Why is the Euro in Trouble?

Monday, Nov 14, 2016
by vrosenth

To many Americans observing the string of economic crises and squabbles that have convulsed the eurozone over the past seven years, the European Union has come to look more like a dysfunctional marriage than the political-economic union it was intended to be—a blended, modern-day family coming out of a union between two entirely different partners who realized that if they didn’t marry, then they would surely end up killing each other.

During a book talk held under the joint auspices of the Bendheim Center for Finance and the Julis-Rabinowitz Center for Public Policy and Finance, Markus Brunnermeier and Harold James (co-authors along with Jean-Pierre Landau of The Euro and the Battle of Ideas), offered a historical and economic perspective on why the euro (and by extension the EU) is in such trouble. They discussed the complex history that shaped France and Germany, the principal partners in the marriage, the baggage that each brought to the nuptials, and the recognition early on, beginning with Maastricht, that a currency union alone would not be sufficient to ensure the survival of the eurozone.

In his introductory remarks, James, who is professor of history and international affairs and the Claude and Lore Kelly Professor of European Studies at Princeton University, suggested that contrary to the received wisdom in the US and in Britain, the euro is not a disaster, nor is it a failed experiment. Instead, he argued, the euro should be regarded as a coordination exercise that was intended to overcome coordination problems. Those coordination problems remain, but the monetary union continues to be an ongoing process.

Fundamentally, the underlying problem with the euro is not just a matter of institutional design; rather, it is a matter of issues that resurfaced at the euro crisis but were already present during the Maastricht negotiations, according to Brunnermeier, the Edwards S. Sanford Professor of Economics at Princeton University and Director of Princeton's Bendheim Center for Finance.

Today, those views, as embodied in France and Germany, contrast starkly, particularly in light of subsequent events. Put simply: The French trust in discretion, solidarity (fiscal union), liquidity/contagion, and stimulus spending; the Germans believe in rules, liability for actions, solvency, and austerity/reform. From a French perspective any economic problem is always a liquidity problem, whereas the Germans always see things in terms of a liability problem.

Given such different perspectives, how then does one deal with an economic and financial crisis? The German view is very much rules-based, while the French view is discretionary-based. Consequently, France tends to be more Keynesian, while Germany mistrusts anything smacking of Keynes. The French view is that an economic crisis is first and foremost a matter of liquidity and that to address the crisis you inject a huge amount of liquidity, thereby shifting from a bad equilibrium into a good equilibrium. The German view, on the other hand, is to see an economic crisis in terms of solvency, the liability principle, and if it is a solvency issue, then one does not accomplish anything by injecting more money into the system—indeed, one winds up simply wasting money.

These contrasting views would appear, on some level, to be irreconcilable. And yet their book, The Euro and the Battle of Ideas, represents an attempt on the part of the authors to bridge that gap and to offer marital counseling for the odd couple.  And at the same time, the authors felt it necessary to think and look deeply at the history that brought the seemingly mismatched couple to the altar and the way that their ideas have evolved over the long history. In fact, during the 19th century the positions of each nation were reverse: then, France was doggedly rules-based, and Germany essentially discretionary in its approach. What changed all of that, the authors note, was World War II. Indeed, that war is central to any understanding of modern day Germany and France: It shaped their identities (and all of Europe); similar to how the Civil War shaped the identity of the United States.

In his discussion of the crisis and Maastricht, Brunnermeier pointed out that the role the banks performed at the time of Maastricht was different than the one they played in the global financial crisis and European debt crisis. At the time of the Maastricht negotiations, Europe’s banks were simpler—not the global players they subsequently would become. They relied on depositors for funding, not wholesale funding. Additionally, the Asian debt crisis with its liquidity spirals and spillover effects was not well understood, just as Japan’s disinflationary compression had not been absorbed.  

So is marriage counseling possible for a couple with fundamentally different views? To a degree, it is the enormity of the crises that the EU faces today that offers this blended family its best hope. Paradoxically, Europe’s growing refugee crisis, its security problem with Russia, its energy needs and global warming may hold out the best chance for unity and progress toward greater fiscal union. As Europe faces these issues, it is the authors’ hope that the EU member states recall the deep and complex history that brought them to the altar and give heed to the enormous challenges they face together.  

Videos from the Book Talk:

Part 1 – Harold James
Part 2 - Markus Brunnermeier
Part 3 – Q & A

You can see photos from the talk here.

You can read more about The Euro and the Battle of Ideas here