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Thinking the Unthinkable in Europe

CAMBRIDGE – When Greece was bailed out by a joint eurozone-IMF rescue package back in May, it was clear that the deal had bought only a temporary respite. Now the other shoe has dropped. With Ireland’s troubles threatening to spill over to Portugal, Spain, and even Italy, it is time to rethink the viability of Europe’s currency union.

These words do not come easily, as I am no Euroskeptic. Unlike others, such as my Harvard colleague Martin Feldstein, who argue that Europe is not a natural monetary area, I believed that monetary union made perfect sense in the context of a broader European project that emphasized – as it still does – political institution-building alongside economic integration.

Europe’s bad luck was to be hit with the worst financial crisis since the 1930’s while still only halfway through its integration process. The eurozone was too integrated for cross-border spillovers not to cause mayhem in national economies, but not integrated enough to have the institutional capacity needed to manage the crisis.

Consider what happens when banks in Texas, Florida, or California make bad lending decisions that threaten their survival. If the banks are merely illiquid, the Federal Reserve in Washington is ready to act as a lender of last resort. If they are judged to be insolvent, they are allowed to fail or are taken over by federal authorities, while depositors are made whole by the Federal Deposit Insurance Corporation.