On the euro’s 20th birthday, Draghi’s tribute perpetuates long-refuted myths

Ashoka Mody 29 January 2019

European Central Bank

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The recent celebratory comments on the euro’s 20th anniversary mainly used high-minded but meaningless words. European Commission vice president Valdis Dombrovskis, for example, tweeted, “Being part of the Euro means being part of a common journey. … European nations will be stronger if they travel together.” European Central Bank president Mario Draghi attempted a more considered, but nevertheless cheery, economic scorecard. To convey cheer, he repeated worn storylines and disregarded mounting contrary evidence.

The single market needs a single currency. No, it does not.

Draghi’s central theme is that monetary union was “a necessary consequence of the [European] Single Market.” He leans on the authority of Nobel laureate Robert Mundell, who asserted that uncertainty in exchange rate movements constituted a “barrier to trade.” To that, Draghi adds, “And the single currency has further enhanced the process by eliminating the costs of foreign exchange payments and settlements and of hedging exchange rate risk.”

The earliest—and, for long, the most influential—econometric analysis cited in support of the proposition that exchange rate uncertainty and costs of transacting across currencies hampered trade was a 1989 study by two Italian economists, Francesco Giavazzi and Alberto Giovannini. In fact, the authors found that uncertain exchange rate movements and transactions costs made no difference to the volume of international trade. Yet, Giavazzi and Giovannini were committed to the proposition they had set out to prove and they asserted that Europe’s exceptional economic and political characteristics required fixed exchange rates.

The Giavazzi-Giovannini empirical finding—as distinct from their preferred conclusion—would not have been a surprise to Otmar Emminger, president of Germany’s Bundesbank, who had noted some years earlier that exporters routinely and inexpensively hedged against foreign currency risk. In 1993, in a now-classic Journal of Literature article on the proposed monetary union, the University of California, Berkeley, economist Barry Eichengreen challenged those who claimed that transactions costs of converting currencies limited international trade. 

Fast forward to today. Here is the evidence. Germany’s trade within the European Union has grown most rapidly with three non-euro countries: the Czech Republic, Hungary, and Poland. It is only a matter of time before Germany’s trade with these countries exceeds the sum of trade with France and Italy, the two largest eurozone countries after Germany. So, no, a single market does not need a single currency.

 Figure 1 German exporters have shifted their sights away from the euro area.
(percent of total German exports to the various countries)

Source: IMF Data, http://data.imf.org/regular.aspx?key=61013712

Draghi repeats the persistent European mantra that the risk of continuing devaluation of the Italian lira would have deterred German exports to Italy. Well, the evidence is in. The euro fixed the lira’s value vis-à-vis the D-mark, and German exporters lost interest in the Italian market regardless. Draghi further claims that “value-added chains”—the dispersal of intermediate production steps across countries—requires a single currency. Yet, value-added chains are most extensive with the three non-euro countries with whom German trade has grown most rapidly.

Defenders of the monetary union may nevertheless argue that trade with non-eurozone countries has increased because those countries are growing rapidly; and absent the euro, trade between member countries would have fallen even faster. Briefly, Andrew Rose of the University of California, Berkeley, in collaboration with other scholars, created a flutter by claiming that European monetary union would create an explosion of trade within member countries of the eurozone. 

But Rose’s econometric evidence did not pass the “smell test,” as the then Federal Reserve Board governor Ben Bernanke pointed out. In 2004—at the fifth-anniversary stocktaking of the euro—Bernanke noted that the share of trade within the eurozone countries was declining, rather than increasing. To him, that was sufficient reason to worry that Rose’s estimates were not credible.

In a sophisticated econometric analysis, reported in 2010, João Santos Silva and Silvana Tenreyro noted that countries that had joined the euro area had long had strong historical trade ties with one another; once these ties were accounted for, the euro’s influence on trade between member countries was essentially “zero.” 

Later, Rose himself, in a 2015 mea culpa, acknowledged that his earlier studies improperly extrapolated from the trade gains achieved within other currency unions to the likelihood that the eurozone would also experience a within–member states trade upsurge. With nearly 15 years of eurozone functioning, Rose concluded that the data were a fog, making any definitive statement impossible. He conceded, however, that the euro “had a mildly stimulating effect, at best.”  

In 2018, two new studies lifted that fog by completing the econometric task that Rose had left unfinished. The first used exactly the same extended data that Rose employed and advancing the superior Santos Silva and Tenreyro techniques (a superiority that Rose himself has acknowledged), this study established more firmly than before that the euro had “zero” influence on trade. 

More remarkably, another study (ungated working paper), again using the Santos Silva and Tenreyro method, finds that neither the original eurozone members nor the more recent members trade more with each other just because they share the euro. Projecting into the future, the authors conclude that the euro will not enhance trade for additional members either. Their blunt conclusion: Possibly the euro generates some political and economic benefits, but “we do not believe that increased trade integration with the eurozone should be considered one of them.”

