Guest Contribution: “Successes and failures of the euro’s first 20 years”

Today, we present a guest post written by Jeffrey Frankel, Harpel Professor at Harvard’s Kennedy School of Government, and formerly a member of the White House Council of Economic Advisers. A shorter version appeared in Project Syndicate on January 26th.

In Europe, twenty years ago this month, 11 long-standing national currencies disappeared and were replaced by the new single currency, the euro.  Since then, the euro has had its successes and failures.

Let us review the experience of the euro’s first two decades.  Where there were failures, to what extent were they the result of avoidable technical mistakes?  Of warnings not heeded?  Or were they the inevitable result of a determination to go ahead with monetary union in the absence of a political willingness to support fundamental changes necessary to make it work?

Three early successes

Three early successes are insufficiently remembered.  First, the transition from individual currencies to the euro in January 1999 went very smoothly.   It was not obvious ahead of time that this would necessarily be the case.  Recall the European currency crises of 1992 and 1993 or more recent chaotic demonetizations elsewhere.

Second, the euro instantly became the world’s #2 international currency by virtually all measures of international use

Third, the incentive of being admitted to the club led to favorable reforms in many aspiring member countries, particularly countries in Central and Eastern Europe that joined subsequently to 2002.

Seven failures

There have been perhaps more failures than successes.  Consider seven failures.

  • First was the problem of asymmetric or unsynchronized shocks.  Many American economists, in particular, had warned beforehand that European economies lacked cyclical synchronization and the other key criteria for a group of countries to constitute an “Optimum Currency Area.”  It is much easier to give up monetary independence if your economy’s needs are correlated with those of the countries that will be setting your monetary policy. It is also easier if you have alternative means of adjusting to shocks, such as if workers can move between regions or if cross-union fiscal transfers can cushion local impacts.   European countries lacked these alternative mechanisms of adjustment compared, for example, to the 50 US states which share a common currency.

The warnings proved accurate.  To take one example, the Irish in 2004-06 needed a tighter monetary policy than the European Central Bank was prepared to set, because they were experiencing a housing bubble and economic overheating. But of course they had given up the ability to revalue their currency or raise their interest rate.  Conversely, during 2009-2013, Ireland needed an easier monetary policy than the ECB was prepared to set, because it was in steep recession. But it had given up the ability to devalue, print money, or lower its interest rate.

  • Second were the large current account deficits of the periphery countries during the euro’s first decade.  At the time, large net capital flows to the periphery were viewed as a sign of efficiency-improving financial integration.  In retrospect, the imbalances were  less benign, attributable in part to a rise in the periphery’s Unit Labor Costs relative to Germany’s.

  • The third failure was high budget deficits and debt levels in some countries, with Greece as the most extreme example.  The problem of moral hazard in national fiscal policy (i.e., the problem that fiscal discipline is eroded by the belief that the country would be bailed out in the event of a crisis) had not featured prominently in academic research.  (The academic emphasis had instead been on the Optimum Currency Area criteria.) But pushed by German taxpayers who were worried that they would eventually be asked to bail out some profligate Mediterranean country, the European architects of monetary union correctly identified fiscal moral hazard as a central vulnerability.  To their credit, they tried hard to address the problem.  They adopted (1) the Maastricht fiscal criteria, including the requirement that countries must get their budget deficits below 3% of GDP; (2) the so-called “no bail-out clause”; and (3) later the Stability and Growth Pact, which made the fiscal requirements permanent.

The fiscal rules proved un-enforceable in practice, however. Virtually all euro members soon violated the 3% deficit rule, including even Germany.  Governments repeatedly claimed that fiscal targets would be met in the future, assertions that could only be maintained via systematically over-optimistic growth forecasts.  (Officials during the first decade never forecast that they would have a budget deficit in excess of 3% of GDP, even though they often ran such deficits in successive years.  When the deficits did come in over the limit, the leaders could than attribute the shortfall to “unexpected negative shocks.”) 

  • Fourth, when periphery governments were suddenly able to borrow at miniscule sovereign spreads in 1999, relative to German interest rates, it was interpreted as good news. That the high-debt countries did not have to pay penalty interest rates, as indebted US states like Illinois have to do, should instead have been interpreted as a signal that the moral hazard problem had not been solved after all

Many have labeled it a fatal failure not to have moved more of the function of fiscal policy to the supra-national level – a failing that became clear in the euro crisis and is as troublesome in Italy today as it was in periphery countries in 2010.  (The same applies to banking regulation.  A few European economists  flagged correctly the need for pan-euro banking regulation if the project were to be successful. But that warning was ignored.)  It is perhaps not fair to label these as “mistakes” — since political opposition to federalizing these functions would have been overwhelming in the 1990s, as it still is today. 

