Wolfgang Münchau declared recently in his Financial Times column that the euro was a mistake, and pinpointed a key illusion. Advocates “knew that, to withstand the rigors of a fixed-exchange system that resembles nothing so much as the gold standard, countries would have to adjust to economic shocks through shifts in wages and prices – a course, they believed, that the euro’s members would be forced to take.”
That is, the euro’s advocates believed that reforms could create enough flexibility to mainly neutralize Milton Friedman’s warning that in the face of negative shocks, countries with fixed exchange rates would suffer large costs: “If the external changes are deep-seated and persistent, the unemployment produces steady downward pressure on prices and wages, and the adjustment will not have been completed until the deflation has run its sorry course,” Mr. Friedman wrote in “The Case for Flexible Exchange Rates.”
But I never believed that this would work, and I based this skepticism on real evidence. During the run-up to the Maastricht Treaty, which set the whole euro project in motion in 1992, a number of studies focused on the United States – a currency union that functions reasonably well. Was that because America, with its weak unions and competitive labor markets, had more wage and price flexibility than other nations?
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Not according to the economists Olivier Blanchard and Lawrence Katz, who discovered back then that wages hardly played any role in regional adjustments to shocks; it was all about labor mobility. So the idea that Europe would be able to achieve a kind of flexibility found nowhere in the world – not even in the brutal, markets-rule American economy – was just implausible.
What none of us thought about at the time was the additional problem of the interaction of deflation and debt – the way attempts to adjust through falling wages can worsen debt problems. But even given what we knew a quarter-century ago, the problems with the euro were obvious.
Ricardo Caballero, Emmanuel Farhi and Pierre-Olivier Gourinchas recently published a new theoretical paper on how to think about a worldwide liquidity trap. I’m still working through the analytics, but it’s clearly consistent with what I’ve been saying for years.
In particular, when the economists write about how liquidity traps in some countries tend to get exported everywhere else, that’s very much what I’ve been worrying about.
And they point out that owning a reserve currency, so that people want to buy your assets, is actually a bad thing in a liquidity-trapped world – an argument I’ve been making for many years, with lamentably little impact on the what-if-China-stops-buying-our-bonds panic.