Winner of the New Statesman SPERI Prize in Political Economy 2016

Saturday 2 June 2018

A Euro Tragedy

“Italy, I believe, is the eurozone’s fault line.” Not from an article on the recent crisis, but from a book by Ashoka Mody, called “Euro Tragedy: A Drama in Nine Acts”, just published in the US and due out in the UK in July.

As the title indicates, this is not a pros versus cons assessment. Instead the author treats the Euro as a clear mistake, a triumph of a political ideal of European unity over basic economics. The author provides a clear (and accessible for non-economists) account of how the idea of the Euro began to dominate the political discourse of particularly the French elite and how Germany leaders agreed on the condition that they determined the design, how warning signs during the pre-crisis period were ignored, how the risks from a Greek default were overblown so the wrong policies were adopted in 2009 and 2010, and how subsequent actions exposed the democratic deficit implicit in that German design, encouraging populist movements across Europe. (For UK readers I have to emphasise that this is about the Eurozone and not the EU.)

Many of these points will be familiar to regular readers of my blog, but here the story is told with the knowledge and authority of someone who, as deputy director of the IMF’s European department, was close to the action. The sections on the Greek crisis especially should be read by all those who stick to the ‘official’ line that Greece turned a crisis (excessive deficits) into a disaster because it refused to take the medicine it needed. The reality, as the author describes, is that Syriza’s call for debt relief should have been granted. He writes
“This demand had overwhelming support in both the scholarly economics literature and the practice of economic policy. Scholars for decades had emphasised that excessive debt - ‘debt overhang’ - reduces the ability and incentive to invest, slows economic growth, causes low inflation or even deflation to set in, and makes debts harder to pay.”

And as he notes earlier, these debts should have led to default in 2009/10 rather than being mainly transferred into obligations of the Greek government to other Eurozone governments. Varoufakis may have been unconventional, but many of his proposals, including linking repayments to GDP growth, were “economically sound”.

Indeed he goes further than I have done. He writes about the final days of the standoff between the Syriza government and the Eurogroup after the referendum. The IMF made increasingly strident public noises about the urgency of debt relief, but the Germans - fearing political comeback from their taxpayers - refused to budge. He writes
“The IMF could have forgiven the debt owed to it by the Greeks. This drastic gesture would have created international pressure on the Germans and other European creditors to do the right thing. The IMF had a moral obligation to take such a drastic step, if for no other reason than to make amends for its complicity in the tragedy. At the time of the original bailout in May 2010, IMF management had prevented the Greek government from defaulting on its private creditors, an action that several members of the IMF’s Executive Board and the vast majority of external analysis then and later believed was essential to reduce Greece’s debt burden”

This book is a comprehensive and impressive history of the creation and subsequent performance of the Eurozone, and one of the few books on the subject where I find myself nodding in agreement most of the time.  (Martin Sandbu’s Europe’s Orphan is another.) There is much more interesting detail and analysis that I cannot do justice to in one blog post. I can think of two areas where I might have told a slightly different story. The author in parts writes as if it was commonly understood by economists that the Euro would not work. I think there were, in Europe at least, two other significant groups among academic economists. The first thought that perhaps the Euro could work, but only if it allowed fiscal policy to replace monetary policy as the national stabilisation mechanism. I still remember how astonished I was reading the Stability and Growth pact when it was announced, which effectively ignored this critical role for fiscal policy. Another group gave more unconditional support to the Euro, although whether they did so because they really believed in its merits or because they saw it as politically inevitable is difficult to tell.

The second story which I do not think is given enough emphasis is the role of German wage undercutting in the early 2000s. As Peter Bofinger has argued, this was a deliberate attempt to devalue the German real exchange rate within the Eurozone. It was significant for two reasons. First, it helped Germany to emerge from the financial crisis in an economically stronger position than France and others, which in turn had a strong economic and political influence on subsequent events. Second, it indicated an unwillingness on the part of the strongest country in the union to play by the rules of the game.

But these are just differences in emphasis. I would absolutely agree with the author that to avoid a continuing tragedy the direction of travel has to change. He writes
“The evidence in this book points insistently to specific measures to improve the functioning of the eurozone. These include scrapping the fiscal rules, creating mechanisms for predictable and orderly default on public debt to instill greater discipline in debtor governments and their creditors, and changing the ECB’s mandate to require that reducing unemployment be an objective of monetary policy on a par with maintaining price stability.”

