Debt

Was The Euro A Mistake To Begin With? (Part I)

Greek, German, and French euro coins.

hide captionGreek, German, and French euro coins.

Joel Saget/AFP/Getty Images

In our latest column for the New York Times Magazine, "Europe's Financial Crisis, in Plain English," the Planet Money team writes, "It turns out that a bunch of vastly different countries, each with control over its own budget but all bound to a common currency, is not a sustainable economic model."

So... was the euro a mistake to begin with? We posed the question to two economists with different takes on the crisis - Jacob Funk Kirkegaard of the Peterson Institute and Desmond Lachman of the American Enterprise Institute.

Jacob Funk Kirkegaard's response is below. You can read Desmond Lachman's response here.

It is perhaps difficult at this time of acute crisis to see the sense in establishing the common European currency in the first place. However, such a conclusion would be wrong and ignore the fact that while the initial institutional design of the euro was flawed, this does not mean that it cannot – provided the political will is present – be fixed.

The euro was overwhelmingly a political project aimed first and foremost at deepening the process of European integration begun in 1957. An unforeseen shock – German reunification in October 1990 – provided the political impetus for the creation of the Maastricht Treaty, which in 1992 established the legal foundation for today's euro area.

Academic research on the design of the euro had been explicit about the need to complement a monetary union with a centralized fiscal policy. But this goal was unattainable within the hurried time-frame dictated by political leaders following Germany's sudden reunification. As a result, the designers of the euro area often made political compromises at the expense of economically sound rules and regulations.

For example, the continued self-identification among Europeans as residents of their home country, i.e. Belgians, Germans, Poles, Italians etc., made the collection of direct taxes to fund a large centralized European budget impossible. Consequently, the common currency was established without a sizable central fiscal authority that could counter region specific economic shocks or re-instill confidence in the market in the midst of a crisis.

Similarly, the divergent economic starting points of the founding members of the euro area made the imposition of common fiscal criteria politically unachievable. Consequently Europe's monetary union was launched in 1999 with a set of countries that were far more diverse in their economic fundamentals and far less economically integrated than "optimal currency area" theories recommended.

Moreover, just a few years after the launch of the euro, European leaders led by France and Germany went further and undermined the remaining credibility of the rules-based Stability and Growth Pact framework, which coordinated national fiscal policies in the euro area. [Both countries violated the pact by running fiscal deficits bigger than 3 percent of their GDP.]

As a result of these shortcuts, the euro area became a common currency area consisting of a very dissimilar set of countries, without a central fiscal agent, without any credible enforcement of budget discipline or real deepening economic convergence. Today's crisis has been an accident waiting to happen.

Yet, the idea of the euro as a powerful political and economic symbol and driver of European integration does not rely on a specific institutional design. The current crisis has shown that the euro area evidently needs a redesign that makes its economic governance rules stricter and its opportunities to provide emergency financial assistance to member states much larger. This in turn will require that the countries using the euro agree to pool much more of the national sovereignty to sustain their common currency – a political process which is only now after 18 months of accelerating crisis coming to fruition.

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