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How the euro overcame nearly impossible odds

By Francesco Giavazzi and Alberto Giovannini

Tuesday, Jan 01, 2002, Page 9

The history of the euro provides a shining example of how economic ideas shape public opinion and how they then, eventually, reshape political and economic institutions. Robert Mundell, a Canadian who won the Nobel Prize in economics in 1999, was the first person to write about the benefits of monetary unions. The project that led to the birth of the euro was inspired by Mundell's ideas and by the acknowledgment of the importance of efficient rules for regulating the interaction between government authorities, like central banks, and the rest of society.

The European Economic and Monetary Union (EMU) was born from the following apparently contradictory argument: that the discretionary powers which governments enjoy over exchange rates and financial markets are often inversely related to their ability to provide stability in those very same markets. Italy provides a good example of this: before the EMU, the country was plagued by high inflation, high interest rates and a very high cost of government debt which threatened the stability of public finances and the standard of living in Italy.

By removing the exchange rate and interest rates from the direct control of Italian authorities, the plague of high inflation and high interest rates disappeared. This does not necessarily imply that Italian authorities were bad or inept, only that the rules governing monetary and fiscal policymaking in Europe before the EMU were no longer appropriate for the highly fluent capital markets that had developed over the previous two decades.

The euro also provides important insights into the politics of economic reform. Interest groups for or against the euro project were never able to coalesce and harden into fixed proponents or opponents because both the economic benefits and costs imposed by the euro are diffuse. The groups for or against the euro changed over time and were different from country to country.

The resistance to the reforms necessary to make the euro project viable, particularly in the area of public finance, was overcome by setting a precise, gradual timetable and clear penalties for missing the deadlines. The scheme was dangerous from the viewpoint of financial markets, but extremely effective for tackling political hurdles.

In countries like Greece, Finland, Italy, and Portugal, joining the single currency ran against the interests of some industrialists, who had viewed the devaluation of the national currency as preferable to better but tougher choices aimed at maintaining and improving competitiveness. The euro also hit hard at those politicians who had discovered that inflation is an attractive form of taxation since it does not require a vote in Parliament.

The euro raised the cost of such comfortable policies. At stake was no longer a higher rate of inflation, but de facto exclusion from the single European market. Smart politicians understood that the balance of political cost and benefits had shifted dramatically, and they changed gears fast. Greece offers perhaps the best example.

Greece was a country that, for two decades, had lived off transfers from Brussels, squandering the money with high wages for public sector employees in an economy with low growth and high inflation. It took less than two years for the threat of exclusion to force a complete reversal in the policies of the Athens government.

Understanding that the euro is part of a much larger process of economic and political integration also helps to see why unilateral experiments with various versions of the same idea, such as that of Argentina and its currency board, have had a much different fate. Deadlines were critical for economic reform in Europe, but one feature of deadlines is that they expire, and once they are gone, the pressure associated with them also subsides. It is clear that once the EMU was established, the tide of change dramatically receded across Europe. Indeed, the so-called welfare state continues to eat into the wealth and welfare of our children.

Labor laws and regulations keep millions of potential workers out of jobs. A multitude of sectors, from car dealing to dentistry, are shielded from competition. As a result, significant amounts of income are transferred from consumers to small groups protected by the law. Worse, the whole economy suffers from chronic sclerosis. After the euro, reform in these areas still faces the traditional obstacles.

These problems notwithstanding, we think the reforms associated with the euro were great and well-executed. The euro's benefits go well beyond the realm of economics. The euro demonstrates that century old rivalries among nation-states can be overcome and forgotten when citizens can move across borders and do business with one another more easily. Sound economic institutions will be the basis of a sound, free society in Europe. Eventually they will lead sound political institutions across the Continent, even in the postcommunist states that are lining up to join the Union. The rest of the world should take notice.

Francesco Giavazzi is Professor of Economics at Bocconi University, and Alberto Giovannini is Chief Executive Officer at Unifortune.

Copyright: Project Syndicate
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