Can the European Monetary Union survive the next recession?


Rule #1: even big things die. Geopolitical analysts too often assume the permanence major nation’s political and economic structures.

ByFabius Maximus

History clearly shows that the trappings of power — impressive buildings, big budgets, somber officials — tell us nothing about the soundness of the structure.

Consider the Euro, and the larger structure of the European Economic and Monetary Union(EMU or Eurozone).  They look like successes.  Not so, as it is too soon to tell.  Social structures are subject to punctuated equilibrium.  EMU stability during global expansion since its creation in 1999 tells us little.  What matters is its stability during the next recession.  The foundation might be build on sand, structurally flawed.  Perhaps even doomed to likely failure.

Flaws in the structure of the EMU

(1)  The US dollar, like most currencies, was issued as a result of nation-building.  The Euro was issued as a step towards nation-building.  The European Union is not yet a state in the full sense of the term.  Its other flaws from this this.  The member states control their own fiscal policy.  More important, the member states see themselves as distinct states.  Differential growth in Georgia and California does not create pressure to break up the Union (not since 1860).

(2)  The EMU is a monetary zone.  Unfortunately one interest rate cannot work for every “part” of the EMU.  Esp those with different economic and social structures, like Germany and Italy.  That is not terminal during a boom, but might be during a recession.  Like the one perhaps starting now.  The governors of the European Central Bank follow the tradition of the German Central Bank:  fighting inflation is the first and only goal.  That works for a strong, stable economy like Germany.  High rates during a downturn might prove too much for Italy to bear giving Italy two choices both with ugly consequences.  Leaving or staying in the EMU.

(3)  The dream was that a strong currency would create competitive disinflation like that Germany experienced during the years after the Bretton Woods system crashed in 1971.  A strong currency forces industrial and labor market restructuring in order to stay competitive.  If this does not occur — and there are few signs of this — then the likely result is slow growth and inflation plus widening divergences between the EMU’s member states.  In which case the pressure on the EMU could become intolerable during a recession.

Please share your comments by posting below (brief and relevant, please), or email me at fabmaximus at hotmail dot com (note the spam-protected spelling).

For more on this topic, links and excerpts

When the Euro Falls Apart“, Hall Scott, International Finance, 1-1998, pages 207-228.  Abstract

This paper recounts some well-known problems confronting European monetary union (EMU), such as withstanding asymmetric shocks and maintaining domestic political support. It then examines how a speculative attack could damage a target country’s banking system, and how the basic structure of EMU could facilitate its break-up. On the basis of this analysis, one might reasonably conclude that there is a significant chance – over one in ten – that EMU may break up in whole or in part.

The paper then focuses primarily on two significant problems related to a break-up. First, a country seeking to leave EMU, particularly after the transition period, may have difficulty re-establishing its national currency unilaterally, as its economy is likely to have become thoroughly `euroized’. Second, any break-up accompanied by re-denomination of existing euro obligations, including government bonds, will create great legal uncertainty and costly litigation. There are no continuity of contract rules for exiting EMU equivalent to those for entering. Both problems require cooperative and deliberative solutions and will be difficult and costly to solve. If such problems are properly taken into account, which has not previously been the case, a euro break-up in the foreseeable future, particularly after transition, is considerably less likely than the above estimate of one in ten.

The Degeneration of EMU“, Niall Ferguson and Laurence J. Kotlikoff, Foreign Affairs, March/April 2000 — Excerpt:

To date, the successful launch of Europe’s single currency has proven the euroskeptics wrong. But over time, the euro will be gravely threatened if the countries in the eurozone do not put their fiscal houses in order. Generational accounting, a careful analysis of long-term trends, paints a bleak picture: unsustainable spending will bury future generations under mountains of debt. Most governments using the euro must either endure deep budget cuts, swallow sharp tax hikes, or be forced out of the eurozone.

