To the editors:

In his essay, Gilles Dryancour identifies some of the threats to the survival of Europe’s monetary union.¹ Such honesty is rare. Doubts about the future of the euro are often unwelcome in polite society, and those expressing such views must proceed with great care. This state of affairs can be attributed to political fears that dismantling the monetary union may prove fatal for the European project, leaving the continent vulnerable to the racist and protectionist programs of the nationalist right.

This concern was clearly evident in a letter published by Le Monde prior to last year’s French presidential election.² The signatories, a group of eminent economists that included no fewer than twenty-five Nobel laureates, were writing in response to the nationalist candidate Marine Le Pen, who had cited some of their work in support of her euroskeptic platform. 

In a trenchant critique of the letter, Roberto Perotti stressed that appeals to authority—by which he was referring to the prestige of the Nobel Prize—are never a convincing way to close a debate.

Economists like to boast of being hard-wired to debunk. So since when did the authority principle hold sway among them? This situation is starting to look like a small-scale version of the Protestant Reformation. For all the fire and fury of their pronouncements, anathemas and excommunications, and for all their academic titles and ecclesiastical benefices, the scholastics found themselves swept away by Luther and Calvin.³

Perotti’s critique demonstrates the folly of making opposition to the euro a taboo. The political dangers thought to be inherent in a eurozone breakup, are, in fact, already emerging in the less competitive member states as an economic consequence of the single currency. Namely, the high unemployment, low growth, and dire prospects of poverty are turning European voters toward nationalist candidates and parties. Nationalism is one of three reasons identified by Patrick Conway to explain why monetary unions are dismantled.⁴ The other reasons are avoiding contagion from monetary shocks originating in other member states and increased control over the collection of seigniorage.

Economic and Monetary, but Not Political Union

Right from the beginning, economists warned that efforts to create a European counterpart to the United States would fail.⁵ The formation of the Economic and Monetary Union of the European Union (EMU) may have been motivated by utopian ideals, but, according to economists, the union was more likely to lead to dystopia. Writing in 1997, Milton Friedman observed that

Europe exemplifies a situation unfavourable to a common currency. It is composed of separate nations, speaking different languages, with different customs, and having citizens feeling far greater loyalty and attachment to their own country than to a common market or to the idea of Europe.⁶

In 2001, Jean-Jacques Rosa declared,

Europe is making the worst mistake since the deflationary policies of the 1920s which turned the 1929 stock market crash into a decade of tragedy. The single currency is not a decisive advantage for the continent. It is a time bomb.⁷

According to Martin Feldstein,

Instead of increasing intra-European harmony and global peace, the shift to EMU and the political integration that would follow it would be more likely to lead to increased conflicts within Europe and between Europe and the United States.⁸

Béla Balassa’s theory of economic integration stressed that monetary unions do not work without political integration.⁹ “Political unity,” Michael Bordo and Lars Jonung observed, “is the glue that holds a monetary union together. Once it dissolves, it is most likely that the monetary union will dissolve.”¹⁰

Successfully maintaining a single currency entails each member agreeing to enter into a cooperative monetary union and accepting all the economic and political constraints attached to such cooperation. In the words of John Stuart Mill, albeit repurposed for governments rather than citizens, membership of a monetary union should mean “to be guided, in case of conflicting claims, by another rule than his private partialities; to apply at every turn, principles and maxims which have for their reason of existence the common good.”¹¹

A Club with Rules

In reality, each member of the EMU is pursuing their own strategy. This uncooperative dynamic may prove an insurmountable obstacle for the successful maintenance of the monetary union. These individual strategies are camouflaged by an elaborate framework of rules. The initial design of the EMU’s rules reflected the collective memory and economic structure of the club’s core member, Germany. The historical events most widely identified as shaping German collective memory in this context are the country’s experience of hyperinflation and the destruction of democracy during the interwar period.¹² The lesson drawn from those calamities was the importance of a rules-based framework as a bulwark against arbitrary adventurism.¹³

