Evan Soltas
Apr 23, 2012

Don't Save the Euro

The small benefits and swelling costs of monetary union

How can we save the euro? That, I would say, has been one of the questions looming over every conversation I've had and every article I've read for the last few years, and over every post I've written. But what if we are asking the wrong question? How we can save the euro, of course, presumes that the euro is worth saving.

Is it?

The answer, I am increasingly thinking, is no.

At the root of this crisis is the reality that the Eurozone is now simply a bad deal for many of its participants. We can see this in a graph of the variance of real GDP quarterly growth rates between Eurozone countries.I don't consider the early volatility important -- it has do to with growth normalizing in Ireland in Greece, usually to the upside. What this graph tells us is that, for a while, it seemed that Eurozone participation was a win-win. Now, it most definitely is not -- the outcomes are wildly different by country in terms of real growth. No monetary union will last where the benefits and costs for its participants are so unevenly shared.

We see this, too, in the "fraying" around mean Eurozone growth. It's not just Greece.Even if the Euro could be salvaged from this current crisis -- perhaps via financial repression, as I have written in the past -- the European Monetary Union is so ill-designed that its costs beyond this current crisis far exceed the benefits in the same time frame.

First, the principal argument against monetary union is that individual nations lose their ability to craft their own monetary policy. As Matt O'Brien writes in The Atlantic, that is an expensive sacrifice:

Haven't we learned that monetary policy, not fiscal policy, is the best way to manage the economy -- with the possible exception of when short-term rates are at zero? We have. But the irony of Europe is that a defective currency union reverses this logic. When one central bank sets interest rates for different countries with different economic needs and different budgets, it's fiscal policy that matters most. There's no other way to stabilize the economy...At best, the ECB runs a one-size-fits-one policy. Interest rates make sense for Germany, but not really for anybody else. At worst, the ECB runs a one-size-fits-none policy. Interest rates don't make sense for anybody: They're too low for Germany, but too high for Spain. So, rather than stabilizing the economy, monetary policy actually destabilizes the economy. The booms and busts both get bigger. It's left to each country to use government spending to temper both.
The cost of passive monetary contraction in many Eurozone economies far exceeds the benefit they have derived in the past decade of monetary integration.

(Note that European integration, minus the euro, has been to the enormous and mutual benefit of these countries. The customs union, the Schengen zone, the Maastricht single-market: the marginal benefits of a common currency are likely small in comparison to these major achievements.)

But I think O'Brien perhaps overlooks an important detail in assuming that fiscal policy in the eurozone countries can pick up the lack left by the surrender of monetary sovereignty. It can't, plainly. Not because their parliaments aren't good enough, but because the lack of monetary sovereignty requires significant restraints on countercyclical fiscal policy. This has been codified, too, in the Growth and Stability Pact -- but even if it were not, the inability to issue debts in one's own currency creates a default risk, which can compel austerity during economic contraction. In effect, the Eurozone has surrendered its entire ability to conduct countercyclical economic policy, both monetary and fiscal, full stop.

Paul de Grauwe's book on monetary union says the benefits of monetary union may total up to 20 billion euro. Well, the Eurozone's GDP is 9.2 trillion euro. Even if the costs of an orderly Eurozone breakup reach 20 billion, that wouldn't justify even one full year of the implied cost in terms of real growth foregone.

The costs of the Eurozone, Kenneth Rogoff also points out in the Financial Times, will continue to endure, even beyond this recession and financial crisis:

The real lesson of the euro’s grand experiment is that, given the weak state of global governance, the optimal single currency area is probably still a country, at least when two or more large countries are involved.
The Eurozone is patently not an optimal currency area, and this inefficiency represents a deadweight loss to the Eurozone countries. Financial crises and growth slowdowns are expensive events -- a monetary union which increases their likelihood or severity is similarly costly and extraordinarily difficult to justify from a cost-benefit analysis standpoint.

Tyler Cowen piles on in The New York Times, saying that these costs are simply not likely to be borne quietly by Europeans:

In general, voters are unwilling to give up their say over policy, or to regard the European Union or euro zone as necessarily superior to national interests...The euro zone probably was unworkable from the beginning, and now we are seeing why.
The resultant political uncertainty, and the way the Eurozone sovereign debt crisis has dragged on for --what, is it two-and-a-half years now -- further increases the costs of monetary union.

One final point: The ECB is not able to tailor its monetary policies to fit the needs of multiple countries. It's not possible. However, they have made the Eurozone crisis dramatically worse by changing the stance of their monetary policy during the recession.

In February, I constructed a framework for the analysis of monetary policy which, using real growth and inflation data, estimates a central bank's relative weighting of the losses which come from deviations from trend in either variable. Now that I built a dataset of Eurozone inflation in this post, I did the same thing for real growth and calculated the ECB's H-value, which is the variable capturing the relative weights on real growth and inflation.A higher H-value means that the central bank is more intent on stabilizing inflation at the expense of real output -- and this graph tells us that, at the worst of the crisis, the ECB's monetary policy implied that it assessed the costs of a 1 percent deviation in inflation at 6.5 times the cost of a 1 percent deviation in real growth. Only a few years earlier, they had viewed these costs as approximately equal. Of course, only one is true -- and the other represents unbelievably costly cowardice.