Back in 1997, Martin Feldstein worried, in
a famous Foreign Affairs article [paywalled], that the introduction of the Euro could lead to war in Europe.
That still seems overstated, but the Euro
is pulling Europe apart politically, in the way Professor Feldstein predicted. The economic suffering of Greece has brought to power a far Left party which is prepared to support Russia against NATO and the EU.
Almost everything in the European situation can be read straight from the script of a little-known
political economy article subtitled "embedded liberalism in the postwar economic order". The original is frankly obscure, but the basic idea is simple. While free market liberalism may be efficient, the dynamism and disruption imposed by markets can cause a lot of pain in the short term. In a democracy, that pain may lead voters to choose populist solutions, a cure that ends up worse than the disease. Keynesian demand management during crises, and some form of welfare state in the long run, are the price economic liberalism must pay to democracy in order to prevent worse. (Those who feel nostalgic for earlier times, when market institutions could be implemented without paying heed to democracy, should remember that the disruptions of the 19th century prepared the ground for the growth of Marxism, liberalism and capitalism's most dangerous opponent. Politics
never goes away - it just hides sometimes.)
The Germans seem to have forgotten this basic idea. But I doubt very much that the German political elite are ignorant of the political dangers of their economic policy. Their problem is their own voters, who suffered through their own structural reforms and reaped the benefits, who have no experience of what Greece is going through, who of course think they have paid enough already, and who fundamentally care more about themselves than about the Greeks.
Let's flip a famous Jean-Claude Juncker quote around: German leaders know exactly what
not to do to Greece, but they don't know how to get reelected after not doing it.
Economists usually ask whether the Eurozone is an "optimal currency area" - one with free movement of labour and capital, synchronized business cycles, and a mechanism for fiscal transfers. An area like this can cope well with asymmetric shocks: unemployed people move to areas of higher employment, fiscal largesse helps weaker regions out, and in monetary policy, one size roughly fits all. Even in the 90s most economists thought the Eurozone was not such an area. They hoped that the introduction of the Euro might itself help it to get there "endogenously" - partly by creating the political will for fiscal transfers. As the
Delors report put it (italics added):
[European Monetary Union]...would imply a common monetary policy and require a high degree of compatibility of economic policies and consistency in a number of other policy areas, particularly in the fiscal field...
[t]he need for a transfer of decision-making power from Member States to the Community as a whole would arise primarily in the fields of monetary policy and macroeconomic management.
It turns out that in a union of democracies, that's hard.
On that basis, I suggest the following
Criterion for a politically optimal currency area:
- The democratic publics involved must have strong enough ties of common identity that they are prepared to help each other through economic and political difficulties.
The Eurozone is currently failing this test. The task for Europe's leaders is now to create this common identity "endogenously": the crisis itself must bring the peoples of Europe together, so that they can overcome it.
One helpful condition is there already. Social psychologists know,
as Bismarck did, that "war with outsiders creates peace inside".
Well, we don't need to manufacture a common enemy. We've got one already!