Risks to the long-term stability of the euro“, Anna J. Schwartz (National Bureau of Economic Research), Atlantic Economic Journal, March 2004 — Subscirbers only.  Abstract:

There are grounds for immediate and long-term concerns with respect to the prospects for the stability of the euro’s purchasing power. The immediate concerns arise from the pressures on the ECB to be more accommodative and the drive to weaken the Stability and Growth Pact. The long-term concerns arise from the spending obligations the member governments have assumed to provide pensions and health care to their aging populations for the next half-century, and the imminent enlargement of the EU to include ten states that are less economically and institutionally advanced than the present group of member states. The outlook is for greater spending by governments than their projected resources unless forces not now visible will strengthen the resolve of political leaders to serve the cause of a sound euro.

Italy: Devaluation or Deflation“, Edward Hugh posted at A Fistful of Euros, 20 June 2005 — Excerpt:

So Italy is caught. To devalue it would have to leave EMU. But then even if it could and did, it would go bust. So, on Guzzo’s reading, the only remedy left is substantial deflation, that is an ongoing reduction of wages and prices which would enable competitiveness to be restored. This sounds very much like the 1930’s and an Italy stuck with a modern version of the gold standard. It also sounds like going through a recession which could turning out lasting for a number of years, even if this was politically feasible it would be extraordinarily painful for many of those most immediately affected.

Department of ‘Urrk!’“, Blog of Brad DeLong (Professor of Economics, Berkeley), 21 June 2005 — Esp note the comments.

Otto:  “Isn’t demographics a part of this issue? I thought even when I went to school (dark ages, 1970’s) it was pretty clear that growing populations of working people would lead to growing economies, given a minimum level of economic infrastructure. Italy (and Spain) are on the downside of that curve, no? Is their GDP per capita in recession? Is this question really stupid?”

Brad Setser (major expert on global captial flows, now with Council for Foreign Affairs):  re: Italy. I agree that deflation is never a good idea — particularly if you have as much debt as Italy. Real interest rates can be quite large with signficant deflation even if nominal rates are around 3%. Among other things, the debt dynamics get ugly. But for Italy to regain competitiveness without outright deflation, but rather lower inflation rates than the rest of the eurozone, the overall eurozone inflation rate probably needs to be a bit higher. 2% overall may be too low — far too low — in an environment where some economies need to adjust by having lower inflation rates than their partners.

{FM note about Setser’s comment:  (1) Brad’s point is that the German-dominated ECB will not tolerate inflation far above 2%, even if Italy and Spain desperately need it.  (2) His observation about deflatinon in a high-debt economy applies as well to the US as Italy.}

Edward:  The problem is structural, Italy (and Portugal, Greece and Spain) have specialised in supplying certain kinds of manufactured products (and tourism) to the rest of the EU. Now the new eastern europe members and China are assuming this role, and they can’t convert to higher value activities quickly enough. Look at the average education levels. I don’t remember Italy off hand, but Spain, Portugal and Greece have something in the 8 to 9 years per head. Germany and France have 12 to 13 years. Think Mincer equations as a rough and ready rule of thumb. And demography is important in many ways, but here in the difficulties of improving general educational level with a top heavy population in terms of age.  This is why I was so opposed to all that nonsense they used to spout about Harrod-Samuelson-Balassa: it just wasn’t relevant to the case in hand. But it did seem like a convenient ‘excuse’.

Will EMU survive 2010?“, Daniel Gros, Centre for European Policy Studies, January 2006 — Conclusion:

Could these tensions lead to a break-up of EMU?  While this scenario has already been suggested by some ministers in Italy, it is unlikely to materialise for the simple reason that the cost of breaking away would be prohibitive for a country with such a high public debt.

The Italian public (and even the most populist politicians) know that leaving EMU, coupled with a devaluation to regain competitiveness, would increase by one stroke the debt/GDP ratio as all existing public debt would have to be serviced in euro. Moreover, interest rates on the new lira are likely to be much higher than within the euro area, thus increasing the cost of servicing public debt easily by several percentage points of GDP. In the end, Italy (and Spain) will thus have little choice but to bite the bullet and undergo their first full business cycle under a hard currency regime. EMU is thus likely to survive, but the sparks will fly for some time to come.

