There is an old joke about economists and their allegedly unrealistic way of looking at the world. The punchline is the economist asking “that’s all good and well in practice, but will it work in theory?” As someone who looks upon the title “economist” as a badge of honour and thinks of economics as an immensely fruitful way of looking at the world, I naturally don’t find this funny. It is extremely important therefore to point out circumstances where economic theory got it exactly right. Like with the Eurozone.
Economist started warning against the Eurozone as soon as the idea was mooted, way back in the 1970s. One of the first was Nicholas Kaldor, an English economist, who wrote against the idea in 1971. In 1997, Nobel Prize winner Milton Friedman warned that a common currency would leave Europe with insufficient mechanisms for adjusting to “shocks.” Paul Krugman gave a speech in 2012 entitled “Revenge of the Optimum Currency Area” in which he stated that “lots of economists could and should have seen it coming, and some did. For we have a long-established way to think about the prospects for currency unions, the theory of the optimum currency area – and right from the beginning, this theory suggested serious concerns about the euro project.” (I haven’t been able to find where Krugman was one of the economists issuing this warning in advance, but I have to admit that I didn’t look that hard.)
There are many variants of the theory of the optimum currency area, but most economists agree on the following minimum criteria:
With this list in front of you, the impossibility of a successful Eurozone becomes obvious. The Eurozone meets the first three tests, but not really the fourth one. Labour mobility in Europe, never particularly strong, is massively impeded between countries by language and cultural differences. This lack of mobility is made even worse by the rigidity of labour markets, particularly due to legislated rigidities in certain countries. So, labour cannot easily move and it cannot easily adjust in situ, which is bound to make any problem bigger.
But where the Eurozone really fails is with the last test: with the exception of some relatively minor “cohesion” and “structural” funds, there is no mechanism in the EU or the Eurozone for transfers between countries. So then the fundamental flaw of the Eurozone becomes obvious. Each member has given up a huge amount of its economic flexibility – in the forms of independent interest rate and currency policies, along with an independent central bank to act as a lender of last resort and to monetize debt in extreme cases – with no guarantee of a European lifeline in the event its economy is overwhelmed by an economic shock. It is precisely this tension that is playing out in the Greece crisis.
But why was the Eurozone created with this obvious flaw? For one simple reason: despite all the talk among the European political elite about solidarity and common purpose, the reality on the ground is very different. Europeans don’t particularly like or trust each other. At least not enough to start eating out of the same fiscal dinner bowl. This dislike and distrust are exacerbated by the large wealth disparities within Europe, particularly a “north-south” divide which makes the Eurozone into a giant version of Italy.
The founders of the Eurozone were aware of this problem, particularly the Germans. The Germans also had a pretty good inkling about which countries were likely to require massive transfers – and it certainly wasn’t them. So they insisted on “convergence criteria” for Eurozone membership, such as the famous tests about the debt-to-GDP ratio and fiscal deficits, and a prohibition on bailouts. The Germans were trying to minimize the risk of Eurozone countries getting into trouble because they knew that they were the deep pockets in the system. They also wanted to be sure that Eurozone members would have the fiscal flexibility to save themselves, rather than having to rely on the other countries.
So let’s recap: The Eurozone was born structurally defective. And the structural defect was deliberate. The Eurozone did not provide for the type of fiscal transfers that were necessary to offset the loss of economic independence that would arise from membership. The politicians did not provide for these fiscal transfers for the very simple reason that the voters in the wealthy northern European countries would have never accepted them. Because while the industrious and wealthy people of Hamburg, Stuttgart and Munich are reluctantly willing to support the “arm aber sexy” (“poor but sexy”) fellow Germans in Berlin, they have no such sentimental attachment to, say, the inhabitants of Athens or Lisbon. Instead, the politicians tried to paper over this problem with “convergence criteria” that were almost certainly insufficient even in an ideal case, but which were made worse in practice through flagrant fudging (particularly by the Greeks, who just outright lied).
