Whither the Euro?

• Author: Kevin Hjortshøj O’Rourke
• Position: Chichele Professor of Economic History at All Souls College, Oxford.

The euro area economy is in a terrible mess.

In December 2013 euro area GDP was still 3 percent lower than in the first quarter of 2008, in stark contrast with the United States, where GDP was 6 percent higher. GDP was 8 percent below its precrisis level in Ireland, 9 percent below in Italy, and 12 percent below in Greece. Euro area unemployment exceeds 12 percent—and is about 16 percent in Portugal, 17 percent in Cyprus, and 27 percent in Spain and Greece.

Europeans are so used to these numbers that they no longer find them shocking, which is profoundly disturbing. These are not minor details, blemishing an otherwise impeccable record, but evidence of a dismal policy failure.

The euro is a bad idea, which was pointed out two decades ago when the currency was being devised. The currency area is too large and diverse—and given the need for periodic real exchange rate adjustments, the anti-inflation mandate of the European Central Bank (ECB) is too restrictive. Labor mobility between member countries is too limited to make migration from bust to boom regions a viable adjustment option. And there are virtually no fiscal mechanisms to transfer resources across regions in the event of shocks that hit parts of the currency area harder than others.

Problems foretold

All these difficulties were properly pinpointed by traditional optimal currency area theory. By 1998 Ireland was experiencing an unprecedented boom, and house prices were rising rapidly. Higher interest rates were warranted, but when Ireland joined the currency union in January 1999 the central bank discount rate was lowered from 6.75 percent in the middle of 1998 to just 3.5 percent a year later. With the Irish party well under way the new ECB was busily adding liquor to the punch bowl.

Similar stories were repeated around the euro area periphery, where capital inflows pushed up wages and prices. But what goes up does not come down so easily when there is no independent currency. Labor mobility within the euro area remains limited: young Irish workers emigrate to Australia or Canada, the Portuguese to Angola or Brazil. And with no federal budget to smooth asymmetric shocks, procyclical austerity, which exacerbates rather than ameliorates recessions, has been the policy weapon of choice during this crisis—whether imposed by the markets or by euro area politicians and central bankers. Mass unemployment in the periphery is exactly what theory would predict in such circumstances.

Indeed...