Draghi’s position has evolved. In a November 2013 speech, he unaccountably said, “The empirical evidence suggests that sharing a currency has indeed boosted trade.” There was no basis for such a statement then; the evolution in the shares of trade was clear and the Santos Silva and Tenreyro study was state-of-the-art. Now, in his 20th-anniversary retrospective, Draghi has steered away from making an obviously incorrect claim. Instead, he has retreated to a hazy view that the euro “protects” the single market. Draghi’s latest assertion—whatever it means—has no support either in the trends in the direction of trade or in the continuing econometric evidence.

Monetary sovereignty creates more problems than it solves, Draghi says. Is that so?

If euro area countries could set their own monetary policy, they would only abuse that autonomy. They would run large fiscal deficits and misuse the central bank to finance those deficits. So Draghi concludes based on behaviour of national authorities during the 1970s and 1980s. Such damaging behaviour, he believes, would have inevitably continued.

The 1970s and 1980s were exceptional decades during which irresponsible fiscal and monetary policies were common worldwide. In part, governments were responding to the two oil price hikes, which raised inflation rates alongside a sharp slowdown in growth. That macro outcome—popularly described as stagflation—proved a policy challenge everywhere. Widespread public discontent led to political pressures for government handouts, which widened budget deficits and encouraged monetary financing of the deficits.

Western nations that did not adopt a single currency learned to discipline themselves. The learning occurred at different times over the course of the 1990s and early 2000s. In the United States, Fed chairman Paul Volcker—in a forceful show of central bank independence—raised interest rates to draconian levels in the early 1980s. Inflation fell and remained relatively low through the subsequent era of the Great Moderation. 

In Europe, the U.K. was the first to make a major break from the stranglehold of fixed exchange rates. On “Black Wednesday,” September 16, 1992, speculators forced the sterling out of the bands specified under the Exchange Rate Mechanism (ERM), designed as a precursor to the single currency. But the ignominy of being forced out of the ERM proved to be a blessing in disguise. In steps, the British government gave increasingly greater independence to the Bank of England, which managed monetary affairs with much success, and Britain experienced golden years of growth with stability. Other European countries went through their own macroeconomic and financial travails but also moved to independent central banks with inflation-targeting mandates. Sweden at the high end of the economic ladder and Poland at the lower end were among the countries that successfully made this transition.

In France, during the debate on ratification of the Maastricht Treaty to adopt the single currency, the conservative politician Philippe Séguin led the opposition, making the case for retaining the franc managed by an independent central bank that would keep inflation under control. Séguin lost his bid to change the course of French—and European—history by a whisker. But just because France and other European countries adopted the euro, officials such as Draghi do not have license to keep alive a blinkered and patronizing view that today’s eurozone nations would not have achieved the macroeconomic discipline that the Swedes and Poles did.

Indeed, the political economists Jesús Fernández-Villaverde, Luis Garicano, and Tano Santos have argued the opposite: the euro weakened macroeconomic discipline. A common monetary policy for the eurozone brought interest rates down too quickly for countries with weak institutional structures. Governments in these countries took advantage of the lower interest rates to increase fiscal entitlements for politically favored groups rather than engaging in the harder business of investing to raise their potential growth rates. Far from instilling discipline, the single currency subverted it.

Draghi puzzlingly does not consider the most important benefit of monetary sovereignty, the ability to absorb large economic shocks through exchange rate depreciations. While continuous devaluations to compensate for lack of productivity growth is a path to economic decline, depreciation to absorb shocks is unequivocally desirable. Moreover, to the extent that exchange rate depreciation shortens the period of distress following the shock, it also helps avoid drawn-out recessions, which recent research emphasises undermine long-term growth potential.

A common agricultural policy required monetary union. No, it did not.

Draghi uses Europe’s appalling common agricultural policy as justification for the single currency. “Absent a single currency,” he says, the promised compensation to farmers needed adjustment whenever exchange rates changed. Those price adjustments, Draghi melodramatically claims, “jeopardised trust in the market” and “poisoned intra-Community relations.” First, the rendition of history is, at the very least, controversial. Andre Szász, the former Dutch central banker, is his brilliant little book in 1999 on the European monetary union’s history, dismissed this as a consideration that European leaders used for introducing the single currency. The European bureaucracy used well-understood formulas, Szász reported, to make needed price adjustments.  

But the deeper problem with Europe’s agricultural policy as an argument for a single currency is that the policy itself was so egregious. The subsidies soaked up large amounts of the scarce European budget, favoured larger farmers over smaller farmers, and protected inefficient farming in Europe. When European farmers dumped their large surpluses on world markets, they lowered world prices, which hurt farmers from developing nations. European agricultural policy never had any redeeming feature and was a creature only of a dysfunctional domestic political economic bargain. To claim, then, that an incomplete monetary union, with its known risks, was required to preserve Europe’s murky agricultural bargain is another case of dredging for reasons to justify ex post the creation of the monetary union.

