Chronicle of a Currency Crisis Foretold

CAMBRIDGE – The crisis in Greece and the debt problems in Spain and Portugal have exposed the euro’s inherent flaws.  No amount of financial guarantees – much less rhetorical reassurance – from the European Union can paper them over. After 11 years of smooth sailing since the euro’s creation, the arrangement’s fundamental problems have become glaringly obvious.

The attempt to establish a single currency for 16 separate and quite different countries was bound to fail. The shift to a single currency meant that the individual member countries lost the ability to control monetary policy and interest rates in order to respond to national economic conditions. It also meant that each country’s exchange rate could no longer respond to the cumulative effects of differences in productivity and global demand trends.

In addition, the single currency weakens the market signals that would otherwise warn a country that its fiscal deficits were becoming excessive. And when a country with excessive fiscal deficits needs to raise taxes and cut government spending, as Greece clearly does now, the resulting contraction of GDP and employment cannot be reduced by a devaluation that increases exports and reduces imports.

Why, then, is the United States able to operate with a single currency, despite major differences among its 50 states? There are three key economic conditions – none of which exists in Europe – that allow the diverse US states to operate with a single currency: labor mobility, wage flexibility, and a central fiscal authority.