Dr. Stephen Silvia is an Associate Professor at the School of International Service at American University and a frequent contributor to AICGS publications and events.
The scene has become all too familiar over the past two years. Bleary-eyed European leaders emerge in the early morning from an emergency summit billed as the “last chance” to save the euro. They announce that this time they have really, truly, finally produced a viable rescue plan. Initially, stock markets rally. Interest rates for troubled European economies momentarily dip. In subsequent days, bond traders and economists inspect the details only to discover that there is far less to plan than at first meets the eye. Markets slump. Interest rates climb. Is this time different? What are the indicators of a credible solution? Unfortunately, the December European summit is only more of the same. The euro crisis will only come to an end when European leaders resolve the immediate problems of deleveraging, address the congenital flaws in the currency union that preclude it from functioning as an optimum currency area, and take proactive measures to soften the blow of an impending European recession. The latest plan European leaders have devised does none of this.
Despite the coordinated provision of liquidity by the world’s major central banks a few weeks ago, European banks are continuing to deleverage. Worse still, this deleveraging is undoing the integration of European financial markets as investors unwind their foreign holdings first. The European plan offers no common backstop and treaty restrictions impair the European Central Bank’s capacity to serve as a lender of last resort. As a result, there is no tourniquet to stop the bleeding. This short-run problem has captured the attention of the markets almost exclusively.
Beyond the short run, however, the underlying flaw of European monetary integration has been that the euro zone has never been an “optimum currency area.” A solution that does not create mechanisms to make the euro area optimum is doomed to fail. When plans to create the euro were being drafted, skeptical economists — such as Martin Feldstein in a famous 1997 Foreign Affairs article — pointed out that Europe was not an optimum currency area. An optimum currency area has means to balance out uneven growth across regions. The United States, for example, relies on internal migration and fiscal integration to keep our currency area balanced. If hard times hit Michigan while Texas booms, Michiganders pay less in income tax, become net beneficiaries of social programs, and move to Texas. Texans, on the other hand, pay more income tax and become net contributors to social programs. Even optimistic economists and politicians who supported creating the euro conceded in the 1990s that Europe was not an optimum currency area, but they argued that it was an “endogenous currency area,” which meant that the very act of creating the euro would change everyone’s behavior in ways that would make Europe an optimum currency area after the euro was introduced. As we all know now, this bit of wishful thinking never came to pass. As a result, policy changes that promote cross-national rebalancing must be included in any viable long-run proposal to save the euro.
Unfortunately, Germany’s growth model since the 1980s contributes to producing imbalances rather than resolving them. From the 1950s into the 1970s, the German’s “economic miracle” economy had a sustainable growth model. Germany was export oriented, but domestic incomes grew as fast as the general economy and German imports kept pace with German exports. In the 1980s, Germany transitioned to a new growth model. This new model has relied on suppressing domestic demand to obtain huge export surpluses, mostly with other European countries. At first, Europe’s weaker economies were able to survive the impact of the new German growth model on their economies through periodic depreciations of their currencies vis-à-vis the deutschmark. The creation of the euro foreclosed that option. As a result, peripheral euro participants steadily lost competitiveness as their wages and prices grew faster than those in Germany, but had no means to adjust.
Does the most recent plan to save the euro address the deep-seated flaws discussed above? No. It does not introduce a common income tax or joint social programs for the entire euro area. It does not liberalize migration. It offers no other viable, credible means to make an optimum currency area out of the euro zone. It instead simply aims to create more effective mechanisms to enforce the austerity menu spelled out in the 1997 Amsterdam Treaty. It does nothing to force chronic surplus countries (such as Germany) to contribute to maintaining growth, which must also be a part of any viable rescue plan. Indeed, the elephant in the room at the December European summit was the looming recession. Europe’s leaders did not discuss it and offered no short or long-term proposals to address it.
We are not there yet when it comes to resolving the euro crisis. The euro crisis will not abate until European leaders address the immediate delivering problem, the deeper structural flaws that prevent the euro zone from functioning as an optimum currency area, and take proactive steps to tackle the looming recession. Pursuing a fast-track Franco-German austerity treaty is unfortunately a costly diversion from accomplishing any of these three tasks.