Unfortunately that is not the path the eurozone is currently on. It retains a belief in ‘falling forward’ from each crisis to further integration. If the governing elite is the head and the people are the legs, the great danger is that the legs will not move and the eurozone will fall flat on its face.


  1. Although you say at the beginning that the EZ is not the EU, for all practical purposes that is not correct; if the Euro goes it will take the EU with it.

    Mody's amendments to EZ practice are irrelevant because they will never pass muster; for the Euro to work you need fiscal union and you will not get that unless there is political union and you will not get that because the peoples of the EU do not want it.

    You are severely critical about Brexit and, economically, I'm agree with you but the EU and EZ are themselves severely dysfunctional and, in my view, are unlikely to stay the course. I don't like what is happening in the EU because that affects the UK but I believe the EU will crumble over the coming years and what may well arise is a form of organisation that the UK could join.

  2. Simon, a nice article.

    But I don't think Germany turned down debt relief for Greece fearing a voter backlash. Merkel has done many unpopular things because she thought it was right, think refugee crisis.

    But every € written off by Greece was then a € in losses for banks, mainly already embattled European banks, including Deutsche and the rest. As the entire bailout process was to benefit the creditors, it made no sense to allow the creditors to lose out through restructuring.

    But that was because the entire process shifted the burden of the banks' recklessness from them to the shoulders of some of the populations of Europe.

    1. Thing is that "PIIG" debt was mainly between companies in the south and banks in the north. When the debt was nationalized to try to keep southern companies going, now it became between southern governments and northern banks.

      Meaning that any debt relief outside of straight payment risk tumbling German and French banks.

      Merkel is not worried about the voters, she is worried about her paymasters.

    2. I suspect Germany's demographics (IIRC it was one of the first European countries to enter a state of population decline) explains both its liberal refugee policy and its stubborn mercantilist economics – in the latter case, Germany is attempting to collectively save for old age by acquiring financial claims over other nations.

  3. “German wage undercutting” was a “deliberate attempt to devalue the German real exchange rate..”??? Far as I can see, Germans have kept very close to the EZ inflation target, i.e. just under 2%, so they can’t be blamed for “undercutting”.

    On the other hand inflation in Greece has been at about the same level since it joined the EZ. So I’m puzzled as to how Greece has become uncompetitive. All I can think of is that demand for German products world-wide has risen faster than demand for Greek products.

    1. .. Germany is still working on inner coherence due to its own monetary union project (a.k.a. reunification) and there is a long open eastern border. And no - the transition period did not make a big difference. Not for investments and not for the mostly self-employed and highly mobile eastern european workers, especially in the construction business. They are around for more than a decade now, hard-working, reliable and comparably cheap guys, glad to have them here.


    2. From 2001 till 2010 unit wage costs in Greece have risen by approx. 65%, while they had fallen slightly in Germany. That's one of the causes why Greece became uncompetitive. Its almost the same story in Italy.

    3. Look at unit labour costs. It is a classic internal devaluation.

  4. Typo: "I might of told" -> "I might have told"

  5. Have you read Varoufakis' "And the weak suffer..."?
    All sounds very similar and with similar conclusions.

    Almost as if a consensus is forming...

  6. "The second story which I do not think is given enough emphasis is the role of German wage undercutting in the early 2000s. As Peter Bofinger has argued, this was a deliberate attempt to devalue the German real exchange rate within the Eurozone. It was significant for two reasons. First, it helped Germany to emerge from the financial crisis in an economically stronger position than France and others, which in turn had a strong economic and political influence on subsequent events. Second, it indicated an unwillingness on the part of the strongest country in the union to play by the rules of the game."

    It is undisputed that there was an internal devaluation in Germany starting around 1997. But why do you sell it as kind of cheating? Because social coherence allows this in northern European countries but not in southern?

    The second aspect is of course, that you with no word discuss the high wage increases in southern European countries at the same time, wage increases that were not justified by improved productivity.

    As economist/scientist it shouldbe possible to quantify these two contributions BEFORE making a verdict.

    RE Moody: While I (as economic amateur) do not have problems with most of his macroeconomic conclusions in respect to Germany, I have a clear feeling after having read some of his articles that Moody is a little bit clueless when it comes to the reality on ground in Germany before 2000, he is in some cases not able to distingish cause and effect of underlying social developments. Did he spend some time in Germany back then or is this a result of living in an academic ivory tower?

    And it is to a certain extend lame to refer to an old contribution when you did not address the critique there.


