Tuesday, December 1, 2009

The Future of the Euro (Part VIII)

It seems Martin Feldstein cannot avoid speculating about the demise of the Euro. Since the late 1990s he has been making the case that there are just too many institutional and economic differences in the EU nations for a single currency to work. In short, Feldstein believes the Euro area falls way short of being an optimal currency area. The past decade of relative success for the ECB has done nothing to change his view. In fact, earlier this year he discounted this period as a "lucky time" for ECB policymakers:
Mr. Feldstein pointed out that the past decade has been, until recently, a lucky time in Europe. European country economies weren’t buffeted by severe economic problems, or big unemployment problems, allowing the European Central Bank to focus on price stability. But now, economic conditions are deteriorating rapidly, and some countries are being much harder hit than others...“In my judgment, the next few years will be an important testing time for the EMU and Europe,” Mr. Feldstein said - one in which the possibility of one or more countries choosing to withdraw from the EMU cannot be ruled out.
That was written in January 2009 when Europe seem poised to implode. Now that ECB has weathered that storm Feldstein still questions the Euro's survivability:

The economic recovery that the euro zone anticipates in 2010 could bring with it new tensions. Indeed, in the extreme, some countries could find themselves considering whether to leave the single currency altogether.

Although the euro simplifies trade, it creates significant problems for monetary policy. Even before it was born, some economists (such as myself) asked whether a single currency would be desirable for such a heterogeneous group of countries. A single currency means a single monetary policy and a single interest rate, even if economic conditions – particularly cyclical conditions – differ substantially among the member countries of the European Economic and Monetary Union (EMU).


The European Central Bank is now pursuing a very easy monetary policy. But, as the overall economy of the euro zone improves, the ECB will start to reduce liquidity and raise the short-term interest rate, which will be more appropriate for some countries than for others. Those countries whose economies remain relatively weak oppose tighter monetary policy.

Feldstein acknowledges there would be technical and political hurdles to overcome for a country to abandon the Euro. Barry Eichengreen argues these hurdles are probably large enough to prevent a country from leaving the currency union. Obviously, Feldstein is less confident on this point than Eichengreen. Interestingly, Desmond Lachman, who foresaw many of the emerging market crisis of the 1990s, sees a "ticking time bomb" for Spain, Greece, Portugal, and Ireland from the "straightjacket of the Euro-zone membership." He too does not see the hurldes to a breakup of the Eurozone as unsurpassable. As I noted in a previous post, Argentina in the 2001-2002 period provides a good example of a country for which the technical and political hurdles--including a financial crisis, the largest-ever sovereign default, and political chaos--were not enough to prevent it from leaving the dollar zone. Never say never.


  1. Leaving the ERM was certainly the making of the UK! Following the infamous Black Wednesday of 1992, the UK launched on a 16-year business cycle expansion marked by falling inflation, rising productivity and falling unemployment. Maybe leaving the euro could be just what Spain needs so it can be sovereign again and follow policies to reduce unemployment below its current Michigan-like levels.

  2. Well, then, maybe Michigan should leave the dollar union to reduce its high unemployment.

    Of course, such moves would only provide temporary respite for Spain and Michigan. Ultimately, structural changes are needed in both economies.

  3. ECB, you are being sarcastic, right? Leaving the ERM has been a disaster for the UK. After a few years while the caution engendered by coming up against the binding constraint provided by the DM anchor dissipated, it was off to the to races again, like the late 1980s boom and bust but larger. And look where that has got us.

  4. Would Rebel really want to argue that being inside a currency union insulates against boom and bust?
    Surely Ireland and Spain argues to the contrary ?
    Of course, as David observes ultimately real factors are determinate. The US housing disaster is reducing labor mobility and moving the country further from being an optimal currency region.

  5. ECB:

    As you know, I have research showing that certain parts of the United States (e.g. Rustbelt) may have benefited from having their own currency. My research, however, only speaks to the potential benefits of regional monetary autonomy and not the potential costs (e.g. higher transaction cost from dealing wiht multiple currencies in the US) assocatiated with it. It would be nice to see a paper that examines all the benefits and costs to the UK of not adopting the Euro.

  6. David your last comment opens up some possibly interesting parallel avenues with free banking. Don't the Selgin/White school advocate "let a thousand banknotes bloom" ? Back in the free banking era they had notebook reporters which compared exchange rates between banknotes. In today's internet world of abundant information, those costs would be far lower.

  7. ECB,

    I see what Ireland and Spain are going through now as a kind of cold turkey process that will engender scepticism about asset price bubbles in future and make them more stable economies. The tragedy of the ERM is that Britain had got a long way through the process when it lapsed and went back on the heroin for an even bigger bender. This time, we are hardly trying to kick the habit.

    Actually, having seen several of these boom bust cycles, I am sceptical that monetary flexibility is worth keeping anywhere. I think it develops a cultural moral hazard, especially as, in practice, monetary policy makers find it much easier to let their currencies depreciate rather than appreciate.

  8. Rebel,
    I certainly would keep an open mind on monetary regimes. Some time back, our blog host put up a graph showing the remarkable stability of US real GDP growth over the past 100-odd years. Through gold standard and no central bank through to fiat standards and floating exchange rates, variations in nominal regime appear to leave no long-term trace on the real economy.
    And I dont know which way the causality goes between monetary flexibility and cultural moral hazard. Hayek thought that it may be the case that democracy and sound money are incompatible.

  9. Euro was something more than a currency for Europe...was a ''ticking bomb''....90% of the European countries were not ready to join the euro...specially countries like Greece,Portugal,Spain.Italy.England had the smartest behavior...There is no future for the euro.That means that a lot of things are going to happen in Europe...the dream is over...''euro zone'' was the perfect trap for major European countries...except England