{FM commnet:  There is another scenario, overlooked by Gros:  unlaterally redemoninate Italy’s debt into the new Lira.  That would provide short-term relief, at a large long-term cost.  But desperate times…}

Risks of a EMU Break-up:  Exaggerated or Understated?“, Nouriel Roubini (NYU), May 2006 — Excerpt:

  1. At the end of the day, sovereign nations can take any actions they want; no effective legal constraint on exit.
  2. Historic monetary unions without political unions eventually broke up (19th Century Latin monetary union). Lack of political union is a problem in EU.
  3. Possibility of other EMU members accepting and negotiating the exit of some members cannot be ruled out.
  4. When the costs of remaining in the union – permanent economic stagnation – exceed the benefits pressure will come to exit.
  5. Devaluation can restore competitiveness and sustained growth (see Argentina). Even in the ERM other members of the system accepted the repeated devaluations of members whose competitiveness had been lost.
  6. It is easier to reduce real wages via a devaluation than via a reduction in nominal wages. It is hard and costly to regain competitiveness via deflation.
  7. This is an implicit default but Argentina did it (”pesification”) and the U.S. did it in the 1930s with the “Repeal of the Gold Clause”. Supreme courts of both countries withheld such effective coercive conversion.
  8. The interest rate costs of exit will be limited by the effective default on Euro debts that reduces the debt burden and the deficit (see Argentina).
  9. Some powerful economic and financial groups will greatly benefit from exit, devaluation and conversion of Euro liabilities.


  1. EMU break-up is still unlikely in the short run.
  2. But in the medium run if reforms that restore growth are not implemented the benefits of exit will increase relative to their costs.
  3. Once financial markets gets concerned about the risks of exits, a vicious circle of rising rates and poor debt dynamics may force exit regardless of the will to stay in EMU.
  4. Some current EMU members may eventually “exit” in the next 5-10 years unless they implement economic policies that lead to sustained growth.
  5. Given the significant costs and collateral damage of exit, the balances of costs and benefits is still heavily in favor of remaining in EMU.

If Italy Thinks the Unthinkable About the Eurozone“, John Kay, Financial Times, 12 September 2006 — Excerpt:

What if a government decided to leave the European Monetary Union and abandon the Euro? A realistic question, and yet nobody dares to ask.  The agreements that established the euro contain no provisions to allow exit. However, if some government – let us suppose the Italian one – decided to leave, there is nothing Europe could or would do to stop it. But what exactly would a government set on such a course – or forced into it – do?

… Some people will conclude that these problems make a break-up of the euro impossible. This would be a profound error. History – not least the establishment of European monetary union itself – shows that, given political determination, practical problems will be overcome. Civil servants, lawyers and bankers are there to ensure that a client’s wishes are met even if misconceived and if the Bank of Italy does not have a plan in its safe, its officers have been failing in their plain duty.

WILL THE EUROZONE CRACK?“, Simon Tilford, Centre for European Reform, September 2006 — free download is on right menu bar.  Abstract:

Europeans often refer to Economic and Monetary Union and enlargement as the EU’s two greatest successes. However, the basis for a sustainable currency union is not in place. Unless the members rapidly boost their reform efforts, and unless economic growth across the eurozone accelerates, EMU faces a bleak future. What happens in Italy will be critical. If Italy fails to improve its competitiveness, it will eventually have to leave the eurozone. This could force other countries to quit the currency union and potentially threaten the EU’s single market.

Divorce inevitable as eurozone splits into two camps“, Ambrose Evans- Pritchard,  op-ed in the Daily Telegraph, 30 April 2007 — Excerpt:

The eurozone has now split into two incompatible camps. Or, in the coded language of the Commission this month: “Persistent differentials in price competitiveness and widening current account imbalances have built up since the inception of monetary union.”

