  13. This discussion will run and run. One point I have not seen stressed often enough is that some differential inflation was foreseen from the outset. The 'peripheral' economies - even Italy - had significantly lower absolute price levels at the time of joining. Not only property but also service-based goods (restaurant meals) and even some traded goods. So it was predictable - and predicted - that prices and wages would rise - would converge to a single price effectively - as the euro effect took hold.

    Where it went wrong, in my view, is that this natural convergence was accelerated, leading to substantial over-shooting, due to the parallel and coincidental expansion of capital availability (to put it politely). Had the worldwide banking system not collapsed (and it did NOT collapse because of the euro) then some property developers in Ireland and Spain would have gone bankrupt but their creditors, and the economies, would have survived.

    Meanwhile the tacit abandonment of the 'no bail-out' rule meant that interest differentials could be exploited by lending to Greece, Cyprus etc.

    The net result was that a credit crunch for Greece (exacerbated by the overriding perception that Western banks must be protected) combined with the property crash pretty well everywhere but especially the Southern and Western periphery led to demands for government funding, both as bail-outs for banks and through economic stabilisers. This would have been fine, and affordable, but for the misguided belief that Greece was everywhere so every country must cut back its government deficit - with results that are all too visible.

    The Eurozone will recover - politics will trump economics if you like - but it will take a long time and a lot more hardship than it should have, thanks to consistently wrong decisions by those in a position to affect the outcome.

  14. The 2 main questions are however imho:
    1.Is the EZ in the present set up and the changes to that that are likely to happen better equipped to deal with a crisis?
    Hardly the "Fiscal Compact" is basically Maastricht reborn. It starts again with no bail out effectively (the only viable political game in town). And a CB with limited powers (logical seen from the perspective that no bail out is the main underlying principle).

    2. What are the advantages for weaker countries to be part of EZ? Not many. Prices will go up. As a consequence competitiveness will go down, unless solved via other ways (like more R&D and better education/training). Interestrates will differ considerably with the no bail out back in place, but likely be somewhat lower. And having no CB makes you much more fulnerable in case of larger unexpected economic or financial problems. Problem getting out is not the same thing as getting in it is much more complicated especially when forced by market circumstances.

  15. What would be an economic sensible policy for the countries involved in relation to memebership tot he EZ.

    1. Rich outsider (Norway, Sweden, Danemark, Switzerland (some not part of the EU). Stay out, otherwise you might be liable for bail outs that are very likley coming. Next to political problems of course in Sweden 90% of the population doesnot want it. If necessary peg the currency to the Euro. More permanently like Danemark or only in case of emergency like the SFR. Looks a no brainer.

    2. Poor outsider. Basically the same, but for other reasons. Mainly membership gives the possibility away for own CB policies. Again if profitable peg the national currency to the Euro and make it easy to pay in Euro and with minimal costs. The reason Latvia (one of the Baltaics at least) joined the thing looks therefor mainly politically motivated and moroinic. If it works you pay for bail outs and if it doesnot exit is very complicated and costly and you are left with inferior tools to fight the problems.

    3. Insiders is a different story. Thing hardly looks sustainable in the current form. Imho at least some countries will fall out (probably by a combination of bail out and austerity fatigue. Bail out fatigue in the North, making the conditions even more harsh and subsequently on top of the present austerity fatigue a new dosis on top of that. Which makes the thing totally electorally unstable etc).
    If major split up or even a total one is likely probably rich countries should leave asap. With the added problem that Germany can not leave without the whole thing falling into pieces. But the other Northeners probably in case of a big split up likely better to be out before the thing colapses. With added problem that likley most Northeners would like to have at least a pegged currency with Germany.

    South. Would mean basically a default.
    With France and Belgium a sort of intermediate category. Will probably depend on market conditions and other circumstances at the time of a split to know if they will be seen as stronger or weaker. My guess as these things usually happen in bad times it will likely be as weaker.

    Complicated exercise what is more benificial. Complicated by the fact that EZ exit means legally EU exit and with a highly complicated and timeconsuming method (and therefor totally unrealistic method). Basically a default will mean that official loans have to be written off. Leading to direct budget expenses with the lendors. And subsequently to cuts on national stuff as most are already over their Fiscal Compact borders anyway. In other words highly unpopular in the North (possibly political suicide) and the kiss of death likely in the remainder of the South. Plus high inflation and a forced and direct back to zero deficit budgets. Pretty awful for both lendors and borrowers.

    Anyway no club you want to be a member of.

  16. Peripheral countries can do fiscal counter cyclical polices by reducing VAT and Corporate Income Tax, and financing the increased deficit with direct issuance of short duration tradable debt (6 month to 2 years) of the increased deficit to state suppliers and and civil servants.

    That would reduce inflation and would improve competitiveness of firms.

    Probably 1 to 2% of GDP per year of this type of stimulus would be enough to improve the path of the economy.

  17. Re competitiveness of the Euro periphery, this might be interest:


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