I was one of the very few prominent American economists who supported the euro. I predicted fearlessly that it would succeed, it would be a strong currency, and indeed over the years would join the dollar as a major world currency. All of those predictions, except perhaps the last, have already occurred, and I still think the last will occur as well.
Over the past few years, I predicted that the euro would successfully resolve its crisis, with no breakup of the eurozone, no exits, and no disorderly defaults. That is admittedly a low bar. I did not foresee a rapid return to growth, or rapid completion of the economic union. But the crisis was existential. Apocalyptic forecasts were prevalent. At least in the United States, a majority predicted that the euro would fail, so I feel justified in declaring at least partial and modest victory.
This record should qualify me as one of the strongest and most consistent supporters of the euro. But the interesting question is why the euro survived the crisis. Why were so many analysts wrong? The reason, I think, is simple. Most analysts, at least in the United States and Britain, were using the wrong analytical model.
Virtually all economists have relied on the theory of optimal currency areas. This says that a monetary union could only work if countries met certain tests, such as having free mobility of labor, which Europe has to a large extent, but also having a regular fiscal transfer mechanism, which Europe does not yet have and certainly did not have at the onset of the crisis. The euro's founding fathers knew they were creating a monetary union that did not have all of the theoretical constructs. They thought that the creation of the monetary union would lead inexorably to further steps necessary to complete the economic union. But times were good in the early 2000s, there was no pressure from the markets to proceed, and when the crisis broke, the house was only half-full. Most experts, seeing the absence of the criteria for an optimum currency area at that point, felt confident that the euro would collapse.
Using a political economy model, a few of us knew that the overriding postwar goal of all the major countries in Europe was to integrate the continent and avoid the repetition of past disasters. The euro had now become both the main substance and the main symbol of that project. And therefore it would not fail.
This overriding geopolitical determination was particularly prevalent in Germany. As the main source of historical disturbances, Germany would never again let itself be blamed for destroying Europe. According to recent accounts in the Financial Times of decision-making during the crisis, German Chancellor Angela Merkel apparently thought of it in exactly those terms, that the failure of the euro would mean the failure of Europe.
A critical but unpopular corollary of this logic was that Germany would pay whatever was necessary to preserve the euro. The European Central Bank would do so as well, with the support and approval of Germany.
For the first couple of years of the crisis, neither the German government nor the ECB was willing to say that they would pay whatever was necessary. That left the markets somewhat uncertain. In my view, the Germans and the ECB were correct to do that because it kept the pressure on the deficit countries to adjust. Also, a little less admirably, the Germans were trying to share the burden of financing with other surplus countries, the ECB, and even the IMF and the rest of the world. I always advised: "Watch what they do, not what they say." And what the Germans did, at every critical stage of the crisis, was to pay whatever was necessary and avoid the risk of failure.
Two years ago, ECB President Mario Draghi changed all that when he said for the ECB, "We will do whatever is necessary." That ushered in Phase Two of the crisis. During Phase One. they were doing the right thing, but not saying it. In Phase Two...