UPDATE: The original version of this post was lost following a hacking attempt on this website. New security and daily backups are in place so with any luck this will no longer be a problem in the future. It has been republished with some modifications. Reactions to the original piece have been lost.
…we have not been able to find any US economist making a strong case for the euro prior to its birth.
This is perhaps the most striking find in a fascinating survey by the European Commission of U.S. economists’ assessments of the coming of the euro, as expressed in some 170 publications. The document is enlightening in two respects: first as an intellectual history of American economic thought on the euro, an “American interpretation” which in fact still predominates, and second as an X-ray into the “Eurocratic mind” and its attempts to explain away criticism of the euro. Every self-styled EU-expert should probably read it or, failing that, this post, which summarizes and provides extracts of its 50-odd pages.
The report was written by two officials in the Commission’s Directorate-General for Economic and Financial Affairs (DG ECFIN). Its gist can be surmised from its title: “The euro: It can’t happen. It’s a bad idea. It won’t last. US economists on the EMU, 1989-2002”. Throughout there is an odd contrast between what seems like a “straight,” sympathetic intellectual history of their American colleagues and a rather forced, unconvincing defense of the euro against American economic theory
The authors were incredibly unlucky in their timing. The report was published in late 2009, exactly when the euro crisis made its appearance with Greece becoming unable to finance itself. As P. O. Neill at Fistful of Euros has noted:
Now one awkward thing about this is the timing. November 2009 was not exactly the time to be claiming that silly American economists were too wedded to optimal currency area theory to see the wisdom of the Eurozone.
It’s almost as bad as when the European Central Bank decided November 2011 was the moment to publish a triumphant pro-euro video, featuring a woman emerging from Greek pottery to walk across the euro-bridges of prosperity (95% disliked on YouTube).
As a rule, my training in history and political science has made me skeptical of the power of general “theories”. I found the empirical, limited, meticulously evidence-based claims of good historians to be far better than the over-arching, universal theories of famous political scientists. I put economic theory only one rung above international relations theory in predictive ability. I’ve always thought it was terribly unfair that economics is almost treated like a hard science by the media (presumably because it has lots of graphs and math that make layman go “uh-huh”) when in reality it is about as “soft” as sociology (and almost certainly softer than psychology). This famous picture by William Blake roughly summed up my attitude:
But let it be said the U.S. economists’ theories on the eurozone, at least, appear to have been largely confirmed by developments thereafter. The two main critiques were: First that Europe did not constitute an “optimum currency area,” and second that Europeans were two politically divided to create a coherent economic and monetary union. What is striking is the unanimity of American economists’ negative assessment and the fact that this went right across the political spectrum. (Was there not somewhere an EU-funded Jean Monnet Chair professor to defend the thing?)
For instance, in December 1998, just before the euro’s launch, the now famously EU-critical Progressive economist Paul Krugman summarized American opinion like this:
[F]or seven long years since the signing of the Maastricht Treaty started Europe on the road to that unified currency, critics have warned that the plan was an invitation to disaster. Indeed, the standard scenario for an EMU collapse has been discussed so many times that it sometimes seems to long term eurobuffs like myself as if it had already happened […].
Libertarian hero Milton Friedman took a similar point of view. His comments from a May 2000 interview have aged remarkably well:
From the scientific point of view, the euro is the most interesting thing. I think it will be a miracle – well a miracle is a little strong. I think it’s highly unlikely that it’s going to be a great success. […] But it’s going to be very interesting to see how it works.
He incidentally does not worry about the fact that the euro’s value had declined significantly compared to the dollar shortly after its launch (it had come down to around $0.90). When asked if the depreciation of the euro was a “bad sign” he said:
No, not for a second. At the moment the situation is very clear. The euro is undervalued; the US dollar is overvalued. … Relative to the dollar, the euro will appreciate and the dollar will depreciate.
On this he was right on the money. The euro’s value under the steady, mechanical stewardship of the ECB eventually rose to around $1.40, and even now is still worth more than the dollar. Why were these Americans of all political persuasions so skeptical?