  7. Prof Wren Lewis: "(For UK readers I have to emphasise that this is about the Eurozone and not the EU.)"

    Maybe - maybe not. It is certainly the case that before the referendum Ashoka Mody published a piece in the Guardian recommending Brexit.

    A democratic deficit is the central problem of the EU and although that problem is particularly acute for eurozone members it is still a problem for all members.....

  8. I think you are slightly misrepresenting Bofinger - certainly, Germany's centralised wage fixation system is effective at fighting inflation (take note pompous mainstream economists who argue that such systems cannot work because economic theory says it can't) , but I doubt very much that this was part of a Machiavellian beggar thy neighbour policy to get a competitive advantage within the Eurozone. For a start, Germany's main competitors are not in the Eurozone - it would be far more concerned about its competitive position versus Japan, China and the United States. And if we know something about the DM, a strong currency was never sacrificed for purposes of competitive advantage - it simply never thought of things this way. It is possible it was thinking about its real exchange rate, ie the competitiveness of its exports vv China, but quite honestly I think to some degree it should have been. But my own feeling is, that basically Germany was very well managed, and has probably emerged from hyper-globalisation in better shape than many other places - both from a GNP per capita and equity point of view - ie the gains have not been entirely accrued by the financial sector or owners of capital. Anyway, it would be interesting to have some contributions from German economists , especially those that know Germany well here.

    The other thing is that it is important to get the view from Europe. We have heard a lot of the IMF/MIT position. And we know it often centres around 'basic economics' - read open economy ISLM and Optimum Currency Area theory. But people who just spiel off this do not really understand the history and the motivations of why many countries wanted to join the Euro - and there were very good reasons why they did. A hard currency is something that long eluded Southern Europe - but which it desperately needed if it wanted to get out of its history of booms and busts and balance of payments/deflation trap. There is also some political economy; the US foreign policy position since 1945 was to support closer European integration for reasons that cannot be elaborated on here; but it never wanted it to go too far - not so far as the US dollar or the NATO alliance would itself be challenged. The IMF is ultimately a vehicle of US foreign policy - that is its raison d'etre, and that must never be forgotten when you read anything that comes out of it. IMF economists may be technicians that play around with models, but its bosses and the State Department know what they want from them.

    The big blow to European integration was rapid Eastern expansion - and this was something that the US and UK pushed for hard. Before this time European populations were broadly either highly supportive or indifferent to closer integration. However, expansion made fiscal and other closer integration impossible in the near term. This left Europe in a position unable to deal with crises and forced long periods of austerity. At the same time it has led to highly unpopular mass movements of inward labour flows. The only way I can see Euro and the EU being saved, is through a two speed Europe.


  9. Christian Dustman (the name suggests a German economist (but I suspect with very strong US/UK Neo-Classical education and leanings) has argued that considerable deregulation occurred in the German labour market in the 1990s and this is what was behind German success (a classical neo-liberal view if there ever was one). In which case you would have to question whether the collective bargaining system could be employed to achieve an across the board result that delivers a real exchange rate depreciation as you describe. I suspect Dustman is half right and half wrong. Yes there has been deregulation - Germany like many other countries had to submit to pressures from globalisation and a strong neo-liberal orthodoxy that stretched from influential economics departments to government to business to finance - but I doubt this is behind any long term success: rather like Thatcher and Blair's deregulation and weakening of unions - in the long run the results on society and the economy are not unambiguously good. I also suspect that a closer look at what has happened suggests that German economic performance has not been as rosy as many suggest, with many emerging and deep social and economic problems.

    For sure Germany's consensual labour market has been a key to its success in delivering a superior and equitable economic performance; deregulation should be a matter of some concern.


  10. I really dislike the term 'populist'.

    The turn towards austerity seems to have been populist.

    Using that term makes it sound as though those mainly Conservative governments in Europe have been doing the correct thing against popular prejudice for the last decade.

  11. in the past 10 years we have been warned of the imminent death of the euro every week by a certain type of people... meanwhile the eurozone only grew and grew...