Two key EMU rules guard against fiscal and macroeconomic imbalances. The same German political culture, itself an expression of modern German nationalism, that inspired those rules has also led Germany to break them. The most frequently cited examples of rule-breaking occurred during 2003–2004. The euro created by the Treaty of Maastricht was to be a common currency with a single monetary policy determined by a European Central Bank (ECB) with an anti-inflationary mandate. The users of this common currency would remain fiscally sovereign nation-states. For this reason, Germany insisted on the introduction of fiscal rules such as the Article 125 “no bail-out” clause, which makes it illegal for one member state to assume the debts of another, and the adoption of a Stability and Growth Pact (SGP) to avoid a situation in which member states could obtain a free ride at the expense of taxpayers elsewhere within the monetary union.¹⁴ Germany policy makers understood that  “[w]ithout such a framework, government debt might eventually reach an unsustainable path, thus forcing the central bank to adopt an inflationary policy.”¹⁵

From the outset, notions of fiscal prudence did not seem to apply to the club’s founders. In November 2003, both France and Germany violated the SGP and used “their political power to prevent sanctions against their own violation of the pact’s fiscal rules.”¹⁶ France broke the 3% budget-deficit-to-GDP limit eleven times, more than any other eurozone member, according to a CESifo report published in May 2015 based on European Commission data for the period 1999 to 2015.¹⁷

More systematic and significant rule-breaking on the part of Germany has occurred in relation to the eurozone’s other key rule designed to avoid macroeconomic imbalances. The goal is to achieve economic convergence despite the difficulties involved in correcting external payments imbalances within a single currency area in which devaluation has been specifically ruled out as an option for maintaining competitiveness.¹⁸ A monetary union between fiscally-sovereign states, such as the EMU, entrenches differences in competitiveness between members.¹⁹ In the less competitive economies, current account deficits will increase.

Dryancour’s essay is effective in explaining the resulting overvaluation of the notional French franc against today’s deutschmark. The Italian lira and many other components of the euro suffer from the same, or even worse, overvaluation. Differences in competitiveness between EMU member states have also been aggravated by German policies. In violation of the ECB’s 2% inflation target, German wages were depressed after the launch of the euro by reforms that culminated in the Hartz IV package implemented in 2003. It was no accident that Germany’s current account surplus expanded to average around 6% of GDP after 2004. The situation was made worse in the wake of the Global Financial Crisis (GFC) of 2008 by a German constitutional amendment requiring balanced budgets, which was enacted in mid-2009 at the height of the post-GFC recession. As a result, the moderate post-GFC budget deficit of 3.5% of GDP achieved using automatic fiscal stabilizers had fallen to zero just three years later. Germany’s private sector surplus of 7% of GDP has duly appeared in persistent current account surpluses of that same 7% of output.

Dryancour surveys the spectrum of opinion among economists on whether the EMU and the ECB’s price stability mandate has had deflationary or inflationary effects. He offers an interesting digression on the theme of monetarists versus Keynesians in the history of economic thought, but tiptoes around the main point. Germany has, by its own actions, amplified a deflationary bias, and neither the ECB nor any other eurozone authority has been willing or able to do anything about it. The European Commission is mandated to enforce the Macroeconomic Imbalance Procedure (MIP) by launching infringement proceedings against eurozone countries running a “3-year average of the current account balance as a percentage of GDP, with indicative thresholds of +6% and –4%.”²⁰ Germany clearly meets the qualifications for such proceedings, under which it would be required to present an action plan to cut the surplus. If that fails, the Germany government could be put on probation and forced to pay a deposit of up to 0.1% of GDP into a special account. If no further action is taken, this money can be seized. No such sanctions have ever been applied. A report by the European Court of Auditors concluded that the “MIP is generally well-designed and based on good-quality analysis. But at some important stages, the process is political rather than technical.”²¹

Any such sanctions would risk destroying German political support for the euro. Clearly, the rebalancing mechanism is jammed. Since internal revaluation by Germany is ruled out, all that remains is for the less competitive fellow-eurozone countries to pursue internal devaluation. But with Germany deflating its own domestic demand, the other countries are obliged to force down unit labor costs to an ever more extreme extent in an effort to regain competitiveness. Given the practical and political limits on cutting nominal wages, this is very hard to achieve. As Dryancour mentions, the practical outcome is high unemployment in the less competitive countries. He might have taken this point further. High unemployment results in de-skilling and impaired productivity, leading to a degradation of the social and productive fabric.

