The Future of the Euro Area

Remarks at the conference "Europe's Place in a Turbulent World" at the Brookings Institution, Washington, DC

The author gratefully acknowledges his colleagues Jacob Funk Kirkegaard, Arvind Subramanian, and Nicolas Véron for their comments on a previous draft. The author is solely responsibility for the final text.

May 26, 2011

In March of 1997, I participated in an International Monetary Fund (IMF) conference on the euro and the international monetary system. At that conference I said:

The third stage of economic and monetary union (EMU) in Europe would create a system with "an essentially stateless currency…. [T]here is some unfinished business in terms of short-term arrangements and the longer-run evolution of Europe…. The concern is that because Europe will be living in a halfway house where economic decision making is shared in an uncertain manner, the smooth functioning of the international monetary system could be adversely affected…. [Outside of Europe] we have some reason to be concerned about the effects of [a] creaky decision making process in Europe that is likely to prevail on some internal and external issues that will be important for the continued stability and prosperity of the global economy."

Fourteen years later, we are in essentially the same place.

The single European currency is a unique experiment. The eurosystem is similar to the gold standard in a few respects, but it is fundamentally a different system. First, central banks did not mine and issue gold; the euro is a managed currency issued by the European Central Bank (ECB). Second, under the gold standard, each country had the freedom to associate or disassociate itself with the system, and did so. Third, the gold standard system was a nonsystem in that countries often did not follow the gold-standard rules of the game: expanding the money supply when they took in gold and contracting it when they lost gold. Fourth, the consequences of these national choices were substantially less globalized than is the case today. In other words, the rest of the world has a stake in the success or failure of the European project today that is much larger than the stake that it had when, for example, the United Kingdom went back on the gold standard in 1925 and off it in 1931.

My concerns in 1997 about the halfway house of the EMU arrangements were mild relative to those of some observers at the time. There were two broad strands of vigorous debate. One, largely European, debate was between the "economist school," which argued that broad real economic integration should precede centralized monetary policymaking, and the "monetarist school," which wanted to erect the European Central Bank and assumed that smooth integration would follow. (I am an economist from Yale who never thought much of monetarism, which was dogma at the University of Chicago at the time.) The second, largely US, debate involved those who worried about whether Europe was an optimum currency area that was, or was not, robust enough to withstand so-called asymmetric shocks.

On the first strand of the EMU debate, the politics of European institution building was ahead of, but now is behind, the economics of convergence in Europe. The politics were already incomplete, and European politics over the past 18 months has been substantially behind the rapidly changing economic realities. The establishment of the euro area with a single currency was not enough; it facilitated the emergence of numerous intra-euro area imbalances. The political narrative, as well as policy, has not kept up.

For example, in Germany and similarly situated euro area countries, the advent of the euro was good for business, better than expected. The real effective exchange rate for Germany is about 10 percent weaker than it was in December 1998. Between 2005 and 2010, the German current account surpluses averaged 6.0 percent of German GDP, more than 60 percent larger than the average between 1985 and 1990 (3.7 percent) during a period in which German surpluses were a source of global policy conflicts. However, the political elite failed to explain to the general public in Germany, and in similarly situated countries, that there would be short-term economic benefits from EMU in the form of a weaker currency and stronger net exports, but there might be a heavy, delayed price to pay if some of the recipient euro area countries subsequently could not meet their financial obligations.1

In those countries now having problems meeting their financial obligations, the political elites also failed to explain to their publics that the benefits of economic convergence might turn out to be short-lived with wrenching economic, financial, and political ramifications. All good things have to come to an end.

Moreover, the politicians initially broke the weak rules established in the Maastricht Treaty when they decided on a large membership of the euro area starting in 1999. In 2003, the Stability and Growth Pact was tested by Germany and France, and subsequently was watered down. No one should be surprised that there now is a crisis in Europe over policy credibility despite and maybe because of steps to create a permanent European Monetary Fund and enhance EU surveillance over fiscal and competitiveness policies.

With respect to the debate about optimum currency areas and asymmetric shocks, critics in 1997 were hard-pressed to come up with ex ante examples that would affect euro area countries differentially other than energy shocks. What we have seen is an asymmetric shock that was largely internal in nature. Europe participated in a global credit boom. It benefited the exporters in Germany, consumers in Greece, and homebuyers in Ireland and elsewhere. The credit boom facilitated the buildup of global imbalances, but also imbalances within the euro area. In the subsequent global bust, the process of deleveraging has affected both borrowers and lenders, including within the euro area.

