The Breakup of the Euro Area: Comment
October 2008
By MARTIN FELDSTEIN
(PDF Version)
Im pleased to be a discussant of Barry Eichengreens paper
about whether the euro and the European Economic and Monetary Union (EMU) will
survive. Before turning to the substance of this interesting
paper I should say something about the views about the euro that I expressed a
decade ago before its launch (The Economist, 1992; Journal of Economic
Perspectives, Fall 1997, and Foreign Affairs, November-December 2007). Contrary to what many people think, I did not
express doubts about whether the EMU could be launched or whether it could
survive. My concern in those papers was that the single currency would have
undesirable long-term economic and political effects, including higher average
unemployment in the euro zone and a weakening of the political alliance between
Europe and the United States. I shall not pursue those ideas here. Barry has given us a careful and balanced analysis
of the possibility that one or more members of the EMU will leave the monetary union in the
coming decade. He concludes that one country leaving in the next 10 years is
unlikely and a complete breakdown of the EMU during
that period is even less likely. He notes that it is difficult to predict
beyond 10 years but suggests that a political marriage that lasts 10 years is
likely to keep on going. I will begin by discussing Barrys analysis and then
to go beyond his framework to consider two other reasons why one or more
members of the EMU might chose to abandon the euro. The draft that Barry circulated to the conference
was dated May 2008, indicating that he prepared these remarks well in advance
of the meeting. But as he noted in his
presentation, the current financial and economic crisis may provide a severe
test of the strength of the monetary union.
But nothing that Barry said in his presentation makes me think he
changed his mind because of the current situation. Ill return to that at the end of my remarks. The potential exit of an EMU member is not just a
hypothetical question. The interest rate
differentials among the 10 year government bonds of the EMU countries shows
that financial markets consider it a real possibility. The interest rate on the German bond is the
lowest. But the 10-year government bonds
of Greece and Portugal pay more than 100 basis points more than German bonds
and even Italian bonds pay nearly 100 basis points more indicating
that the markets think that there is a risk that during the next decade those
countries will not be able to pay in euros either because they are insolvent
or because they have left the EMU. Barrys analysis proceeds along two basic
tracks. First he considers whether it
could be in a countrys rational self interest to leave the EMU. Second he considers the barriers technical,
legal and political that might cause it to stay in the EMU even if the government of
that country thought it would be desirable to leave. I will start with the latter issues. Barry notes
that many previous currency unions or single currency states have broken up
(the Austro-Hungarian empire, the Soviet Union, the
Czech-Slovak split). But he then goes on
to argue that those splits occurred either at a much earlier time in history
when financial systems were simpler or in countries with simpler financial
systems. He also notes that the exit by
one EMU country might not be by mutual agreement, adding treaty
complications. But in the end he
concludes that splitting a country out of the EMU would be possible although
the leaver would have a diminished political status in the EU. Having set those issues aside I can focus on why a
country might decide to leave the EMU.
Of course, countries dont decide.
Political leaders decide. I will come back to
that important distinction. RATIONAL OPTIMAL POLICY I will start as Barry does by asking whether it
could be in a countrys interest to leave the EMU. Barry focuses on the desire of a country to
pursue a different monetary policy. He notes that a country with slow growth,
high unemployment and a large trade deficit -- he gives Greece, Italy and or Portugal as current examples --
might be tempted to leave in order to ease monetary conditions and devalue its
currency. Barry explains why that might
be a foolish decision because leaving the euro zone might lead to higher real
interest rates and higher inflation. Conversely, a country that wants a tougher monetary
policy that could be Germany if some future majority in the ECB is less
concerned about inflatation than Germany is at that time could leave the EMU
in order to pursue a tighter policy.
Barry explains the risks of that strategy, particularly the capital
inflow that might occur, but recognizes that the economic consequences for a
strong country leaving the EMU would be less adverse than for a weak currency
country. Although the problem of a one-size-fits-all monetary
policy is the most obvious reason for a country to want to leave the EMU, it is
not the only one. The Stability and Growth Pact that limits fiscal
deficits might be another reason why a country might want to leave the
EMU. In a serious downturn, a country
may wish to pursue a traditional Keynesian policy of fiscal stimulus. Although the Stability and Growth Pact may be
elastic enough to permit some of that stimulus, a country may feel constrained
from acting as aggressively as it wants.