Rudiger Dornbusch predicted these outcomes in 1996.²² The effects can be seen not only in Italy, but also throughout Mediterranean Europe, including France. Dryancour mentions productivity increases in France as evidence of the convergence required for sustainable participation in the eurozone. These productivity gains have been achieved at the expense of long-term mass unemployment, around 10% in France while Germany has virtual full employment. In France, the resulting social tensions are clearly evident. As a result of lackluster growth, public and private debt has grown rapidly relative to GDP. For this reason, any sense of complacency about France remaining a happy member of the monetary union should be treated with great caution.

There are no real winners from this situation. At first glance, Germany might appear the winner, but German workers would likely see the situation rather differently. After-tax personal disposable incomes have fallen far behind Germany’s output growth. The worst-placed countries, such as Italy, have not experienced any output growth at all. Last year, Italy’s GDP was still 6% below the pre-GFC level and, even more shocking, the personal disposable incomes of its citizens are lower than when the euro was launched in 1999. As with any complex phenomenon, Italy’s growth struggle has various causes, including long-standing structural and institutional weaknesses. But addressing those problems while constrained by the EMU in its present form is next to impossible. In the absence of growth, Italy’s public finances have deteriorated. At the time of writing, the European Commission is poised to recommend the launch of an excessive deficit procedure against Italy. This is the same commission that has refrained from launching a symmetrical MIP against Germany. The rules governing this rules-based monetary union are distinctly lopsided.

Mercantilism

The losers from Europe’s monetary union in its present form are not limited to the citizens of its participating countries, but also include the rest of the world. This is the result of the ECB’s introduction of quantitative easing (QE) in 2014. This policy initiative had the desired effect of driving down the euro’s exchange rate against the US dollar and other trading partner currencies. If the ailing eurozone countries, such as Italy, could not benefit from growing demand in the German-centered core of the eurozone, they would be able—thanks to QE—to tap into the rest of the world’s demand. This drive for export-led growth was launched when the eurozone was already running a huge current account surplus against the rest of the world. While even Italy managed to eke out some modest growth—helped by the simultaneous collapse in oil prices—the main effect was to make Germany even more competitive.

Dryancour sometimes seems to pull his punches, but on this particular subject he nails the consequences of what he calls German mercantilism.²³ In their letter to Le Monde, the Nobel laureates criticized protectionist and beggar-thy-neighbor policies. Ironically, the eurozone’s own policy through QE has been beggar-thy-neighbor. This has, in turn, provided a rational justification for the Trump administration’s protectionist response.

Federal Transfers

A logical solution to the eurozone’s problems would be to move to a political union with a federal budget and unified sovereign bond market. Given the economic and social tensions facing France inside the eurozone it is no wonder that the French president has been pressing Germany to agree to deepen the eurozone by moving toward a common fiscal policy.

Aside from his incisive analysis of mercantilism, the other highlight of Dryancour’s essay is his demonstration of the unrealistic nature of this project. One reason for its implausibility is the scale of the fiscal transfers that would be needed. Dryancour refers here to Jacques Sapir’s estimates that Germany would need to redistribute at least 8% of its GDP to the ailing eurozone member states. Dryancour goes on to highlight a second and even more fundamental problem. In the unlikely event that such transfers ever became politically acceptable in Germany, they simply would not work. The case history cited by Dryancour here is that of the former East Germany, still depopulated and mired in weak productivity despite massive fiscal transfers in the three decades since the monetary union with West Germany. He might also have added the case of Italy. An analogous relationship between the relatively prosperous north and backward south has failed to lift the Mezzogiorno out of a similar predicament.

Outlook

Dryancour concludes that Italy would be the most likely cause of any eurozone breakup “unless the deterioration of TARGET2 balances forces Germany to leave first.” TARGET2 is the settlement system for euro payment flows between banks, operated by the eurozone’s system of central banks—the ECB and the national central banks (NCBs). Germany’s net TARGET2 assets have risen to almost a trillion euros. It is for this reason that Dryancour believes TARGET2 should be seen as a potential cause for the collapse of the single currency.

