In 1999, when 11 European countries launched the Euro, a number of prominent American economists, including Milton Friedman and Martin Feldstein, warned that a common European currency would turn out to be a costly economic policy mistake. Events are now proving how prescient were those warnings.
Europe’s economic performance over the past two decades lagged considerably behind that of the United States. In 2010, the Eurozone experienced a major sovereign debt crisis centered on Greece. Now it seems well on its way to another such crisis, this time centered on France and Italy. Both of those countries have economies many times the size of that of Greece.
At the heart of the American economists’ warnings was the idea that the disparate Eurozone countries did not constitute an optimum currency area. They did not have the labor mobility or the wage and price flexibility enjoyed by the United States. Nor did the Eurozone countries constitute a political union that allowed for a fully functioning monetary and fiscal union.
To their credit, European policymakers recognized that with its structural weaknesses, if the Euro was to thrive, member countries would need to comply with strict rules of economic policy stability as laid out in the Maastricht Treaty. They were to keep budget deficits below three percent of GDP and the public debt to GDP ratio below 60 percent. They were also to aim at price stability.
Unfortunately, the Maastricht Treaty was observed in the breach, particularly by a number of so-called peripheral Eurozone countries including Greece, Italy, and Portugal. Those countries ran budget deficits that were a multiple of those envisaged in the Maastricht Treaty and allowed their public debt levels to climb to well over 100 percent of GDP. Contributing to those countries’ wayward budget policies was the fact that, for many years, markets failed to discipline these countries. Rather, they financed these governments’ budget excesses at unusually low interest rates.
The 2010 Eurozone sovereign debt crisis exposed the Euro’s underlying structural weakness when markets finally became reluctant to finance unsustainable budget deficits. Namely, those countries with highly compromised public finances found it extremely difficult to restore public debt sustainability by resorting to budget austerity. Stuck within a Euro straitjacket, the Eurozone’s peripheral countries found that they were unable to resort to money printing or currency depreciation as a means to boost exports as an offset to the contractionary effect on demand of budget belt-tightening. The net result was a deep recession in the Eurozone’s periphery in general and in Greece in particular. Despite massive IMF and the European Central Bank (ECB) support, Greece experienced an economic depression on the scale of the 1930 Great Depression as it was forced to adopt drastic fiscal austerity.
Fast forward to today, we have France and Italy, the second and third largest Eurozone member countries, in conceptually the same situation as Greece found itself back in 2010. Both countries have close to record high public debt to GDP ratios, 110 percent for France and 140 percent for Italy. They also are running budget deficits considerably higher than the Maastricht criteria’s three percent of GDP. Those deficits will ensure that their debt levels will keep on rising. Like Greece before it, stuck within a Euro straitjacket these countries would risk sending their economies into recession if they were to engage in serious budget belt-tightening.
Making matters worse is the crumbling of the French political center and the rise of a fiscally irresponsible French political extreme left and extreme right. The extreme parties’ pre-election promises could lead to more public spending that would only deepen the budget hole in which France finds itself. This point has not been lost on the markets that have send the French-German bond spread to its highest level since 2012.
Phillip Lane, the ECB’s chief economist assures us that there is no need for ECB intervention in the French bond market. But then this is something similar to what Eurozone economic policymakers were saying on the eve of the Greek crisis. Given the size of the French and Italian bond markets, in the year ahead, it is more than likely that the ECB is going to have to intervene in these countries’ bond markets on a greater scale than they did in Greece if they are to prevent the single currency from unraveling.
The post The Eurozone’s Chickens Are Coming Home to Roost appeared first on American Enterprise Institute – AEI.