The Future of the Euro
Introduced in 2002 as “the realization of a dream,” the European common currency was on its deathbed only one year ago. Today it is out of the intensive care unit, thanks to clever interventions, but its final prognosis is still uncertain.
The problem of the euro goes back to its birth," Professor Luigi Zingales told a crowd at a an informal talk on Dec. 10, 2013. Politicians created a currency union in pursuit of a larger, laudable goal: a political union that would bring lasting peace and stability to Europe. Viewed as a necessary economic tool for regional unification, the euro was a flawed instrument that that failed to reduce risk and tied our hands when dealing with troubled economies.
The financial crisis revealed the euro's flaws and debts hidden during a decade of prosperity. Although the crisis has quieted for the moment under European Central Bank president Mario Draghi’s management, Zingales said it remains a dramatic situation, and solutions will be painful.
Zingales, Robert C. McCormack Professor of Entrepreneurship and Finance at the University of Chicago Graduate School of Business said the euro grew out of decades of movement toward European unification. “The process started from ashes of World War II. People looked at the disaster they’d created and said, ‘never again.’ “
The postwar period spawned trading organizations for steel and coal, followed by a free trade area established in 1957. This grew to 28 countries and was quite a success, leading to improved mutual understanding and cross-border recognition and cooperation.
The goal was a currency that could not be inflated. “People wanted the Deutschmark, basically. They wanted to have an institution that could have some power in world monetary affairs,” Zingales said.
Stressing that he viewed unification as “a terrific idea,” he said that the currency union, as designed, was not. Many others agreed; economists across the spectrum, “from Paul Krugman to Martin Feldstein, were saying ‘you’re crazy,’ he recalled. “The Europeans said, ‘So what, we’ll fix it later.’”
Part of the problem was that cultural and national differences ran too strong, and resurfaced in an economic crisis. Zingales said that his favorite aspect of the Eurozone was the Erasmus program, which provides fellowships for students to go spend time in another country. This is creating a generation of young people who see themselves as European first, then as a national of their country.
“The problem (with the EU) is that we created Europe before we created Europeans. We need 50 years of that."
Currency Union Constraints
In a currency union, the goal is to maintain stable level of prices so exchange can take place. “Most importantly, you want to maintain an exchange rate vis á vis the rest of the world when a shock takes place,” Zingales said.
To do so, nations need to be able to devalue their currency. The problem the euro is that it allowed no flexibility for adjusting to differing conditions in different economies and national cultures.
One condition for the Eurozone was that it should not be subject to asymmetric shocks that hit one area without affecting others. Zingales called that a “ridiculous” expectation. Using the US as an example, he said Texas is like an oil nation subject to oil shocks that would leave areas like Massachusetts—a “biotech nation”—relatively unscathed.
Mechanisms to deal with these regional shocks include labor mobility and fiscal redistribution from one nation to another. Both are common across U.S. states. In the Eurozone, cultural barriers hindered labor movement, and no Eurozone nation was receiving more than 2 percent of their income from EU transfers.
“To join the EU, you’ve given up fiscal flexibility. Readjustment [to changing economic conditions] is extremely difficult if don’t have an exchange rate.”
In anticipation of the launch of the euro, interest rates quickly converged and risk basically disappeared, with virtually no spread among nation’s sovereign debt until the global financial crisis hit in 2008.
“How is this possible?” Zingales asked. If you look at the fundamentals in each nation, “who is the person who thinks borrowing from Italy is the same as borrowing from Germany?”
“It was assumed if you could join euro and you could not inflate, risk would disappear. Risk did not disappear. You cannot change fate of a country just by fiat. After a number of years, risk started to resurface, and we all started to realize we don’t have an mechanism to manage it.”
The Euro Solution
It was political pressures that created the euro, and now political unrest is threatening its future and stabilization plans. Germans resent bailing out the “lazy” Greeks and Italians (who actually work more hours than Germans, partly to fund their inefficient governments, Zingales quipped.) Others, particularly the French, fear the growing economic strength of Germany.
The political environment is splintering, with resurgent communist and neo-Nazi and right-wing factions gaining strength. “The European parliament in 1914 will be full of anti-Europeans. Anti-euro sentiment is really rising among us. Unfortunately, I don’t see anybody with the wisdom and vision to address this,” Zingales said.
He noted that an exit of the most troubled nations from the euro would be a “blood bath,” because credit holders can not redenominate their obligations; bonds would remain in euros, while revenues are in less valuable currencies. So what is the solution?
He had an idea for a possible way out of the mess: creating a more valuable “northern” euro and another for the economically weaker southern nations.
“I was so optimistic about this. Now I think it’s not feasible,” he said. “The big problem is called France. We don’t know if it’s in northern or southern union. Economically France, can’t afford to be with northern nations, but politically can’t afford to be in the south.
“Germany cannot afford to start a northern European Union without France. Why? That looks a little too much like a Fourth Reich. And having the Germans, Dutch, Finns creating a union? That’s not going to work.”
Responding to an audience question, he addressed what this means for the world economy. “A slow dissolution of southern Europe is not a disaster for the rest of the world. A sudden breakup of whole EU would be,” he concluded.