In a footnote, Dryancour appears to offer a somewhat revised view, describing TARGET2 as being closer to a symptom than a cause. This seems a more accurate summation. He makes explicit reference to TARGET2 imbalances reflecting imbalanced trade. The implications are, in fact, far broader. This is due to the fact that capital and financial flows of all types contribute to net TARGET2 assets and liabilities. At the height of the 2010 crisis, such flows included residents of Greece transferring their deposits from Greek to German banks. The more recent build-up of TARGET2 imbalances stems from the uneven distribution of liquidity arising from the ECB’s QE program.

The views of Hans-Werner Sinn are briefly mentioned by Dryancour.²⁴ According to Sinn, Germany’s net TARGET2 assets presage real losses and justify German withdrawal from the monetary union. Last year, the current president of the ECB, Mario Draghi, made a surprising intervention in this debate. If a country were to leave the Eurosystem, according to Draghi, the liabilities of its NCB to the ECB would need to be settled in full.

If a country exiting the eurozone was unwilling or unable to meet any such obligation, the equity of the Eurosystem would be reduced, if not wiped out. But there is no requirement, neither legal, nor in practice, for either the ECB or the eurozone’s NCBs to retain positive equity. The ECB could choose to disregard the fact that it was insolvent on paper and stick to its operational mandate. If the ECB were determined to rectify a negative net worth position on its balance sheet by means of recapitalization, this could have inflationary consequences. Germany would then be faced with an unappetizing choice between trying to live with a formally insolvent central bank and the inflationary recapitalization of the central bank. The latter would also likely be accompanied by the necessary recapitalization of several commercial banks due to the cascading losses that would follow the exit of a country—especially one as large as Italy—from the single currency.

Dryancour mentions the problems confronting the Italian banking system as a likely proximate cause for an Italian exit from the eurozone. A little further on, he refers in passing to German pressure for higher interest rates as another trigger. This last point should be emphasized. The ECB is now ending its QE program and large-scale purchases of government bonds and other securities by the ECB are also coming to an end. As a result, pressure on Italian bond markets will intensify. A parallel effect arising from the end of QE will be strengthening of the euro exchange rate, which will, in turn, constrain the growth of less competitive economies, such as Italy. Another crisis for the euro is in the cards.

The consensus view among commentators would likely be that, as was the case during the prior crisis, the political will to prevent the collapse of the single currency will result in the next crisis being contained by a similarly muddled accommodation that leaves the underlying problems unresolved. Regardless of whether that particular expectation proves accurate, one can predict with confidence that Europe will experience continued and intensified distress—financial, economic, and ultimately social.

My own research, undertaken with Alberto Bagnai and Christian Mongeau Ospina, has found that the transitional shock of an Italian exit would be less severe than anticipated. In relation to the TARGET2 discussion, such an outcome might be less implausible than is widely supposed. The costs incurred by Germany would boil down to recapitalizing its own banks, as opposed to the far more objectionable alternative of a federalizing transfer union requiring the redistribution of vast resources from Germany to southern Europeans.

Dryancour begins his essay by briefly mentioning the history of failed monetary unions. Andrew Rose offers a somewhat more reassuring verdict:

I find that countries leaving currency unions tend to be larger, richer, and more democratic; they also tend to experience somewhat higher inflation. Most strikingly, there is remarkably little macroeconomic volatility around the time of currency union dissolutions, and only a poor linkage between monetary and political independence. Indeed, aggregate macroeconomic features of the economy do a poor job in predicting currency union exits.²⁵

Brigitte Granville

Gilles Dryancour replies:

I would like to sincerely thank Brigitte Granville for her thorough analysis of my essay. Her comments perfectly complement my diagnosis of the structural dysfunctions of economic and monetary union.

I have been writing about the euro since 1998, not with the goal of questioning those who defend the single currency, but with the desire to understand its implications for our economies. I have no particular antagonism toward the euro. My thoughts could have targeted any currency of the same nature, such as the single Italian lira issued in 1861 that Granville rightly mentions. It is an indisputable fact that this monetary unification, instated by the leaders of northern Italy, permanently impoverished the Mezzogiorno through mechanisms comparable to those that feed Germany’s enrichment today.