In some other areas, however, the leaders really did score “own goals.”

  • The ECB mistakenly raised interest rates in July 2008 and again, twice, in 2011, despite the global recession.

  •  When the Greek crisis emerged at the beginning of 2010, European leaders did not handle it well.  They might have been able to contain the forest fire.  Instead it spread.
    Mistake #1 was the failure to send Greece to the IMF promptly.  Brussels and Frankfurt thought that the history of EM crises was not relevant to a euro member.  Mistake #2 was a refusal to write down Greek debt quickly enough, despite Debt Sustainability Analysis showing the debt/GDP path to be explosive even with stringent fiscal austerity.

  • The post-2009 emphasis on austerity — applied especially to Greece but to other countries as well — was a major mistake.  More specifically, the troika (EU Commission, ECB and IMF) in 2010 under-estimated the fall in income that would follow from fiscal austerity in the periphery countries.  Even leaving aside the economic cost of the recession and the political cost of associated populist anger, fiscal austerity did not achieve its financial goal of putting Greece and the others onto sustainable debt paths. To the contrary, the fall in GDP was greater than any fall in debt, with the result that debt/GDP ratios rose at accelerated rates.  

Failures #3 and #7 together add up to a history of pro-cyclicality in fiscal policy.  The combination of high spending in 2001-2007 and austerity in 2010-2018 made Greek fiscal policy one of the most highly pro-cyclical of countries in the world.  Government spending in other periphery countries, too, has shown positive cyclical correlations.   Fiscal pro-cyclicality of course exacerbates the amplitude of the business cycle.

Three more successes

One can conclude more optimistically with three further observations on the “success” side of the ledger:

First, some periphery countries, particularly Spain have gradually managed (via painful recessions) to bring their previously-uncompetitive unit labor costs back down.

Second, ECB President Mario Draghi warrants top marks for successfully walking the tightrope between the German need for discipline and the Mediterranean need for accommodation – most famously for the July 2012 press conference that contained the immortal sentence, that the ECB was “ready to do whatever it takes to preserve the euro.”  It worked.  The euro survived the crisis with all 19 members intact, contrary to some predictions in 2010 that Greece, for one, would have to drop out.  Draghi will be hard to replace when his term expires this October.

Third, opinion polls in recent years show the euro to have achieved high popularity, supported by 64% of the public as of November 2018.  So there is hope after all.

This post written by Jeffrey Frankel.

15 thoughts on “Guest Contribution: “Successes and failures of the euro’s first 20 years”

  1. 2slugbaits

    While I’m not a big fan of the euro, there is one additional (sort of) success story. It’s not well known, unless you read books like “Crashed” or Ben Bernanke’s book, but during the various Great Recession crises on both sides of the Atlantic, there was a fair amount of helpful coordination between the Fed and Brussels. I’m not sure if that same degree of cooperation and swapping would have been possible without a single currency for much of Europe.

  2. Moses Herzog

    You know I respect Professor Frankel, I think he’s overall a good economist, a good person, and I’m glad he contributes to Econbrowser. However, I’m fascinated by economists who spend the vast majority of their time extolling the “virtues” and “successes” of the EU (because economists’ profession has spent the last 25+ years selling/marketing it to us and are “fully vested” at this point??) who can never (certainly recently) get two simple words typed or out of their mouths: “employment” and “unemployment”. Two words that do not appear ONE SINGLE time in Professor Frankel’s post. Two words that under the very strange, bizarre, and freakish understanding of mine, were generally very important to people.

    But then I’m weird that way.

    How do “ivory towers” get (earn??) some of their stereotypes anyway?? Hmmmmm…………

    1. 2slugbaits

      Moses extolling the “virtues” and “successes” of the EU

      Prof. Frankel’s post is about the euro, not the EU. Different things. All countries that use the euro are in the EU, but not all countries in the EU use the euro.

      1. Moses Herzog

        @ 2slugbaits
        I’ll go share the good news with the 15% unemployed in Spain, the 18% unemployed in Greece, and the 10% unemployed in Italy. Boy, are they going to be giddy when they hear your good news!!!!! This newfound differentiation is EXCITING!!!!

        1. 2slugbaits

          Well, there surely is a big difference. You can fairly blame the euro for some of the unemployment problems in southern Europe, but blaming the EU is a much harder case. If anything the EU has improved things for Spain, Greece and Italy. On balance the EU is a good thing, as the Brits are about to find out the hard way. OTOH, the euro is a mixed bag…or in Prof. Frankel’s analysis, three successes and seven failures. I would hardly call Prof. Frankel’s post a ringing endorsement for the euro.

          1. Moses Herzog

            2slugbaits says: “If anything the EU has improved things for Spain, Greece and Italy.”

