Conservative economists triumphantly expect that the end of the euro is nigh. They take the Greek budget troubles as proof: one size cannot fit all. But they are wrong. The euro has contributed to the largest job creation in Europe’s history: 15.1 million new jobs in the first decade compared to 3.9 million in the previous period.
It has maintained price stability and, therefore, the purchasing power of otherwise stagnating wages. It has imposed budget rules that contribute to social justice and fairness (see my February column). And last but not least, it has helped to water the financial crisis, which otherwise would have devastated Europe even more.
Maybe it is no coincidence that the loudest critics come from America, where conservatives fear the loss of the dollar’s predominance. The latest example is Martin Feldstein’s recommendation of a “Greek holiday from the euro” that would be a disaster for Greece undermine the euro. Feldstein was President Reagan’s chief economic adviser. He never liked the euro and called it “an economic liability” that would cause political tensions, if not wars, between member states.
Now he has argued that the necessary fiscal consolidation in Greece would need to be complemented by a temporary exit from the euro area: “If Greece still had its own currency, it could, in parallel, [with cutting wages and deficits] devalue the drachma to reduce imports and raise exports, cutting the 15 per cent of GDP trade deficit. The level of Greek GDP and employment might then actually increase if the rise in exports and decline in imports added more to domestic employment and output than was lost through raising taxes and cutting government spending. But since Greece no longer has its own currency, it is not free to follow this strategy.”
The argument is straight out of economics textbooks, but that does not make it right. First of all, it does not work. Abundant evidence in the 1970 and 80s has convinced Europeans that, in the end, devaluing their currency only increased inflation and never economic growth. They had to pay for depreciations by severe austerity programs causing higher unemployment and larger debt. In fact, devaluations raise the value of foreign liabilities and push interest rates up. They, therefore, burden citizens further with growing debt obligations to wealthy investors abroad. This is hardly an attractive vision for Greece’s future.
Secondly, conservatives have never understood the economic nature of monetary unions. They believe it is similar to a currency board, where countries fix their exchange rates permanently to each other. However, in the euro area member states do no longer have national monies, and therefore they also have no exchange rates to fix. The essence of a currency area consists in the unrestricted access to liquidity from the European Central Bank by all authorised commercial banks in the monetary union.
Central bank liquidity is “money”, the ultimate asset that extinguishes debt contracts. The ECB sets the conditions and the price, i.e. the interest rate, for which commercial banks can obtain this liquidity, but all European banks are free and equal to use this facility. Hence, “national economies” have ceased to exist, even if national governments still set the regulatory framework for economic conditions. Conservatives confuse the political unit of “a country” with the economic unit, which is the currency.
A third misunderstanding is the thinking in old categories of resource balance and national savings. First year students learn that the current account balance is the difference between savings and investment. If savings are too low, a current account deficit occurs that reduces a country’s net foreign assets or increases its foreign debt. As long as capital inflows (i.e. foreign savings) supplement the low domestic savings, such a deficit can be financed; otherwise a country runs out of reserves and this fact is the ultimate constraint on the resource balance.
In a monetary union, the common and unrestrained access to central bank money abolishes constraints on national resource balances. Only the current account and balance of capital movements of the euro area matters for the savings-investment balance in the monetary union: within the euro area, the ECB sets the overall budget constraint by controlling money supply. Resources are allocated according to where the use of money can be expected to yield the highest return given the risks involved, and this assessment has little to do with geography or location. For example, if financial markets are no longer willing to fund the Greek government because it risks defaulting, they may still finance the Greek economy and the private sector, if there are profitable investment opportunities. Greek banks would continue to get liquidity from the ECB.
If Greece had its own currency, banks would have to worry about their liquidity in the shadow of a looming state bankruptcy. Capital would rush out of the country and the Greek National Bank would have to print money to keep banks afloat. A credit crunch would prevent local investment, which could not be financed out of national savings. Hence, being inside the euro area protects jobs. This is a powerful argument why a defaulting government should not opt for leaving the euro area.
However, competitive distortions within the monetary union will affect the profitability of investments and can undermine governments’ capacity to balance their budgets. Over the medium term, restoring sound public finances requires economic growth. The problems of slow growth in some Southern European member states are not a “negative resource balance”, i.e. insufficient savings, but lost competitiveness, lack of investment, and slow productivity growth.
This puts economic policy in the euro area into a completely new ball game. Segregated national policies, where each national government does its own “homework”, are becoming counterproductive. Economic policies are of “common concern” (Treaty of the European Union), because what one government does may affect citizens all over the euro area. If Germany cuts wages, it improves its own competitiveness and worsens it for everyone else. If Greece runs a large deficit, it stimulates German exports as well. If one government does nasty things at home, it may harm European citizens anywhere. Europe is economically united. It now needs policies that take this into account.
Correctly understanding how European monetary union works is important for policy-makers on the left, for otherwise they may fall into the conservative trap which people like Feldstein have laid. The social democratic answer must be: more solidarity and a democratic European government to preserve our common interests.
 Martin Feldstein, 1997. The Political Economy of the European Economic and Monetary Union: Political Sources of an Economic Liability, Journal of Economic Perspectives 11(4), Fall, pp. 3-22.
 Martin Feldstein, 2010. Let Greece take a eurozone ‘holiday’, Financial Times, February 16.
 This argument was recently made by Daniel Gros, 2010. Greek burdens ensure some Pigs won’t fly; Financial Times, January 28.