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June 03, 2005

Was the Euro a Bad Idea?

Now they tell us. The Economist suggests that the euro was a bad idea:

The Economist: Even before the euro was adopted, in 1999, it was clear that neither the EU nor the 12-member subset that has joined the monetary union was an optimal currency area. Ideally, currency zones should be compact and homogenous enough to show little regional variation in business cycles—otherwise a one-size-fits-all monetary policy will leave some regions lingering in recession, while others grow so fast they overheat. Many argue that this is what is happening in Europe, where a few countries, like Ireland, are experiencing rapid growth while big economies, like Germany and Italy, stagnate.

There are ways to mitigate imbalances within big currency areas.... America has important features that temper the problems of unified monetary policy. Federal programmes act as automatic fiscal stabilisers, siphoning off tax revenues from booming areas and transferring them to ailing regions as unemployment insurance or health benefits for the poor. America’s labour market is also highly flexible... capital flows freely as well.... In Europe, by contrast, few mechanisms exist to bring the euro area’s widely divergent business cycles into sync. The ECB has been trying to chart a middle course between slow- and fast-growing countries while establishing its credibility as an inflation-fighter. The result has been a monetary policy that is too “hot” for some, too “cold” for others, and “just right” for almost no one.

The lack of adjustment mechanisms means that “ever closer union” is not just a glowing ideal; it is a matter of survival. Language and cultural barriers-—not to mention wide differences in social insurance and retirement programmes-—encourage workers to stay in their own country, no matter how bad the economy, closing off one of the easiest avenues of convergence. If Europe’s economies do not drive forward towards... labour markets that are more flexible (and international), there is a growing risk that some of its members will eventually find the gulf between their economies and their monetary policies too wide to endure....

[R]ecent policy moves have all been in the wrong direction. Not only has the stability and growth pact, which was supposed to help force fiscal policies into rough alignment, been weakened... stalled... EU’s services directive... fierce public resistance to eroding generous worker and consumer protections... governments unwilling, or unable, to implement... deep structural reforms.... [T]he euro will probably be able to limp along, at least for a while—-particularly if the ECB cuts interest rates.... But if nothing is done, the instability will mount. Already Italy is being compared to Argentina.... At this point such comparisons are scary possibilities, not likely outcomes...

Posted by DeLong at June 3, 2005 02:45 PM