In my article, I favored the example of German monetary unification after the fall of the Berlin Wall since its effects are less known by the general public. This example is also chronologically closer to the euro; only eight years separate the disappearance of the ostmark on July 1, 1990, and the implementation of the euro on January 1, 1999. By 1999, German monetary unification had already realized most of its negative consequences, in particular the loss of competitiveness of the East German economy, which led to its deindustrialization, followed by the departure of two million East Germans, often young and qualified, to the West. West German leaders had competent knowledge of the harm that a fixed exchange rate currency could cause when uniting two fundamentally heterogeneous economies.

The question then arises: What did German leaders expect from the euro, beyond the end of competitive devaluations in the internal market? It is difficult to respond without falling into historical reconstruction; nevertheless, it can be argued that they did not act against their own interests.

Both the German monetary union and the European monetary union strengthened West Germany’s economic power. And the latter did so much more. Unlike when the mark was unified, the euro was not accompanied by a transfer of wealth from West Germany to the less productive members of the new monetary union. On the contrary, Germany has managed, over the last three decades, to have the cost of its own reunification partly financed by European taxpayers through the union’s structural funds. Admittedly, this has occurred in modest proportion—80 billion euros out of 1,600 billion between 1991 and 2015—but it is nonetheless morally questionable since some of these transfers took place after the eurozone had formed.

As Robert Mundell thought, the proper functioning of a monetary zone without internal devaluation requires the geographical mobility of individuals.²⁶ Otherwise, unemployment will eventually increase and concentrate in the least productive regions of the currency zone.

The United States has long been perceived as the optimal currency zone. The cultural homogeneity of the country allows relatively easy geographical mobility. In the 1960s, 20% of the American population moved each year.²⁷ By 2016, this rate fell to 11.2%, probably as a result of the middle-class labor supply becoming inadequate to the demand of large globalized cities.²⁸ The United States is no longer as optimal a currency zone as it once was. Lower mobility is now reflected in uneven unemployment rates between states, ranging from 6.3% in Alaska to 2.4% in Iowa.²⁹ This is a difference of a little more than double, but with low variance.

By way of comparison, the annual geographical mobility rate in France is around 7%, that of Italy 4.5%, and that of Spain 4%. A very small fraction of these percentages, less than 0.5 points,  concern moves to other countries within the European Union.³⁰ In other words, geographical mobility within the eurozone is next to nonexistent.

Not surprisingly, the low mobility among eurozone countries leads to greater disparity in unemployment rates than in the United States. In autumn 2018, these rates ranged from 3.4% in Germany to 19% in Greece. This is a difference of 1 to 5.5 with high variance, more than double the US gap—1 to 2.6. Unemployment rates at this same time were 8.1% in the eurozone and 3.7% in the United States.³¹ In other words, the US economy has twice as much capacity to homogenize the labor market as the eurozone, even though its mobility rate has fallen by more than 40% over the past fifty years. These statistics reveal the suboptimal nature of the euro area.

Granville points out that Europe is composed of different nations, speaking different languages, with different customs, and whose citizens are more attached to their own countries than to a European ideal. She is right that Europe’s cultural disparities act as a brake on geographical mobility. Underlying low mobility within Europe are the high opportunity costs of expatriation. Leaving family and friend networks, learning a new language, integrating into another culture, facing complex administrative procedures, working in an unknown professional environment, all this has a cost that typically has to be offset by significantly higher income than would be available in the home country. The unemployed in southern Europe who would most need to relocate to find a job are not necessarily the most employable. As Granville observes, they may be disqualified by lack of training or skills. If they cannot find work in their home country, they have virtually no chance of finding a well-paid job in Germany, Austria, or the Netherlands. The only jobs they could claim would be so-called mini-jobs, notoriously low paid, and often less than the welfare incomes to which they are entitled in their own country. As a result, the opportunity costs of expatriation are perceived as exorbitant, except for the most skilled or enterprising workers. Europe’s advanced social safety nets discourage individuals from seeking employment outside their own country.