Don’t blame Anglo-Saxon perfidiousness
A first thing to make clear is that these American economists do not strike me as particularly anti-European. Many Frenchmen in particular like to imagine that the “Anglo-Saxons” are plotting against the euro, fearing the rise of a rival superpower. Former French President Valéry Giscard d’Estaing has blamed Anglo-Saxon banks for the euro’s problems and German MEP Elmar Brok (formerly Helmut Kohl’s man in Brussels) rather more out of character spoke of an American “war” against the euro. (They never paused to consider that the construction they themselves had contributed to might be flawed.)
This little canard needs to die. There is no indication, as one World Bank economist suggested, that “American economists were jealous of the euro” and were apparently critical of it out of spite. There are of course Europhobes in America, many in fact, but these are not really to be found among U.S. economists in government and academia. On the contrary, economists on both sides of the Atlantic following the EMU’s development formed a community of “eurobuffs,” as Krugman calls them, familiar with one another’s geeky work, and who could probably more easily have a conversation about the subject with each other than with even the more educated of their countrymen.
The academic economists surveyed have a very relaxed view of the euro in terms of U.S. national interests. They may have been critical of the idea, but they could hardly fear it because none of them thought it would really work. Several (Krugman, Barry Eichengreen, Rudiger Dornbusch) were in addition not worried about the euro “dethroning” the dollar from its position as a global reserve and reference currency (notably for oil pricing), because they did not believe the U.S. economy benefited much from having this position. For them, as the authors put, “the seignorage benefits accruing to Europe as a result of the internationalisation of the euro were minor.”
The lack of anti-Europeanism is particularly clear for the economists working for the U.S. government, either for presidential administrations or the Federal Reserve System. The report’s authors consider them to have described EMU “in fairly neutral and balanced terms.” (The ones they cite are almost all uncritical or positive.)
William J. McDonough, president of the New York Federal Reserve Bank, for example said in a 1997 speech that “would be a mistake to think that the United States looks at this prospect with concern” and argued that “it seems safe to assume that significant changes in the international role of the dollar and the functioning of the international monetary system would occur only gradually an surely in a manner that could be easily coped with”.
Presidential administrations also had similar views. A March 2000 administration document entitled “The Euro-Implications for the US” argued that “the euro is not likely to cause a sudden decline in the dollar’s use as an international currency in the near future, and any shift away from the dollar will be gradual”. Similarly, the Council of Economic Advisers’ 1999 Economic Report of the President states simply: “The United States salutes the formation of the European Monetary Union. The United States has much to gain from the success of this momentous project. Now more than ever, America is well served by having an integrated trading partner on the other side of the Atlantic”.
The EU report’s authors themselves believe that hostility or fear of European integration may have been a cause for some American skepticism, but that this motivation was “probably minor”.
The inconvenient theory of optimum currency areas
American economists’ most common criticism was based primarily on the optimum currency area (OCA) theory developed by Nobel prize-winning Canadian economist Robert Mundell. This theory posits that a geographical area must have certain characteristics to be a valid currency area. The most important problem posed by a common currency is the impossibility for the area’s sub-economies to revalue (or devalue) their currency in order to adjust for imbalances (typically divergent competitiveness and trade imbalances).
Instead, the authors describe U.S. economists’ views thus:
Their OCA-inspired research resulted in a common view: potential EMU Member States were further away from a well functioning monetary union than the United States because of the lack of a pan-European fiscal redistribution mechanism, the low labour mobility in Europe and a higher frequency of regional asymmetric shocks in Europe than in the United States.
Europe was missing all these characteristics necessary to an optimum currency area. Labor mobility, even within EU nations, is much lower than in America. The U.S. federal budget accounts for over 20% of GDP and redistributive mechanisms (pensions, unemployment benefit, healthcare) mean that economic losses in any state are on average offset by 40% thanks to lower federal taxes and higher social spending. The EU budget, just above 1% of GDP and with an incredibly bureaucratic process for its main redistribution mechanism (regional policy), can assume no such role. More recently, a JP Morgan analyst came up with this OCA-inspired chart based on World Economic Forum data, purporting to show that the major eurozone make a less optimal area than even “countries beginning the letter ‘M’”.