In sum, the halfway house has not served the euro area well aside from preventing internal nominal exchange rate instability. Deficits and debts expanded, imbalances grew, leverage increased, and asset bubbles emerged and burst.

What about the non-EU countries? How countries outside the euro area, inside and outside of Europe, were affected by the successes and shortcomings of the first decade of the euro is a question that I will not try to answer. I will only observe that a case can be made that there were both winners and losers. However, for the past 18 months, non-euro area, as well as euro area, countries have been adversely affected by the euro area crisis. The euro has been weaker than it otherwise would have been, growth on average has been slower, financial market volatility has been higher, and countries outside of Europe have shouldered some of the financial costs of dealing with the euro area crisis.

The last development is part of participating in a globalized economy and financial system and in associated multilateral institutions such as the IMF. The IMF is designed to promote crisis prevention and encourage sound crisis management. The IMF did a very poor job on the former, some would say, but I suspect that most of the blame lies with the members of the European Union itself and the principal institution of the euro area, the European Central Bank, which felt that IMF surveillance had little to offer to policymakers in Europe. They reluctantly turned to the IMF for financial and policy advice when Latvia, Hungary, Romania, and Poland faced pressures in the global phase of the financial crisis. Initially, they were even more reluctant to turn to the IMF during the crisis coda affecting members of the euro area themselves.

I do not want to be misunderstood. The economic case for the IMF (and the Federal Reserve via its swap facilities) to assist Europe, in general, and the euro area, in particular, to limit the adverse economic and financial fallout of the euro area crisis is strong. At the same time, decades of smugness from European economic policy elites blinded them to the emerging crisis-a weakness of the monetarist school. A crisis of this type just could not happen inside the euro area. That smugness also has exacerbated the normal political difficulties associated with selling such assistance to a skeptical public in the United States and their representatives in Congress, and the United States is not unique in this regard.

There are economic, financial, and political limits to the amount and nature of outside support provided to Europe. Taxpayers in Europe are skeptical about the wisdom of the continuation of the current Plan A trajectory; most politicians and policymakers appear determined to press ahead. In the United States, Asia, Latin America, and Africa, taxpayers and their political representatives understandably are more skeptical. They are likely to be much less directly affected by any negative fallout from a true Plan B, which would involve a significant write-down of the sovereign debts of Greece and potentially of other euro area countries, if and when that becomes necessary.

Politicians and taxpayers are also likely to become increasingly less tolerant of perpetuation of the European halfway house. Either Europe should move forward toward greater economic, financial, and political union, or Europe should move back toward a looser form of economic and financial integration, including the reintroduction of exchange rate flexibility. This choice involves as well the status of the 10 countries that are members of the European Union but not members of the euro area. They inhabit their own halfway house. To be clear, dating back to when I worked under Robert Triffin more than 40 years ago, I favor the first option.2

More immediately, however, the leadership of the IMF, the principal global institution responsible for international economic and financial stability, should not be held hostage to the parochial interests of Europe and the euro area. The next managing director of the IMF must represent the system as a whole. Europeans argue that she or he should come from Europe because about half the IMF's potential exposure is to Europe. That argument does not pass the smell test. Did any European advocate in 1987 (when Camdessus succeeded de Larosière) that the managing director should come from Latin America or in 2000 (when Köhler succeeded Camdessus) that the managing director come from Asia? No.

The interests of the international monetary system require that in the period immediately ahead decisions about the terms and scale of support for economic and financial programs in the crisis countries of the euro area should not be made in Berlin, Brussels, Frankfurt, Helsinki, or Paris. In an open selection process for the new IMF managing director, any candidate from Europe must receive the broad support of other members of the IMF. Those members must be convinced that the new leader of the IMF will analyze the pros and cons of moving to Plan B from the perspective of the system as a whole.


1. A similar point is made by my Peterson Institute for International Economics colleagues Olivier Jeanne, Arvind Subramanian, and John Williamson in the Financial Times of May 25, 2011, "Germany Owes More to Prodigal Periphery."

2. Robert Triffin was my PhD thesis advisor. I am proud to have had the opportunity to participate in two festschrifts for him. I turned in the first draft of my dissertation on trade creation and trade diversion in the European Economic Community with a long chapter on the political and economic origins of the European project. He told me to cut that chapter essentially because I did not know what I was talking about. After I received my degree, I gradually began to ignore Bob's advice.