Whither the Euro?

Top of the stack this week is Europe and the future of the euro. Since last week both France and Greece have thrown out leaders who backed “austerity” solutions to the euro crisis. With Greece unable so far to form a government and preparing for probable new elections shortly, it is unclear whether Greece will stick with the austerity agreement with the EU. Greece may leave the euro, go back to a national currency, and default on its debts.

There are two issues at play here. One is the question of austerity versus stimulus as the best response to a protracted recession such as Europe has experienced. Paul Krugman has been making a good case that much more stimulus was needed (a Keynesian approach). Imposing austerity on countries like Greece and Spain that are already economically depressed only worsens their economies and thus leaves them even less able to pay debts.

The more interesting issue is the structure of the euro currency itself. The edition of my International Relations textbook that came out in 2000 before the euro came into effect put it this way: “The creation of a European currency is arguably the largest financial overhaul ever attempted in history, so nobody knows how it will really work in practice.” The problem was that “in participating states, fundamental economic and financial conditions must be equalized.” The solution was to restrict membership to those countries who could meet standards of financial stability. With newfound fiscal discipline, 12 nations qualified, including Italy, Spain, and Portugal near the end and Greece at the last minute. Later it turned out that Greece had cooked its national books to appear to meet euro requirements (debt-to-GDP and such). But then it turned out that others, even France, had fudged their data a bit, so everyone moved on.

The euro currency creates the same problem, actually, as Argentina and China each did at one time by pegging their currencies to the U.S. dollar. The peg, like the common European currency, takes away monetary policy from national leaders but leaves them in control of taxing and spending. When two countries diverge — as China and the United States did over years of rapid Chinese growth — the currencies couldn’t adjust to reflect these changes. Both China and Argentina eventually dropped the dollar peg.

Argentina suffered four years of recession in the late 1990s during the dollar peg period, and racked up $100 billion in debt. The IMF demanded an austerity program as the solution — again the opposite of Keynesian advice during a prolonged recession. In 2001 Argentina’s economy collapsed and in 2003 it defaulted on billions of dollars in debt, eventually giving foreign investors pennies on the dollar. Since then, Argentina seems to have gotten back on track economically. Perhaps Greece will end up on a similar path if it leaves the euro zone. But for now, whatever path Greece takes is going to be a painful one.

Greece is too small to sink the euro, but Spain or Italy might. Still, I am betting that the Europeans stumble through again and that the euro will be OK, with or without Greece.

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