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The eurozone was established in
1999 as the monetary union of the 11
European Union states shown here. By
2012, there were 17 eurozone members,
with eight more scheduled to join.
annual deficit was not to exceed
3 percent of GDP. A new European
Central Bank would act for the euro
area, replacing the national central
banks and setting monetary policy
across all the member states.
Fatal flaw
However, the provisions for the euro
did not contain a mechanism for
risk-sharing—crucially, they did
not include a means for fiscal (tax
revenue) transfers across European
countries. The reason for this was
simple, and political. Despite the
long establishment of some transfer
mechanisms, such as the Common
Agricultural Policy, there was no
desire in any EU country to lose
its ability to set its own taxes and
spending levels. Fiscal transfers
across the continent would have
required a strong, central authority,
able to take taxes from surplus
regions and redistribute to those in
deficit—for example, to tax
Germany and spend in Greece. But
the political will to perform this
was lacking. Instead, Europe’s
leaders hoped that the stability and
growth pact would provide enough
of a bind on government activities
that an explicit fiscal transfer
mechanism would not be needed.Eurozone crisis
For nearly a decade after its launch
the euro functioned well. European
trade increased by up to 15 percent
by some estimates. Capital and
labor markets became more
flexible. Growth, particularly in the
poorer countries of Ireland and
southern Europe was impressive.
But underneath this picture were
profound problems. Differences in
labor costs helped exacerbate trade
imbalances between different
countries. The euro area as a whole
was broadly in balance with the
rest of the world, exporting roughly
as much as it imported. But within
the euro area, huge differences
appeared. Northern Europe hadgrowing trade surpluses that were
matched by rising deficits in the
south. Without the mechanisms to
provide for fiscal transfers between
surplus and deficit countries, these
deficits were (in effect) funded by
the creation of rising debts in the
south. When the financial crisis
broke in 2008, the unbalanced
system was pushed over the edge.
The euro crisis has raised
questions about whether Europe
is an optimal currency area. Some
countries have seemed ill-matched
in trading terms, and the absence
of a fiscal transfer mechanism has
meant that these imbalances could
not be overcome. The stability and
growth pact was not robust enough
to force distinct national economies
to converge.
Euro member countries face
difficult choices. If a mechanism
to undertake fiscal transfers can
be constructed, euro countries
may be able to overcome their
own unevenness. If the political
consensus for such a mechanism
can’t be reached, the existence of
the euro may be threatened. ■POST-WAR ECONOMICS
... countries with tight
international trade
ties and positively
correlated business
cycles are more likely to join,
and gain from [European
Monetary Union]...
Jeffrey Frankel
Andrew Rose