In many cases the predictions made by American economists based on OCA have been spot on. For example, the authors say:
Gwen Eudey (1998) considered the potential dangers associated with a permanently fixed exchange rate regime (a monetary union). She acknowledged that the loss of an independent monetary policy to counter asymmetric shocks necessitated adjustment occurring “through changes in wages or through the movement of workers from one country to another”.
This is exactly what has happened and the massive cutting of wages in Greece, Spain, Ireland and Portugal is now the stated objective of European policymakers (even if this requires further unemployment, recession, deflation, etc). The problem is shown quite clearly in these two charts: inflation led to overly high wages in the periphery and wage restraint in Germany allows it to dominate exports. The common currency makes this imbalance extremely difficult to rectify.
Some economists, such as Martin Feldstein, argued consistently that EMU would prove an “economic liability” with overall negative economic consequences: to impose a single interest rate and fixed exchange rates on countries characterised by inflexible wages, low labour mobility and lack of centralised fiscal redistribution, would achieve nothing except increasing the level of cyclical unemployment among the members of the single currency area.
It is hard to find fault with that assessment given the current divergent performances of the eurozone and American economies following the financial crisis. In the immediate recession, the eurozone and the U.S. performed about the same and had almost the same level of unemployment, but there began to be a huge divergence with the onset of the euro crisis in late 2009. The OECD pointed this out last March and it has only gotten more pronounced since. The eurozone economy began shrinking again in late 2011, achieved zero growth in the first quarter of 2012 while unemployment has been consistently rising to now reach 11.1%. This is in turn has reduced growth in Russia, Eastern Europe and North Africa. In contrast, the U.S. economy is expected to have 2.5% growth in 2012 while its jobless rate has been steadily falling, now at 8.2%.
Federal Reserve economists, though broadly pro-euro, also had OCA-related concerns.
It should be said that there is very little U.S. economists said – at least according to the report – on the problems posed by the absence of a lender of last resort and of common EU debt. This is the second big problem the eurozone needs to resolve. Because the ECB cannot directly finance states like the Fed or the Bank of England do, governments have to rely on the financial markets for loans and are threatened by (potentially catastrophic) bankruptcy when the interest rates demanded for these loans are too high. It is not clear if U.S. economists chose to place less attention on this issue or whether the authors decided to omit it.
Creating the eurozone: politics bullying economics
American economists were then virtually unanimous in their negative assessment of the euro. But they still had to answer one nagging question: If this is so economically stupid, why are the Europeans still going through with this?
They overwhelmingly considered that politics had attempted to dictate reality to economics. And by “politics” we mean the grand compromise between François Mitterrand and Helmut Kohl around the time of the fall of Communism: German Reunification must go hand in hand with European integration, and in particular, a commitment to economic and monetary union.
The drift into EMU then appears almost irresistible. Once Mitterrand and Kohl formalized their deal at Maastricht – give up the Deutschmark and we’ll make the ECB a copy of the Bundesbank – and especially once that Treaty was ratified by the 1992 French referendum (albeit with only 51% “oui”), it was almost impossible to backtrack. And as John Witt in 1997 argued “as long as the political leaders in the two largest countries in the EU, Germany and France, are committed to going ahead, the prospects for at least a mini-union beginning in 1999 seem favorable”.
The Americans, it should be noted, did not consider every possible EMU to be necessarily doomed. They generally appear to have thought that a union including Germany, the Benelux and France could be workable. To go beyond that however was to invite disaster. Feldstein seems to have been quite perceptive on why the Europeans decided to take in Italy, Spain and the periphery. As the report states:
[He] viewed other EU Member States, such as Italy and Spain, as participating in EMU, not due to its questionable economic benefits, but rather due to a combination of the fear of being excluded from the deepening of the political union of the EMU likely to follow the implementation of the single currency, and the belief/fear that countries will be discriminated against in other EU policy areas if they do not join.