All of this is why I get rather cross with the liberal commentary about the horrible Huns and how they are ruining the Eurozone. And why I get downright pissed off with the bleating about the “troika” thwarting the “democratic” choices of the Greek people. The voters of northern Europe made a democratic choice at the formation of the Eurozone. Their democratic choice was that they would accept it only on the condition that it could not become an open-ended raid on their wallets. It is therefore ridiculous that liberal commentators and politicians blame the Germans for insisting on the deal they were promised. And it is the height of hypocrisy for these commentators and politicians to insist on the “democratic” will of the Greek people, while happily endorsing policies that would run roughshod over the democratic choice of the Germans (and other northern and, increasingly, central Europeans) who would have to pay the bill. It is almost impossible to imagine a more flagrant double standard than this, particularly because these same commentators and politicians know very well the conditions under which the Germans and others accepted the Eurozone.
The response of the Eurocrats to this problem is, of course, “the beatings will continue until morale improves.” Even though the Greek crisis has laid bare the fundamental fault lines and has brought forth the simmering resentments of Europe, as well as given a big push to xenophobic and extremist political tendencies (as I have pointed out in Unintended Consequences in the EU), the tone-deaf EU leadership in Brussels has recently come out with a proposal to increase the degree of fiscal cohesion. This plan has been endorsed by French President Francois Hollande, as ever the bellwether of bad policy. The folly of this continuous attempt to put the cart before the horse, to force a fiscal cohesion before a sentimental one exists, brings to mind another spot-on prediction of Friedman’s 1997 article:
The drive for the Euro has been motivated by politics, not economics. The aim has been to link Germany and France so closely as to make a future European war impossible, and to set the stage for a federal United States of Europe. I believe that the adoption of the Euro would have the opposite effect. I would exacerbate political tensions by converting divergent shocks that could have been readily accommodated by exchange rate changes into divisive political issues. Political unity can pave the way for monetary unity. Monetary unity imposed under unfavourable conditions will prove a barrier to the achievement of political unity.
As a final example of economic theory getting it exactly right, I will leave you with a quote from Friedrich von Hayek, a Nobel Prize winning economist who particularly focussed on the role that limited knowledge plays in undermining most forms of social, political and economic engineering. His statement is generic but it certainly applies to the Eurozone, and it comes from one of his books appropriately entitled The Fatal Conceit :
The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.
Roger Barris, London
 It is no coincidence that the three countries that “opted out” of the Eurozone at its creation were the United Kingdom, Sweden and Denmark. All are northern and wealthy, and although the UK has always been Euro-sceptic, Sweden and Denmark are famously community-minded. The Germans would have probably wanted to opt out, too, but their history always pushes them to be more Catholic than the Pope when it comes to the EU.
 Although only with a lot of grousing from the “wessie” (west Germans) about the “ossie” (east Germans) made lazy by years of communism.
 If anything, the formerly communist countries of central Europe are even more violent in their rejections of Greek requests than the Germans. After the weekend summit that set out the harsh rules of a third bailout, Lithuanian President Dalia Grybauskaite declared an end to “party time at the expense of others in Greece.” These countries, which are poorer than Greece, which underwent brutal adjustments in order to qualify for EU and Eurozone entry, and which have recently endured sharp austerity in order to abide by the rules of the club, have absolutely no sympathy for the Greeks.
 It is amazing to me how widely held is the belief that the EU is responsible for the absence of war between major European countries since World War II. I have had a number of educated Europeans cite this to me as the greatest accomplishment of the EU and the best reason to endure sacrifices on its behalf. This, of course, is total nonsense. The reason there has been no war in Europe since WWII is the rise to super-power status of the USA and Russia, a status to which no European country can possibly aspire and a status which guarantees that, unless it is started by one of the super-powers, no European war will be possible or tolerated. The EU has nothing to do with it. My thanks to Lars Christensen in Contra Corner for pointing out the aptness of this quote in the circumstances.