The euro

All eyes are on the euro. I surveyed two professional groups of economists on LinkedIn. My question was whether they think that the euro would collapse.  The majority of responders (60) said no, and a handful (5) said yes.

In Robert Mundell’s theory of the Optimum Currency Area, a single currency among trading regions maximizes efficiency.  But for regions to form an OCA, they ought to have open capital and goods accounts, asymmetric shocks must be small in size, and labor must move freely across boarders.  Almost all economists agree that the euro is not an Optimum Currency Area.  The euro is a political project.

Nevertheless, many European countries, the so called periphery countries such as Greece, Ireland, Spain, and Portugal, benefited economically from joining the euro.  They were considered risky countries by investors before joining the euro. Investors demanded higher returns on their investments, and therefore high real interest rates.  Those risky countries became equally safe as Germany after joining the club. They borrowed money comfortably and spent a lot more than their incomes.  However, somebody benefited from the debt and the expenditure frenzy.  Not that anyone complained when things were hunky-dory. 

Figure 1 shows the real 10-year bond yield differential between Germany and some of the troubled European countries. Note how the differences were large before the risky countries joined the euro, died out when they joined the euro, and how they have begun to increase recently.  The 10-year bond yield is a complex variable.  It reflects expected inflation and risk among other things. 

Figure 1
(Source ECB)

Figure 2 shows the indebtedness of the periphery nations, and the IMF forecasts up to 2016.

 Figure 2
(Source IMF)

 

The euro was created by politicians and it will survive and die by them. Thus, in the end the people in any member country (including Germany) will decide whether they want to stay in the euro or not.  However, the factors that influence voters are the key.  Elections are almost surely affected by economic conditions.  Incumbent politicians stay in power if the economy is healthy and people have jobs and they depart if the opposite is true.  Clearly, Europeans in general are not happy with the economic conditions.  The French already replaced their government with a socialist one, which has major differences with Germany. The Greeks will, and the rest will too. 

Some French and Greek voters went to the extreme left and right. It is reported that the French legislative body’s majority is socialist, but the extreme right occupies 35 percent. The Greeks will be, highly probably, voting for an anti euro government on Sunday 17 June, 2012. These trends might grow in Europe; and when they do, which is very likely because they are associated with calamitous economic conditions, new governments not fond of the euro will be elected and things will change. Because the exchange rate is persistent and the European labor markets are inflexible, the adjustments will be long and painful.