Another argument, and this also goes back to the relentless logic of commitment and momentum, was that they had “a fear of the economic consequences of losing the benefit of many years of hard work to get into Europe’s monetary club.” You can’t be slashing budgets for years as many euro candidates did (notably Italy and Belgium), saying “Europe” is forcing us to, and then turn around and say they won’t be letting us in.
The authors summarize:
As many US economists believed that the single currency for Europe was primarily a political project, which ignored economic fundamentals stressed by the OCA approach, they feared that the Europeans were building a badly designed monetary union with an expected short lifespan.
The authors themselves don’t appear to have been completely immune to the “politics first” interpretation of EMU:
The process of monetary unification leading to the Maastricht Treaty was facilitated by several developments such as the demise of the Soviet Union, German reunification and growing nominal exchange rate stability within Europe contributing to a unique window of opportunity to move towards a single currency.
I find very little to disagree with in all this.
Why don’t these Americans get it?
If the Americans had to explain why Europeans were going ahead with EMU, the EU officials writing this study had to explain why these erudite American academics were so critical. As they state: “We find this [skepticism of the euro] surprising as they lived in and benefitted from a large monetary union, that of the US dollar.”
They come up with a few minor reasons: good, scientifically skeptical economists may have “a pessimism bias in our world outlook” and “the market for pessimistic forecasts is probably more attractive than that for optimistic forecasts.”
They also list these four major reasons:
- “the strong influence of the original optimum currency area theory on US analysis, leading to the conclusion that Europe was far from an optimal monetary union;”
- “the use of a static ahistorical approach to study monetary unification by comparing the full-fledged US monetary union with Europe prior to monetary unification, in this way failing to see monetary unification as an evolutionary process;”
- “the failure to identify pegged exchange rate regimes in Europe as the alternative to a single European currency;”
- “the belief that the single currency for Europe was primarily a political project that ignored economic fundamentals, thus dooming the single currency to collapse.”
The all-out assault on optimum currency area theory does not come off particularly well. The authors claim that American economists were “analytical prisoners of the OCA-approach,” ignoring “a history of traumatic realignments of pegged exchange rates,” which resulted in “a high degree of misunderstanding in the United States of the economic costs and benefits of EMU.” In any event, the problems of the currency regime pre-euro, while problematic, had never caused Depression-like conditions and permanent recession.
The European ideology
But if the Americans were right, why did the Europeans – whose proto-federal institutions are crawling with economists – take a different view? The existence of the euro requires EU economists to rationalize away optimum currency area theory. The authors’ attempt to discredit this pillar of American economics relies heavily upon what I would call the “European ideology”. In short: that the constant, evolutionary process of European integration would gradually harmonize European nations and address the problems posed by OCA.
They criticize Americans using OCA for having a “backward looking” model and for “the use of a static ahistorical approach to study monetary unification by comparing the full-fledged US monetary union with Europe prior to monetary unification, in this way failing to see monetary unification as an evolutionary process”. Instead:
So far [November 2009], the pessimistic forecasts and scenarios of the 1990s have not materialized. […] It has fostered integration of financial, labour and commodity markets within the euro area. Trade has increased, and so has business cycle synchronization. Inflation differentials within the euro area are presently of the same order of magnitude in the euro area as in the United States.
The authors also pointed to the work of some U.S. economists:
They argued that the OCA-criteria should be viewed as endogenous. Once a country becomes a member of a monetary union, its economy adjusts to the new environment. Membership of a monetary union is likely to boost trade within the union and thus increase the correlation of the national business cycles, bringing it closer to fulfilling some of the OCA-criteria.