It is certainly possible that the current downturn especially if it
becomes very deep and very long will provide a fiscal challenge to EMU
solidarity that has not occurred during the past decade. It is of course also possible that a substantial
number of countries will decide at some future tome to pursue a very
expansionary fiscal policy and that the ECOFIN will choose to allow that
because of a significant economic downturn. A country that is opposed to such large fiscal
deficits and that sees itself hurt by the resulting rise in euro interest rates
and by the induced change in the value of the euro might feel that it would
rather pursue a tighter fiscal policy in order to avoid those exchange rate and interest rate
consequences and would leave the EMU in order to do that. The current financial crisis raises another problem
the lack of a clear national lender of last resort. It remains to be seen how willing the ECB
will be to provide national central banks with the volume of euros needed to be
a full lender of last resort. If a
country sees its banks failing because the national bank cannot create as much
currency as it would have been able to do before the EMU,
that would be a further reason for a country to consider leaving the
EMU. There is one further reason that might apply to
leaving the European Union (EU) as well as the EMU. As of now, taxation is a national responsibility
within the EU. Income redistribution
among the EU countries is thus relatively limited. But there is frequent discussion in some
circles that this should be a matter for the EU, opening the way to substantial
income redistribution. High income
countries might find this reason enough to want out. Although each of these four reasons monetary,
fiscal, lender-of-last-resort and taxation -- might be enough to cause a
country to want to leave the EMU, Barry might of course be able to explain in
each case that doing so would be a mistake.
But the economic officials in the EMU countries might not understand the
economy as well as Barry does or may have a quite different view of what drives
inflation, exchange rates and other key variables. We certainly know that thinking about those
key relations has changed substantially even in the United States during the
past few decades. So officials might be
provoked by any of these four reasons to believe that withdrawing from the EMU
would be helpful even if the majority of economists at this conference would
disagree. THREATS But lets for a moment assume that the government
officials fully understand the adverse consequences of leaving the EMU and do
not want to do so. These officials may
nevertheless not like the way policy is going in the EMU monetary policy at
the ECB or fiscal policy because of an inadequately (or excessively) permissive
ECOFIN. That may cause the country to
threaten that it will leave the EMU if policy is not changed. That is clearly a substantial risk if the
country is Germany or France. But even
if it is one of the smaller countries it might be a serious threat because it
could be seen as the beginning of an unraveling of the EMU. So either type of country could make the
threat in the hope that the threat would be enough to cause their EMU
colleagues to agree to their desired change in policy. The risk of course is that the other countries may
not be intimidated. The threatening
country would then have to choose between accepting a humiliating defeat or leaving the EMU. DECISIONS OF POLITICIANS I want finally to return to the idea that policy
decisions are made by individual politicians or groups of politicians who are
motivated by the own self interest rather than by a pure interest in the
national well being. Democratic
procedures are of course supposed to align the self-interest of politicians and
the well being of at least a majority of the public. But that only works in a complex area like
economic policy if the public is sufficiently wise, technically sophisticated,
and far sighted. If not, and this is certainly a more reasonable
description, a politician could make the
case for a policy that will help him or his party to get elected even if it is
not in the long run national interest. Heres an example of how self-interested politicians
could lead to an EMU withdrawal by building on existing voter attitudes. A
recent official Eurobarometer survey indicated that 95 percent of respondents in the Euro 12
coungtries believe that the EMU has raised prices (Lane, Journal of Economic
Perspectives, Fall 2006) . In Italy it was 97 percent and in Germany 91
percent. If at some future time inflation is rising rapidly, it might
occur to some political group to argue that if they are elected they will bring
down prices or inflation by taking the
country in question out of the EMU . Or, to take a different
example, what if the current economic downturn and financial crisis becomes
very severe, producing very high unemployment. It is
certainly possible that some politicians will argue out of a mixture of
conviction and self interest that, if elected to a position of control, they would take
their country out of the EMU, permitting the combination of easy money, fiscal
deficits and lender-of-last resort assistance to banks to revive the economy. It is important in this context that the support for
the EMU and even for the EU is generally very weak. For example, when the Eurobarometer recently asked French respondents how
attached they are to the European Union, only 16 percent said that they are
very attached. In contrast, 56 percent of that group said they were very
attached to France as a nation. Barrys paper reports similar lack of support for
the EMU among respondents in many countries.
When asked in the 2006 Eurobarometer survey whether they thought EMU
membership had been to the advantage of their country, only 40 percent of
Italians said yes. The proportion was
similar in Portugal and even smaller in the Netherlands and Greece. In Germany
it was only about 45 percent. Only four
countries showed really substantial belief more than 60 percent -- that EMU
membership had been advantageous: Ireland, Luxembourg, Austria and Finland. Similarly, when asked whether they had confidence
in the ECB, only 44 percent of Italians said yes. In short, after a decade of experience with
membership in the EMU, the public support for EMU is weak at best. A political leader or political party could
use this weak support to promote its political power by promising to withdraw
the country from the EMU or by saying that they will threaten to withdraw the
country from the EMU if the other member countries do not agree to their
proposed policy changes. The currently developing economic crisis may provide a
significant test of these temptations. October 2008 [1]
This is a comment on a paper with the same title presented by Barry Eichengreen
at an NBER Conference in Milan, Italy on 17 October 2008. (Revised November
2008)