  12. Although you are very cynical about the collective bargaining system, I would argue that Germany's collective bargaining system has acted to increase the real wages of German workers. This is contrast to British, or say Detroit, workers where there is no such contract between capital and labour, or it has been severely broken. I would argue that such worker representation is socially, and for that matter economically, healthy. I would argue that this system has actually increased real wages for German workers compared to foreign workers. It has had to defend this system against a very strong global neo-classical economic and neo-liberal political orthodoxy that was especially strong during the 1990s and 2000s and that emphasised individual optimisation and the freedom to be able to do so and 'efficient' market determined allocations of labour. Like here, German universities want want to climb global league tables and internationalise. Someone with a PHD from MIT, who writes in English and publishes in the AER will be more useful for this purpose than than someone who really understands how collective bargaining systems have worked in Germany and how for a very long time they have managed to be a positive thing for labour. This would be useful for all of us to know.

    I suspect though, that considerable deregulation has taken place in the German labour market in recent decades, and I do not think this will bode well for German society in the future.


  13. So, you don't like Brexit, and you don't like the Euro.

    The view of nearly all Leavers I know, including myself, is that ultimately the position of being in the EU but not in the Euro is not tenable. The EU is clearly heading in a particular direction, and that direction is one of enforced conformity not tolerated diversity. Remainers are currently seemingly intent on demonstrating that the UK cannot survive outside the EU; having demonstrated that, it is clear and obvious that a UK in the EU would have no influence over how the EU treats the UK as we have no viable path of resistance, hence we would end up in the EU.

    So, Prof, as it is exam season, Of the two realistic long-term choices, the UK in the EU and in the Eurozone, or the UK out of the EU, which would you prefer? (answers staying being in the EU but not in the Eurozone will be awarded no marks).

  14. Haven't read that book (no time), but I did find Yanis' rhetoric to be very in line with newer models of monetary economics. Wonder where he could have got those radical ideas from?

  15. How could the germans stop the IMF from forgiving the debt? The text you quote is shifting resposability to the IMF not the EU. The reality is that nobody wanted to fund the extra greek spending.

    Plus are you actually sure the EU didn't forgive the greeks debts? As far as I know they have extended maturities and cut interest rates, so I think you could at most argue that they didn't cut the debts enough, but that's really it...

    You can argue about the faults of the Euro area, but maybe you should actually read the Italian government program before judging. I think it would be hard to push for reforms that could weaken potential growth more (tax amnesty, less labour flexibility, lower pension age, limit retail opening hours, massive unfunded tax cuts skewed to the top of the distribution, less immigration in a country where active population has not grown in 30 years). This is ignoring the entire social chapters which are if possible even worse...

  16. Rajoy's fall in Spain is no doubtless less significant than the rise of the populists in Italy, but it still matters. I'm not sure if I get this right, but Sanchez (a trained economist) and his party have by and large gone along with forced austerity. However, he leads a very minority government dependent on the votes of the erratic lefty populist and anti-austerity party Podemos to pass a budget or other legislation. The slow recovery in the Spanish economy makes Madrid less dependent on Brussels. Maybe Spain will become a voice for sanity in euro policymaking.

  17. Professor Wren Lewis,

    You claim "an unwillingness on the part of the strongest country in the union (Germany) to play by the rules of the game".

    The contrary is true: Germany played according to the rules, the others did not.

    In 1991,the year of the Maastricht treaty introducing the euro, Germany was wanted political, i.e. fiscal union. The others, France and Italy, refused, in spite of the fact that Chancellor Kohl had pointed out that a currency union could not work without fiscal union.

    Furthermore, German public opinion was vehemently opposed to the euro - correctly, as it turned out: It was a very bad idea.

    So why did Germans accept it? Because, in the present form, it was rammed down their throats by France and Italy as the price of German reunification.

    Had France and Italy and others either agreed to a political and fiscal union in Europe or followed German public opinion in opposing the euro, none of the problems following the euro would have occurred.

    Now put that in your pipe and smoke it.

    1. Typo:

      What Germany wanted was political, i.e. fiscal union.

  18. I’m with Mody on most things. But I am not with this blog and Bofinger that German wage setting was a deliberate attempt to undercut the Euro area. German wage moderation - including the “Buendnis fuer Arbeit” - was in response to 5 Million unemployed. It served primarily to reduce the price of labor relative to that of capital, not relative to the price of labor in other countries. Would other countries have reacted to this by cutting labor cost as well, the euro area as a whole would have moved to a better equilibrium. And with the appropriate monetary policy, this process would not have had to be deflationary.

    What worked against this was that euro introduction generate a huge interest rate windfall in the European periphery, which unleashed demand and boosted wages especially in the non-tradeable sector. While the same did not happen in Germany. The result was enormous wage divergence, triggering the protracted disequilibria that remain unresolved to this day.


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