The Corner

A Euro-Zone/Twilight Zone Moment

While looking for a link to the second paper by Professor De Grauwe that I mentioned in the previous post, I came across (via Eurozoneremarkssomething else he had written, together with some interesting background.

Here’s an extract from De Grauwe’s article:

Suppose a country, which we arbitrarily call Spain, experiences a boom which is stronger than in the rest of the euro-area. As a result of the boom, output and prices grow faster in Spain than in the other euro-countries. This also leads to a real estate boom and a general asset inflation in Spain. Since the ECB looks at euro-wide data, it cannot do anything to restrain the booming conditions in Spain. In fact the existence of a monetary union is likely to intensify the asset inflation in Spain. Unhindered by exchange risk vast amounts of capital are attracted from the rest of the euro-area. Spanish banks that still dominate the Spanish markets are pulled into the game and increase their lending. They are driven by the high rates of return produced by ever increasing Spanish asset prices, and by the fact that in a monetary union, they can borrow funds at the same interest rate as banks in Germany, France etc. After the boom comes the bust. Asset prices collapse, creating a crisis in the Spanish banking system.

This appeared in the Financial Times in February . . . 1998.

And here’s that background (from the New York Times last month):

Some two decades ago, when Europe’s leaders worked out the details of their grand vision to connect the European Union with a single currency, virtually every economist on this side of the Atlantic — and most of those on the other — figured out that the euro would be fatally flawed.       

What took economists some time to understand was that Europe’s leaders didn’t much care what they thought.

“The European Commission did invite economists to present their views. It was a Darwinian process,” said Paul De Grauwe, professor of European political economy at the London School of Economics. “I was invited, but when I expressed my doubts I wasn’t invited anymore. In the end only the enthusiasts were left.”

The single currency served an overriding political objective. Like the single market before, it was conceived primarily as glue to bind Europe more closely together, tie Germany’s prosperity to that of its neighbors and prevent a third world war from the Continent, which had brought us two. A few engineering flaws wouldn’t be allowed to get in the way of such an important project…

And, for some, of course, those flaws may have been a feature, paving the way for a ’beneficial crisis’ that would force the euro zone into a much deeper union. Well, the crisis is here all right. The correct adjective to describe it remains, however, undecided. 

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