The Eurozone’s Real Weakness

LONDON – The 20th anniversary of the euro this year is a good time to reflect on the robustness of Europe’s monetary union. The memory of the last crisis, which began in the United States in 2008, is still fresh in the minds of Europeans: the eurozone suffered more than the US, with some of its members getting hit much harder than others. At a time when the eurozone is once again showing signs of a significant slowdown, it is important to understand what happened last time. Did we learn anything in the euro’s first 20 years that could help fight another recession?

The most popular narrative of the eurozone crisis relies on the economist Robert Mundell’s theory of an “optimum currency area” (OCA), which warns against establishing a common monetary policy in a federation of different states with different levels of economic resilience. This view emphasizes that eurozone members lack the exchange-rate flexibility that might help them respond to a negative shock. To make matters worse, because the European Central Bank targets the average eurozone inflation rate, its monetary-policy stance may not be suitable for all member states. In the weakest countries, this may lead to real interest rates above the level required for full employment.

Another narrative focuses on financial fragility. In good times, some eurozone countries build up excessive leverage because of relatively low real interest rates – partly a consequence of the ECB’s one-size-fits-all monetary policy. In countries with weak institutions and poor governance, this can lead to a loss of competitiveness and excessive consumption. A crisis would then be nastier than normal, triggering a fall in asset prices and debt defaults, followed by a period of deleveraging and weak demand.