            Assuming you’re proud of that comment, I’ll let it stand and speak for itself.

            As far as Britain/UK, it’s going to be interesting to watch. I don’t think it’s going to be the disaster people are anticipating. And you can feel free to save the link to this comment and use it whenever you like. No one (no country) is going to look good if there is a global downturn, so weighed in with that happening, later attack/satirization of this comment or my thoughts on Brexit not causing as deep a harm as many think is fair game for attack later.

  3. 2slugbaits

    Moses Herzog I don’t think it’s going to be the disaster people are anticipating.

    That’s a strange policy test. Apparently you’re okay with Brexit being merely bad as long as it isn’t an outright disaster. Why would you support any bad policy irrespective of whether or not it’s bad enough to be called a disaster? Bad economic policies are fine with you, but you draw the line with disastrous economic policies??? I don’t understand that reasoning. Brexit might not be such a disaster that the British find themselves wearing animal skins while huddled around a fire and using stone tools to build solar calendars, but it’s pretty clear that a generation from now they will be significantly poorer than their continental cousins. That strikes me as a disaster for the next generation. And for what?

    And just to remind you, Britain is not and never was part of the EZ. Britain is (at least for now) in the EU, but not the EZ.

    1. Moses Herzog

      Brexit is not “bad policy” over the long term (other than joining the EU to start with). You might realize, if you ever followed markets and economic policies, that short-term pain sometimes has to be paid for long-term gain, and that is how I view Brexit. There is obvious pain and penalties to exiting prior contractual agreements. Even people not quite as bright a light of guidance as you imagine yourself, can observe that.

      And I realize the difference between a single currency and a single market as I have stated in my interactions with Menzie long before this post. I know you think very very highly of yourself oh great 2SlugbaitsGandalf, but you’re not quite as an enlightening a person as you imagine yourself. You are so benevolent to share though. And we’re oh so grateful.

      But, oh great and benevolent Gandalf 2slugbaits the White. Elf of the Wand, you might find comparing Iceland’s economic numbers to Greece and many other members of the EU to be highly educational—if you don’t mind me saying there is a possibility some things out there might supplement your great knowledge, Oh great Wizard. Please, oh great 2SlugbaitsGandalf, don’t be angry at me suggesting just that ever so small possibility.

      Oh Great, powerful, and benevolent Slugbaits Gandalf, please please forgive me for beseeching you to entertain the idea, you could learn something from another being.

        1. Moses Herzog

          You know I respect your thoughts greatly Menzie. Your examination of things economic, and ability to dissect economic issues on a much deeper level than me or most people is something I admire (and there’s no sarcasm there). And certainly it gives me pretty strong pause, makes me want to run it over in my mind more. It’s near impossible to argue Brexit is not going to have a short-term negative impact, and it’s very obvious it will have a short-term negative impact. But the label disastrous I disagree with, and I’m going to have to break away from you on this one. That’s not easy for me to do as much respect as I have for you, you know. It’s like I’m cutting off my own ideological umbilical cord and watching blood fly everywhere (nice visual??). I was going to say it’s started to give me a nervous tick in my left shoulder, but I’ve had that for many years now (joke). I just don’t see Brexit effecting UK that deeply.

          I just hope this doesn’t end up being like the scene in Ghostbusters though, and I’m the guy competing against the hot looking blonde.

  4. 2slugbaits

    Moses Herzog Iceland isn’t a formal member of the EU, but it is a member of the EEA. And except for agricultural and fishing markets this amounts to a distinction without a difference. EEA member states still belong to a single market.

    Brexit is not about short term pain and long term gain. That’s a fairy tale. Brexit is about short term pain and even more long term pain. And if you wanted anymore evidence that Brexit is for fools, just remember that Donald Trump thinks it’s a good idea. How does it feel to know that you and Trump agree on something?

    1. Moses Herzog

      The only point you made that hit your intended mark was the last comment. It’s certainly not on my “to do list”, but I have agreed with the orange bastard on other things—such as NATO member states increasing monetary contributions and/or otherwise. I’m generally pro-Israel (certainly when they don’t have corrupt guys like Netanyahu running the ship). I’m sure there’s others where I agree with the orange bastard. Is it “comforting”?? No. But he’s not a gauge for me either way. I think we’ve made our positions clear, and if I end up being wrong, I will wave my white flag at the appropriate time. But I feel strongly about it. I wouldn’t be standing on this side of the fence, on the Pro-Brexit grass, if I didn’t.

      I’ve tried to make this argument as respectfully as I can towards you. Let’s please leave this boxing round at that. You’ll have your future boxing rounds, and if I’m breathing I will be in the blog to take your shots.

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