It is therefore unsurprising that ruling parties in Germany have recently decided to encourage immigration from outside the European Union in order to address their labor shortage.³² From the point of view of German leaders, it makes sense to use a workforce from outside Europe, where people have positive costs of emigration. These come from countries that are chronically underemployed, often with precarious living conditions and no social protection system.

If we take the United States as a reference for an optimal currency zone, we quickly realize how far we have to go to homogenize the eurozone’s labor markets. This goes beyond the question of overcoming cultural differences. As we understand it, greater geographical mobility within the eurozone would require the dismantling of welfare states, which are at the heart of the European social model.

One of the best measures of the size of these welfare states is the tax rate. In 2017, it was 27% in the United States, 37.5% in Germany, 42% in Italy, and 46% in France.³³ Assuming that a 25% tax rate ensures full labor mobility in an optimal currency zone—it was 23% in the United States in 1965, at a time when the geographical mobility rate was still 20%—France would have to reduce its tax rates and social security net by 21 percentage points of GDP, or 450 billion euros. This would be a challenge, especially when we see that the reforms undertaken by Emmanuel Macron have plunged France into a pre-revolutionary state. The French president recently had to concede 10 billion euros in unfunded social measures to try to put an end to the yellow vest protest movement.³⁴ These measures will further increase France’s budget deficit; before 1973 and the ban on monetizing the debt by the Banque de France, they would have led to the devaluation of the franc and higher inflation. In this respect, we gladly join Granville in her quoting of Andrew Rose, for whom a return to national currencies would lead to significantly higher inflation than with the maintenance of economic and monetary union.

But would the countries that decide to leave the euro necessarily be richer for it, as Rose assumes? For Italy, this is a likely reality since growth has been almost zero since the euro was adopted. For Germany, greater wealth is far from certain. The inevitable revaluation of the mark after abandoning the euro would likely be violent. It is enough to look at the share of exports in German GDP since the euro was adopted. They were 27% of the GDP in 1999 and 47% in 2017—an increase of 20 percentage points.³⁵ Of course, a return to the mark would not automatically lead to a 20-percentage-point drop in the German GDP, since the competitiveness of exporting industries is not determined solely by the mercantilist effects of an undervalued euro. But if we imagine that the return to the mark could result in a 10% reduction in the volume of exports, German GDP would fall by almost 5%, a shock comparable to that of the 2008–2009 crisis, with, in this case, probably longer-lasting effects.

Granville rightly observes that the euro has deflationary effects within Germany and that these effects are spreading. The non-revaluation of wages and the reduction in social assistance in Germany, against the backdrop of an undervalued currency, are pushing all the other countries in the region to race to deflate. For the least productive countries, this race is all the more unsustainable as they have high public debt that they cannot liquidate through domestic inflation and the devaluation of their national currency abroad. The only way for them to stay in the eurozone is by following the path of Greece. But this path, it should be remembered, led to the collapse of Greece’s social system and its GDP, which has fallen by 27% since 2010. Greece could have been better off if it had liquidated its public debt through inflation. Its international creditors would probably have lost more than the Greek employees and pensioners have. In any case, Greece’s example shows that the deflationary nature of the euro has revived old disputes over the rent-geared-to-income economy and favors holders of capital or a public pension over private employees. For the time being, the potential conflict among these three interest groups has been partially offset by the ECB’s policy of zero interest. As soon as interest rates rise, conflict among these groups will become inevitable and result in political upheaval, the first signs of which are beginning to appear in France and Germany. Then, the prophetic title of Granville’s letter will take on its full meaning.

But for the time being, the euro seems to be enjoying a renewed popularity that temporarily protects it from any ruling that would dismantle it. According to the November 2018 Eurobarometer:

A majority of 74% of respondents across the euro area said that they thought the euro was good for the EU. This is the same as the record high score set last year and confirms that popular support for the euro is at its highest since surveys began in 2002.³⁶

But as all monetarists know, the fate of a currency does not depend solely on an opinion poll or political will. The opposing economic forces within a fixed exchange rate monetary zone determine a currency’s duration. The European Economic and Monetary Union is likely to be much shorter than the Latin Union (1865–1927), which was firmly based on the gold franc.

Between the various predictions for the euro’s end, economic fact will decide. It could still have many surprises in store for us.

Translated from the French by the editors.