Now there may be some truth to the idea of seamless integration, harmonization and convergence in many areas of European policy. But as concerns the eurozone, nothing could be further from the truth. Rather than quietly converging, the currency area’s economies were being blown apart, with Germany restraining wages and gaining competitiveness in the core, and slushy eurozone money spurring massive, inflationary booms and property bubbles in Spain, Ireland and Greece. Nowhere is the chasm between the pays légal and the pays réel so great (if you’ll excuse the Maurassian vocabulary). EU economists may have had some concerns but were apparently blind to the scale of the problem. As then-ECB President Jean-Claude Trichet stated in 2007: “[V]ery often, I and my colleagues of the Governing Council are mentioning the Irish economy as a role model in many respects for the euro area.”
The authors also consider that American economists made the “mistake” of basing their assessment of the viability of the eurozone on conditions today rather than the imaginary (federalized?) Europe of tomorrow: “Instead of comparing Europe before the introduction of the euro with the United States of the 1990s, a more proper comparison would be with the future workings of the euro area.” However, Americans were skeptical of this future Europe precisely because European governments had a proven track record of repeated, profound disagreements and the euro would be created without consensus on political union and economic government.
The European civil servant, understandably, has to work with the assumption that if the European setup does not make sense today, it will be reformed into something viable in the future. But sometimes this really does seem to lead the authors astray:
[Assessments of the euro] should also consider whether the US system of fiscal federalism would function more or less efficiently than the EMU system, where fiscal policy is designed according to regional (national) preferences within the framework of the Stability and Growth Pact.
This may sound like parody but it is in a serious publication. It both takes the (long-discredited) Stability & Growth Pact seriously and flips OCA theory on its head by speculating that a monetary union without a central budget could be superior! (Eichengreen, for one, went so far as to argue that Europe’s heterogeneous economy would require a bigger federal budget than the American one.)
What about European economists?
All this does beg some questions: How did Europeans sleepwalk into this flawed system? What did European economists think of all this? Those in the EU institutions, necessarily prone to groupthink, may not have had much freedom to protest. But what about all the government and academic economists across Europe, and especially those in Italy, Spain and Greece? Did they approve, did they raise their voices against the coming disaster for their countries, or did they censor themselves out of fear of appearing “anti-European”?
I don’t have the answer to this. The only European I have read in detail on this is Belgian LSE professor Paul De Grauwe in his early 1990s edition of The Economics of Monetary Integration (now Union). It basically accepted American OCA theory and predicted a eurozone beyond Germany, the Benelux countries and (maybe) France would be suboptimal.
The report has an odd line on this. It says a comparable study of European economists “would be of interest” but cautions: “Such a study, however, is difficult to carry out as it would cover several countries with contributions in other languages than English.” This is a rather incredible issue to be raised by two officials in the European Commission – which has vast translation services and is supposed to have three working languages. It may be a testament to the overwhelming, crushing predominance of English in DG ECFIN and the ECB. (In press conferences, even Italian journalists will ask questions about their own country in English to ECB President Mario Draghi. I don’t know if Jean-Claude Trichet took questions in French but, in any event, I’ve seen far less kerfuffle raised by Frenchmen about the non-use of the langue de Voltaire in the ECB than in institutions in Brussels, despite the fact that, err, this eurozone business is rather more important.)
The economics profession is an interesting case-study of English-language dominance. As the study notes:
First, [U.S. academics] played a dominant role in both international research and policy debate around the euro. Their views were widespread on both sides of the Atlantic, impacting on the work of European economists on EMU and the single currency. Thanks to the size and intellectual dominance of the US academic profession, US economists set the parameters of the academic discussion on European monetary unification.
Some, especially Frenchmen, fear that the overuse of English as a working language will lead to bias and the adoption of “Anglo-Saxon” values (read: neoliberal, ultracapitalist, laissez-faire (ha), un-French, etc). As France’s top EU journalist Jean Quatremer once argued: “I am simply saying that the predominance of English allows the imposition of a system of values.” But, for the EU’s monetary and financial institutions at least, the fact of working in total Anglophonie did not prevent them from being completely immune to the heresies of American economic thought. Speaking Anglo-American does not necessarily mean thinking Anglo-American.
In any event, in English or not, it would be very interesting to see what European economists thought about all this business.