Euro zone’s future put in spotlight

Does the Euro zone have a future? A panel of Western economists organized by the Economic Policy Research Institute recently examined that question.

The panel, comprised of David Laidler and Michael Parkin, two former Western Economics chairs (and presidents of the Canadian Economic Association), as well as Jim MacGee, Bank of Montreal professor, agreed the future of the Euro zone was in doubt unless fundamental and far-reaching actions were taken.

Laidler argued a flawed Euro zone structure has unfortunately made policy responses there – driven by incompatible national interests – into outstanding examples of economic policy-making’s three Ds: ‘denial’ of the fundamental nature of the flaws in question leads to ‘dither’ in the form of a series of inadequate quick fixes which, increasingly likely with every passing month, leads to ‘disaster.’

He noted flaws in the Euro zone structure were recognized long before the crisis. In the 1990s, Laidler and other leading monetary economists warned of the risks of launching a European currency without creating institutions to manage the politics of its interactions with national economic policies. That’s not to mention the pre-setting of policy rules without knowing exactly how it would work or the damage a botched system’s failure could inflict.

While many saw the Euro as part of an ongoing post-war political project to bind Europe closer together, it was also seen as a way to lower trade costs and encourage poorer (mainly southern) European nations to undertake needed economic reforms. Combined with a stable macroeconomic climate (backed by the European Central Bank), this would foster rapid economic growth in the poorer Euro zone countries.

This expectation, combined with a belief that other nations in the Euro zone would step in to prevent defaults, initially led investors to treat the debt of all countries equally. MacGee argued many of the anticipated structural reforms to labour and product markets unfortunately did not happen, resulting in recent investor concerns that slow growth not only Greece, but also Italy, Spain and Portugal, would leave these countries unable to repay their debts.

Until concern about the long-run solvency of these countries is successfully dealt with – either via sovereign defaults, bailouts by other European countries or credible structural reforms that look likely to support long-run growth – the European debt crisis will drag on.

Parkin argued finding a way to make the Euro successful is the best option for all Euro zone nations. All benefit from the economic gains of Euro zone membership: higher trade, real incomes and stable prices. Moreover, leaving the Euro zone and reintroducing a national currency would be extremely difficult, due to questions about how to redenominate numerous contracts written in Euros as well as how to convince people to trade-in their Euros for a new currency.

Since a country that left the Euro would have little to gain, Parkin argued the Euro zone should survive so long as “ignorance or irrational inattention does not replace rational self-interest.”

Unfortunately, all of the panelists felt further mistakes were a real risk, and the most likely choice of Euro zone policy makers was to continue to delay on making the tough choices required to end the crisis – leaving the future of the Euro zone an open question.