Why the Euro Doesn't Work

Currently there are two existential problems in the euro area. The first is a relatively recent development and must be dealt with immediately, while the second has been building for about a decade and requires longer-term solutions:

1. The positive feedback loop between insolvency in the European periphery and stresses in the European banking sector.
2. The long-term structural divide between unit labour costs in the north and the south of Europe.

Let’s start at the beginning – ironically the second problem above. Before anyone gets pedantic, I realize that what follows quite a stylized story (ie short on details) but I am simplifying for the sake of clarity.

Before the nations now known rather pejoratively as the European periphery joined the euro area, their workers were kept competitive with those industrious Germans through a regime of flexible exchange rates. For example, if the Portuguese were not innovating as quickly as the Germans, the Portuguese escudo would depreciate against the German mark, making Portuguese products relatively cheaper (all else equal) and thereby allowing the Portuguese to compete with the Germans in international trade.

When the euro was introduced, this mechanism disappeared and the European periphery rapidly lost competitiveness with the core.

Seems like a raw deal right? Well not entirely. The upside for these chronically uncompetitive countries was that, despite all of structural differences between the economies, the bond markets began treating debt issued by any European government as essentially the same credit (assuming an implicit mutual guarantee). This allowed these countries to fill the gap created by the erosion of their domestic private sector with government spending financed by cheap debt issuance.

This was all good until it wasn't. Once people woke up to state of the sovereign finances in these countries (initially just Greece), they rushed for the exits. With European policymakers refusing to take bold action to resolve the crisis, it spread and evolved to the point where we stand now - uncomfortably close to the abyss.

The next post will describe in more detail why policy fixes introduced have been insufficient, and detail the policy prescription necessary for Europe to extricate themselves from the mess they have found themselves in.

Note: I have not included Ireland in this discussion because I consider both its path to fiscal ruin and the steps to recovery be considerably different from the nations detailed above.