The Eurozone’s Real Weakness

Lucrezia Reichlin

A new eurozone crisis would most likely have a less uneven effect than in 2008 or 2011, not least because its largest economies are currently weak. But if a recession hits, policymakers will find it hard to mount an effective response.

LONDON – The 20th anniversary of the euro this year is a good time to reflect on the robustness of Europe’s monetary union. The memory of the last crisis, which began in the United States in 2008, is still fresh in the minds of Europeans: the eurozone suffered more than the US, with some of its members getting hit much harder than others. At a time when the eurozone is once again showing signs of a significant slowdown, it is important to understand what happened last time. Did we learn anything in the euro’s first 20 years that could help fight another recession?

The most popular narrative of the eurozone crisis relies on the economist Robert Mundell’s theory of an “optimum currency area” (OCA), which warns against establishing a common monetary policy in a federation of different states with different levels of economic resilience. This view emphasizes that eurozone members lack the exchange-rate flexibility that might help them respond to a negative shock. To make matters worse, because the European Central Bank targets the average eurozone inflation rate, its monetary-policy stance may not be suitable for all member states. In the weakest countries, this may lead to real interest rates above the level required for full employment.

Another narrative focuses on financial fragility. In good times, some eurozone countries build up excessive leverage because of relatively low real interest rates – partly a consequence of the ECB’s one-size-fits-all monetary policy. In countries with weak institutions and poor governance, this can lead to a loss of competitiveness and excessive consumption. A crisis would then be nastier than normal, triggering a fall in asset prices and debt defaults, followed by a period of deleveraging and weak demand.

Two questions are relevant today. One is whether weaker eurozone countries would be better off outside the monetary union with their own national currencies. This is not just an academic debate, given the increasingly vocal anti-euro constituencies in some member states. A second, more urgent question is whether a new eurozone recession would once again cause a crisis with highly uneven effects. The answer will help to set policy priorities in the event of an economic shock.

My answer to the first question is no, largely because the OCA theory disregards two key factors. For one thing, globalized financial markets and large short-term capital flows can cause wide exchange-rate fluctuations for countries with floating currencies – and for small, open economies in particular. As many emerging-market countries have demonstrated, such currency swings may affect a country’s ability to repay foreign-currency debt, and could force it to adopt a monetary policy at odds with its domestic objectives.

Furthermore, the OCA theory does not consider the stabilizing effect of central-bank credibility. It is difficult to imagine that Ireland, for example, would have avoided a financial crisis had it been able to devalue its currency sharply in 2008 – especially with debt denominated in euros and other strong global currencies. In the crisis years from 2008 to 2013, eurozone policymakers struggled with a “flight to safety” toward core members, as well as with increasing geographic “balkanization” of financial markets, with investors favoring their own countries’ government bonds. As a result, the ECB’s loose monetary policy was less effective than it otherwise might have been. In these circumstances, it is hard to believe that a national central bank could have secured lower risk premia through nationally targeted asset purchases if a macroeconomic adjustment program lacked credibility.

Advocates of reverting to a national currency often point out that Japan and the United Kingdom were more successful than Spain, Ireland, Greece, and Portugal in fighting the last recession. But this viewpoint fails to take into account that historically, these countries had been economically more volatile than Germany or France, and remained so after adopting the single currency.

As for the second question, a new eurozone recession would most likely have a less uneven effect than in 2008 or 2011. Today, almost all eurozone countries have current-account surpluses. Ireland is growing faster than China, while Spain and Portugal are also doing relatively well. And although robust house prices are fueling some of this growth, leverage is lower than it was ten years ago. The next recession in these countries is therefore unlikely to come with a nasty banking crisis that could make matters worse.

The eurozone’s three largest economies, on the other hand, pose a bigger recession risk. Germany and Italy have weak banking sectors and are facing a sharp cyclical slowdown, which in Italy is combined with very low long-term trend growth and high public debt. France also is growing sluggishly and has high private debt. A recession in the big three would drag down the eurozone’s smaller members, too.

The resulting eurozone-wide shock would require a common response, with countries coordinating monetary and fiscal policy to engineer the right stimulus. But such a coordinated fiscal stimulus would be difficult to implement unless Germany, the country with the largest fiscal capacity, took the lead. Moreover, policymakers would have to try to prevent another bout of balkanization of eurozone financial markets. As the last crisis showed, such fragmentation impairs monetary policy, limits risk sharing, and removes all the advantages of having a large, liquid, integrated capital market.

The eurozone’s real weakness is not the lack of exchange-rate flexibility, or its common monetary policy. Rather, it is the breakdown in risk sharing when the economy is hit by large shocks, combined with the absence of a common fiscal policy. That is the main lesson of the past 20 years. /project-syndicate