Who Killed the Euro?

Matías Vernengo

Before the Great Recession it was common to suggest that the international reserve position of the dollar was in jeopardy, and that a crisis could generate a run on the dollar.  Yet, the unexpected casualty of the crisis was the euro.  If there were any doubts about the demise of the euro after the Greek crisis these have been lifted by the Irish crisis.  Who did it?  There is no need for a CSI team to pour over the evidence; the culprit has left its fingerprints all over the bloody scene.  No, not the butler, it was the European Central Bank (ECB).

In the United States the crisis led to an effort by the Fed to maintain the interest rate on long-term government debt at low levels, with the controversial quantitative easing policy.  By buying great quantities of treasuries, the Fed not only keeps stable bond prices and low interest rates, but it also provides assurances that Treasury bonds remain a secure asset.  That allows the US Treasury to maintain high fiscal deficits on a sustainable basis.

That is the exact opposite of what the ECB has done for the countries in the periphery of Europe.  Countries in a currency union lose control of monetary policy and cannot depreciate the exchange rate.  But a common currency setting also brings to an end the possibility for a single nation to run fiscal deficits since the sources of funding are either removed or subjected to supra-national control.  If the ECB decided to buy Greek and Irish bonds (and Spanish and Portuguese too), and maintain their interest rates on par with the German ones it could.  But, alas, the ECB decided to show that euro-denominated bonds are all equal, but some more equal than others.  If the ECB says that some euro-denominated bonds are worthless, who would deny it.

As in the Greek case the Irish are accepting a European Union, International Monetary Fund, and ECB bail-out, which will imply severe fiscal adjustment – and increasing unemployment – and which will eventually fail.  They should simply leave the euro; even though the political reality is that they are very likely going to stick to it (as Argentina did with a fixed peg) for several years.

So the ECB did it; but there was an accomplice.  The economics profession was helping all along to kill the euro.  The European crisis shows another example of the mainstream trying to act as if nobody foresaw the crisis, since it was fundamentally too complex to be anticipated. Brad DeLong, for example, admits that he was wrong in believing that no government would allow a 10% unemployment level for a long period.  He should note that back in 1998 Brad DeLong (I think they are related) said, in a NBER edited book, that: “economists working in the Keynesian tradition … [believe] that deficit spending is not expansionary.”  That’s how much New Keynesians believed in expansionary fiscal contractions!  According to that logic he should have no concerns with Obama’s or the ECB’s policies.

The failures of the mainstream are more profound and are deeply connected to what Paul Krugman refers to as the Samuelsonian synthesis, which was based on the notion that Keynesianism was about market failures (wage or interest rate rigidity).  It was not.  Read chapter 19 of the General Theory; it’s about how wage flexibility made things worse.  And yes, fiscal policy was the solution.

Only Dean Baker, who has been consistently right, and, perhaps for that reason, often forgotten, noted that Ireland has had big fiscal surpluses (yes that’s correct) up to the crisis.  In fact, Ireland was the example of an expansionary fiscal contraction.

The Irish would have been better off if they heard Wynne Godley, the great Irish economist, who warned in 1992, that: “the incredible lacuna in the [European] program is that there is no blueprint whatever of the analogue, in Community terms, of a central government. … If a country or region has no power to devalue, and if it is not the beneficiary of a system of fiscal equalization, then there is nothing to stop it suffering a process of cumulative and terminal decline leading, in the end, to emigration as the only alternative to poverty or starvation.” Arestis & Sawyer asked in 2001 whether the euro would cause an European crisis, and they believed it would.  But in economics being right doesn’t count, what pays is to say what the markets want to hear.