Abstract
This paper looks at the short history of the Eurozone through the lens of an evolutionary approach to forming new institutions. The euro has operated as a currency without a state under the dominance of Germany. This by itself may be good news, as long as Germany does not shirk its growing responsibility for the euro’s future. This would require Germany to invest more in upgrading Eurozone institutions and balancing its dominance gains with the economic and political responsibilities that come with it. Germany’s resilience and dominant size within the EU may explain its ‘muddling-through’ approach toward the Eurozone crisis: doing enough to prevent the unraveling of the Eurozone while resisting policies that may mitigate the depth of the crisis if they involve short-run costs to Germany. We review several manifestations of this muddling-through process. Germany’s attitude toward the Eurozone resembles the attitude of the United States toward the Bretton Woods system in the 1960s – benign neglect of the growing tensions, which led to the ultimate demise of the Bretton Woods system. Chances are that unraveling the Eurozone would be much more costly than the end of the Bretton Woods regime. One hopes that the muddling-through process would work as step**-stones toward a more perfect euro union, yet hope may not be enough to deliver it.
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Notes
IMF (2008, October, p. 228) noted ‘… emerging Europe’s ability to borrow foreign capital for long periods suggests that the standard growth model, with capital flowing downhill, remains relevant.’ ‘In emerging Europe, the large current account deficits are related to a rapid liberalization of domestic financial markets and open capital accounts, which attracted large capital inflows and prompted a rapid rise of foreign bank ownership. The process of integration into the EU also enhanced foreign capital inflows by improving prospects for economic and policy stability’.
Gourinchas and Jeanne (2006) found that the welfare gains in switching from financial autarky to full capital mobility equal a paltry 1% increase in domestic consumption for the typical emerging market. Aizenman et al. (2007) and Prasad et al. (2007) noted that fast-growing develo** countries have tended to self-finance their investment, and run current account surpluses.
Applying evolutionary logic in economics goes back to Veblen (1899) and the Austrian evolutionary school, with further developments applying Evolutionary Game Theory (Hodgson, 1998; Young, 2001 for overview and references).
Even forward-looking policymakers may opt to sequence the formation of new institutions taking into account the limited capacity and support in dealing with contingencies that are viewed by the public as low probability events. In these circumstances, policymakers may prioritize the formation of policy instruments and new institutions dealing with tail risks, along the line of ‘don’t wake up slee** dogs’. This attitude was probably reflected in European Commission President Romano Prodi’s statement in 1999, ‘I am sure the euro will oblige us to introduce a new set of economic policy instruments. It is politically impossible to propose that now. But some day there will be a crisis and new instruments will be created’.
Frankel (2011) showed that official forecasts of budgets and GDP in a 33-country sample are overly optimistic on average. The bias is stronger for longer horizons and in booms. Chile learned from past volatility and crises, experimenting during the 2000s with innovative fiscal rules supported by entrusting the needed forecasts to independent expert panels.
Taken from the ECB web page, http://www.ecb.europa.eu/paym/t2/html/index.en.html, accessed 26 July 2014.
Data taken from Euro Crisis Monitor, http://www.eurocrisismonitor.com/.
The process of redenominating domestic euro deposits into domestic currency, which would then lose value against the euro, would trigger a system-wide bank run, at times that the ECB would be reluctant to provide the lender-of-last-resort support. As most euro governments are already in a weak fiscal position, they would not be able to borrow in order to bail out the banks and buy back their debt. This would induce a financial meltdown similar or deeper than that of the Argentinian crisis in the early 2000s, destroying the savings of the middle class. Chances are that such a process would trigger economic and political dynamics that may unravel the EU.
Nominally, France is well-represented in the decision making, as is reflected in nominating Mr Moscovici, the former French finance minister, as the EU economy commissioner. However, the momentum in the EU shifted toward Germany’s positions – the Financial Times commented on September 2014 ‘It was widely expected that Mr Moscovici’s powers would be curbed when Jean-Claude Juncker, the new commission president, unveiled a new structure this month where a handful of vice-president commissioners would have oversight of their colleagues’.
The banking system of the US was ‘Balkanized’ during the three decades post WW II. While this system came with its costs, the United States grew at a healthy rate during that period. The deregulation of the US banking system in the 1990s came with its short term benefits, and the longer run costs. Chances are that the growth challenges of countries are less the balkanization of their banking and financial systems, and more their structural distortions.
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Acknowledgments Insightful comments by Jerry Cohen, Barry Eichegreen, Andrew Rose, Paul Wachtel, two anonymous referees, and the 20th Dubrovnik Economic Conference participants are gratefully acknowledged.
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Aizenman, J. The Eurocrisis: Muddling through, or on the Way to a More Perfect Euro Union?. Comp Econ Stud 57, 205–221 (2015). https://doi.org/10.1057/ces.2014.37
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DOI: https://doi.org/10.1057/ces.2014.37