The Euro’s one-size-fits-all model doesn’t fit

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Ten years ago, the European Monetary Union teetered on the brink of collapse as the Greek crisis came to a head. In what is now a little remembered detail, the then German Finance Minister Wolfgang Schäuble proposed that it might be better for a certain time to support Greece outside the Eurozone. This idea was squashed by his boss, Angela Merkel, along with the French president François Hollande. Another significant detail was the Obama administration weighing in to support what turned out to be the successful effort to head off “Grexit”. That effort stemmed from the perception that any such exit from the Eurozone, even of a small economy like Greece, could be fatal not only for the monetary union itself, but also for the European project as a whole – with geopolitical as well as economic implications.

Such acute sensitivities for long meant that scepticism about the viability of the monetary union was widely equated with the perceived populist-nationalist threat to prosperity and progress. Sceptics countered that their opponents – that is, the pro-Euro establishment – were confusing cause and effect. That is, problems with the monetary union were the cause of, not caused by, resurgent populist nationalism across the continent.

Beaten at its own game

The fundamental challenge lies in the euro’s one-size-fits-all monetary policy, a blunt instrument for managing the contrasting economic realities of the countries participating in this monetary union. The Eurozone’s structure, combining a shared currency with national fiscal control, has entrenched competitiveness gaps and locked different regions within the monetary union into divergent productivity paths. In this monetary union without a fiscal union, the convergence required for any “optimal currency area” has always been supposed to result from individual countries’ policymaking efforts directed towards shared goals.

There has all along been a massive problem with this in practice. In this group of open economies trading intensively between each other in a regime of irrevocably fixed exchange rates, the only remaining price that could be adjusted to reduce divergences in competitiveness has been wages. Yet the adjustment focus has always been asymmetric. That is, the less competitive areas have been pressured to strive for internal devaluation, but the essential counterpart of internal revaluation in the more competitive parts of the zone has never even been broached in official policymaking circles, let alone implemented or enforced. The major countries at either end of this dichotomy have been, respectively, Italy and Germany.

The main instrument of internal devaluation has been fiscal “austerity”. Expanding budget deficits were the counterpart of weakening activity from lost competitiveness. Fiscal retrenchment is meant to compress domestic demand and wages, pricing workers back into the European single market. Austerity was also, and crucially, baked into the monetary union’s foundational rules – the “no bail-out” clause and the Stability and Growth Pact (SGP) – aimed to guard against fiscal irresponsibility and inflationary pressure. This framework, largely shaped by German historical anxieties over hyperinflation and democratic collapse in the inter-war years ¹, was intended to impose discipline on member states ².

Damaging effects of discipline

To the extent this discipline was applied, its effects were deeply damaging. Far from restoring competitiveness, internal devaluation locked in unemployment and the erosion of skills which led, by the effect of “hysteresis”, to vicious downward spirals of declining productivity. Italy is the most economically important but not the only example of such destruction. The social and political reaction conventionally labelled “populism” is the inevitable and unsurprising result.

To a large extent, however, this prescribed fiscal retrenchment medicine was avoided. Germany, the champion of this treatment, played an ironical central role in undermining it: It colluded with France, the other core participant in the Eurozone, to become the first violators of the SGP’s 3 percent of GDP budget deficit rule in 2003/2004 – and then use their political clout to avoid sanctions. France has always enjoyed a kind of exorbitant privilege within the monetary union by chronically violating the fiscal convergence rules. Even since the SGP, suspended during the Covid pandemic and its aftermath, was revived in ill-advised doctrinaire form two years ago, France has got away with running deficits close to 6 percent of GDP. The reason is political – in keeping with the purely political essence of the monetary union since it was forced into existence by France as a counter to German reunification in 1990. As an indispensable cornerstone of the monetary union, France escapes accountability for dodging the destruction of internal devaluation.

The economic and political damage caused by internal devaluation has been greatly aggravated by the above-mentioned absence of the balancing internal revaluation despite this being explicitly provided for in the Eurozone’s rulebook. The rule in question is called the Macroeconomic Imbalance Procedure (MIP) which, like the SGP, envisages sanctions for violators. In 2002, Germany undertook its own internal devaluation by suppressing wages in the Hartz IV reforms. The compression of domestic demand in Germany was reinforced by the 2009 constitutional amendment known as the fiscal “debt brake”. The result has been chronic external surpluses – both with its trading partners inside the monetary union and the wider world. Even in 2024, despite the negative terms of trade shock caused by the decision to renounce cheap Russian gas, Germany’s current account surplus remained close to its multi-year average of around 6 percent of GDP. But the same political constraint that exempts France from respecting the SGP applies to Germany as regards the MIP.

«Far from restoring competitiveness, internal devaluation locked in unemployment and the erosion of skills which led, to vicious downward spirals of declining productivity.»

The Eurozone’s excess of savings over investment – a deprivation for its own people – has made it dependent on external demand. In 2014, the ECB – while ineffectually urging more fiscal activism – adapted its monetary policy to this reality by its negative interest rate policy that weakened the Euro to maximize net export demand.

The Eurozone’s globally anti-social preying on other countries’ demand was bound to result in an external reaction substituting for the monetary union’s failure to apply its own rule book to itself. China has beaten the Eurozone at its own mercantilist (“beggar-thy-neighbour”) game. In the case of the US, the reaction began with Donald Trump’s first trade war in 2018 which, compared to the present dramatic escalation at the start of Trump’s second presidential term, was a mild warning which the Eurozone ignored rather than responded to by changing its ways.

The voters aren’t asked

At the dawn of the Euro project, Martin Feldstein even predicted that the Economic and Monetary Union would provoke internal strife and strain transatlantic relations ³. This view echoed Bela Balassa’s 1961 proposition that monetary unions cannot endure without political integration ⁴. But might the external reaction to mercantilism from Trump finally jolt European countries into embracing the full fiscal – and hence political – union necessary to make the monetary union fully viable? While economists can have a legitimate debate about how large a real “federal” budget – voted by a real federal parliament – would have to be relative to total GDP to ensure that viability, the key to answering that question is not some choice of technocratic solution but lies rather in the political domain.

«Donald Trump’s first trade war in 2018 was a mild warning which the Eurozone ignored rather than responded to by changing its ways.»

It was a non-economic shock – the Covid pandemic – that overcame previously insurmountable political opposition to instituting the first ever “federally” financed spending in the form of the “Next Generation EU” Fund. Now the political shock of Trump’s challenge to traditional alliances has broken the logjam in the German political system with the parliamentary approval in Berlin of a major fiscal expansion that will provide a long overdue stimulus to domestic demand in Germany.

On the principle that “you never want a serious crisis to go to waste”, convinced federalists like President Emmanuel Macron may be expected now to press ever harder for a fiscal union – with the extension of the Covid-era measures likely focused on joint financing for rearmament in the wake of the Ukraine war. As always, however, the project will be advanced by stealth, rather than asking voters directly and openly whether they would prefer to be part of a federal union. There is no evidence that most voters, notably French ones, are truly ready for this. It follows that there is a risk of overreach triggering a new round of social and political reaction against the path set by the European monetary union. Given public fears of the costs – especially the threat to savings – from dismantling the monetary union, the project even now seems to remain stuck in no man’s land. In any case, the enduring conflict between federal ambition and national autonomy is reaching a critical juncture, and the outcome of this struggle is poised to irrevocably define Europe’s destiny.