The Euro Was a Bad Idea From the Start

After frantic eleventh-hour negotiations and continent-wide hand-wringing, eurozone authorities and Greece’s new left-wing government have reached a deal. If you’re surprised, you shouldn’t be. A deal was in the cards from the beginning for one simple reason: Ultimately, neither the Greek government nor Germany and other euro member states could risk triggering a financial crisis by cutting off Greek banks.

Financial stability in the 19-country currency area has been preserved — at least for now. But patching up the situation has not removed the key question of where to go from here. There is a lot of “austerity fatigue” in Europe right now. That’s understandable, but it shouldn’t be allowed to distort the debate and allow Europe to dodge the much-needed thorough assessment of the entire euro project: Does it still make sense, given its constraints and limits? What should be the way forward? And was it even a good idea to begin with?

Europe’s monetary union has been based on bad economics from the start. As German economist Rudiger Dornbusch wrote in Foreign Affairs in 1996, “If there was ever a bad idea, EMU is it.” The eurozone does not have the features of what economists call an “optimal currency area.” According to the standard definition, an optimal currency area is characterized by perfect labor mobility, perfect wage flexibility, and a risk-sharing system, such as fiscal transfers when a region — or a member country — is affected by an economic or financial shock.

The imbalances between surplus and deficit countries in the eurozone began to build even before the 2008 global financial crisis, and they remain at the heart of Europe’s problems. The fact that too much emphasis has been put on myopic measures of fiscal consolidation has not helped. And insisting, as in the bailout program, that Greece maintain a primary surplus of more than 3 percent of GDP in order to reduce the public deficit and put the public debt on a downward trend has never been a good idea. But these foolhardy measures might have been inevitable: This program reflects political pressures in core eurozone countries to limit the scope of concessions to high-spending, fiscally irresponsible countries.

The survival of the euro within the context of heterogeneous national preferences has resulted in a lengthy recession, with high unemployment and the deterioration of living standards in some countries, unmanageable public debt, and increasingly Euroskeptical public opinion. Greece, for example, saw its economy contract from 2008 to 2013. Italy has experienced a double-dip recession and 14 consecutive quarters of negative growth since 2011. Both countries have high levels of unemployment: 25 percent in Greece and 12 percent in Italy.

And the end is not near. Problems have been patched up, but not solved. For instance, the question of how to deal with very large public debt levels given the currency area’s structural rigidities and institutional constraints — including the ban on monetizing the debt at the eurozone level — will continue to haunt the survival of the euro project, threatening both financial stability and political feasibility.

The only way forward for highly indebted countries like Greece and Italy seems to be to continue more or less with the same recipe: deflate wages, increase the flexibility of the labor market, and implement supply-side reforms, such as privatization and shrinking of the public sector. This correctly addresses the rigidities of a fixed-exchange-rate system such as Europe’s monetary union and aims to improve productivity. But it brushes aside political considerations such as how much austerity voters are prepared to put up with.

Within the current system, member states are locked into fixed exchange rates, which reflect the conversion rate of national currencies into the euro. The exchange rate can no longer be used as a policy tool to make exports more competitive and rebalance the domestic economy. Thus, a country can only achieve competitiveness in the short run by deflating wages and reducing labor costs.

Since the beginning of the euro crisis, a limited policy debate and the prevailing views of the economically and politically stronger countries (think: Germany) have turned the already constraining fixed-exchange-rate currency union into a punitive system. Deflationary pressures, as in the case in the eurozone’s periphery, make it even harder to reduce the public-debt-to-GDP ratio.

And here’s the worst part: None of this should have been a surprise. The euro project isn’t the first time a fixed exchange rate has forced countries to rebalance through painful and pointless deflation. Before World War I and briefly afterward, the global economy worked on the gold standard, which functioned globally much the same way the euro does within the 19 countries that use it as their currency. As a result of the Great Depression, countries could no longer cope with the reductions in prices and wages necessary to maintain competitiveness, and they began to leave the gold standard. Britain left in 1931 when it became clear that the sterling’s exchange rate was too high and was pushing unemployment up.

This option is not available for the eurozone’s member states. They are bound by treaty obligations and no longer have their own currencies in place — unless they are prepared to go down the messy route of breaking up the euro, something even the radical government in Athens says it doesn’t want to do. But austerity fatigue has raised the bar and made deflationary policies less acceptable in democratic countries. This is reflected in the debate that is more and more polarized, between pro-euro and anti-euro parties, and between those pro-Germany and those anti-Germany.

Europe’s monetary union is a political project built on the impossible assumption that a single currency — and a single market — can transcend national interests and domestic politics. The story of the last five years shows the costs of these assumptions. And this offers Europe the opportunity to reflect on whether the commitment to keep the euro going — doing “whatever it takes” in the now famous words of European Central Bank chief Mario Draghi — is the right way forward, especially if this strategy adversely affects the welfare of some member states and risks undermining democracy.

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