… Spain is about to relive Britain’s ERM torture in 1992: forced to tighten into an accelerating downturn, this time with no easy way out.  “Spain faces a cycle of recession, deflation and widespread private sector default – a depression in fact,” says Bernard Connolly, global strategist for Banque AIG. Greece is more or less a photo replica.

The euro is today stronger than it was in mid-2005 when two Italian ministers called for a return to the lira. Now France is suffering too: house prices fell in January; the car industry has lost its footing. France’s share of eurozone exports has fallen 18pc under EMU.

Nicolas Sarkozy, front-runner for the French presidency, has already declared war on the ECB, calling for political control over the exchange rate. Markets assume he will be rebuffed. Maybe, but how will he react to that?  France will not sweat out deflation, like the others. It might pick its marbles and walk, doing to the euro what it did to the EU constitution.

And what of Germany, conquering market share at the expense of Club Med in a beggar-thy-neighbour policy? House prices are rebounding after a long slump. Pent-up demand is bursting out. Germany will need higher rates, perhaps much higher.

Berlin gave up the D-Mark under an implicit contract that the euro would never fuel German inflation.  This contract will be enforced. If not, German citizens will pull the plug on EMU.

The only question is who will file for divorce first: the Latins or Teutonia. They cannot both share the currency.

EMU: Divergence or Convergence?“, Nouriel Roubini (NYU), 26 June 2007

The Breakup of the Euro Area“, Barry Eichengreen (University of California, Berkeley), Presentation to the NBER Summer Institute, 12 July 2007 — Conclusion:

The conclusion of the author is that it is unlikely that one or more members of the euro area will leave in the next ten years and that total disintegration of the euro area is more unlikely still.  The technical difficulties of reintroducing a national currency should not be minimized.  Nor is it obvious that the economic problems of the participating member states can be significantly ameliorated by abandoning the euro, although neither can this possibility be dismissed.  And even if there are immediate economic benefits, there may be longer-term economic costs, and political costs of an even more serious nature.

Still, as Cohen (2000) puts it, “In a world of sovereign states….nothing can be regarded as truly irreversible.” Policy analysts should engage in contingency planning, even if the contingency in question has a low probability.

EMU’s second 10 years may be tougher“, Martin Wolf, Financial Times, 27  May 2008 — Excerpt:

The conclusion, then, is that the eurozone is a triumph as a monetary union. Yet it is much less so as an economic union. At the very least, its creation has not caused the acceleration in dynamism that proponents hoped for. If anything, structural reforms have slowed.  Moreover, as the euro soars, the pressures of adjustment to internal divergence are likely to grow to enormous levels.

Europe Debates Perfection It Demands of Its Produce“, Washington Post, 8 July 2008 — Opening:

When is an onion more than an onion, or less? How can consumers choose between a carrot and a mere pretender? That bendy cucumber, those wannabe peaches — do they have the firmness of character to be on the shelf?

Urgent and vital questions all, especially for lawmakers in the European Union, which has 34 regulations on marketing standards — from the allegedly essential to the patently absurd — for fruits and vegetables.

Consider the Class I cucumber, which must be “practically straight (maximum height of the arc: 10 mm per 10 cm of the length of cucumber).” Translation: A six-inch cucumber cannot bend more than six-tenths of an inch. Following 16 pages of regulations on apples (Class I must be at least 60mm, or 2 1/3 inches, in diameter) come 19 pages of amendments outlining the approved colors for more than 250 kinds.

As for peaches, “to reach a satisfactory degree of ripeness . . . the refractometrix index of the flesh, measured at the middle point of the fruit pulp at the equatorial section must be greater than or equal to 8° Brix.”

Originally published at Fabius Maximus and reproduced here with the author’s permission.Related RGE Content: 

1) Eurozone On The Verge of Recession?

2) EMU Macroeconomic Policy Governance: Are EU and ECB Pulling Together?

3) Welcome to EMU@10: What Will the Next 10 Years Bring?