The euro area promotes economic convergence. No, it does not.

The euro’s founding fathers were right, Draghi says, in their belief that the single currency’s “culture of stability” would promote higher growth and employment. A valuable manifestation of such gains, he postulates, would be “convergence,” the narrowing of per capita income differences between member countries of the euro area. Draghi acknowledges that Portugal and Greece—oddly, he does not mention Italy—have stagnated and so diverged rather than converged. Yet, in defence of the convergence thesis, he points to the Baltic countries and Slovakia as successes.

Such casual use of evidence is deeply problematic. Slovakia joined the euro area in 2009, Estonia in 2011, Latvia in 2014, and Lithuania in 2015. They were on an impressive convergence path well before they adopted the euro, as documented here and here. They converged for reasons well established in traditional growth theory and empirical findings. Their strong inheritance of human capital from years under socialist planning, their transition to market economies, and, especially after they joined the European Union in 2004, reinforcement of rule of law and protection of private property, primed them for economic convergence. 

If the argument is that the prospect of eventually entering the euro area (and the fixed exchange rate regime these countries worked under in prior years) added to the pace of convergence, there simply is no evidence for that. Other countries that did not join the euro area and apparently have no near-term plans for doing so—the Czech Republic, Hungary, and Poland—have also converged towards living standards in higher-income European economies. 

The contrary argument that a single currency increases divergence rather than promoting convergence, goes back to British economists Nicholas Kaldor and Alan Walters. Both noted that a single monetary policy would be too tight for the weaker country, further weakening short-term growth prospects; the same monetary policy will spur higher growth in the stronger country. The evidence is consistent with this more pessimistic view. Once the global financial crisis began, the one-size-that-fits-none monetary policy clearly increased economic divergence, as I document.

 The single market is Europe’s great achievement. Yes, but don’t idealise it.

I believe in the virtues of the Single Market—they are not as grand as touted, but they are real. Unfortunately, Draghi makes absurd claims: “the Single Market was designed to reap the benefits of openness while also tempering its costs for the most vulnerable; to promote growth while protecting the people of Europe from the injustices of untrammelled free markets.” 

Whatever the social protections in European legislation, the most vulnerable in Germany, France, and Italy have lost their manufacturing jobs to or seen their wages deeply compressed by East European workers. 

Controversy has also swirled around “posted workers,” the signature symbol of a single market in services. Such workers—the fabled Polish plumber, bricklayers, and truck drivers—are typically posted by their Eastern European employers in the richer European countries. French president Emmanuel Macron describe posted workers as a form of “social dumping” because they receive benefits in line with the lower Eastern European standards. Macron lobbied for and succeeded in imposing more constraints on posted workers—and Draghi applauds that achievement as a worthy effort to “curtail unfair labour practices.” That is not the view of Eastern European governments, who insist that the new directives curtail free trade in services.

The truth is that under the gloss of protecting labour rights, European governments have been pursuing the creation of “flexible” labour markets, the word “flexible” being a euphemism for making it easier to fire workers. Yes, employment has increased because workers are forced to accept temporary jobs at lower wages. To the realist, such an outcome merely reflects the more efficient working of the market economy. Yet, temporary work contracts are associated with lower productivity; hence, lower wages provide no boost in competitiveness. Meanwhile, the underbelly of vast numbers of monthly, even daily and hourly, contracts creates unsustainable social anxiety.

The consequences of a false narrative can be dire

The Nobel laureates George Akerlof and Robert Shiller have highlighted the crucial role “stories” play in determining economic policies and outcomes. Repeated endlessly, the stories we tell ourselves become our motivating force, impelling us to ignore contrary evidence. As Shiller more dramatically says, because a story is an “easily expressed explanation of events,” it sometimes propagates like a disease. It can “go viral.” As it spreads, he warns, the story has an “economic impact.” Often a more dire political impact, he may well have added.

For the 10th-anniversary celebration in June 2008, former ECB president Jean-Claude Trichet gushed that the euro had been extraordinarily successful. This at a moment when the eurozone was already experiencing gale force winds. Describing Trichet’s speech, I paraphrased George Orwell in my book EuroTragedy: A Drama in Nine Acts. Trichet, I wrote, was narrating the history of the euro as it ought to have been rather than how it was.

Draghi is more careful in his 20th-anniversary speech. He acknowledges that the eurozone remains an incomplete monetary union with its attendant risks. 

However, Draghi then recites long-held but repeatedly refuted myths about the euro’s economic virtues. And, especially in his closing, Draghi is unable to resist the high-minded political rhetoric of his compatriots to describe his desired—rather than the actual—historical evolution. The monetary union, he says, is the “defining” symbol of the European “political project,” which unites Europeans “in freedom, peace, democracy and prosperity.” Such gloss only serves to undermine credibility, especially since European nations are more divided than at any time since World War II, and the euro has contributed greatly to deepening euroscepticism. 

Monetary union, Draghi continues, was necessary to end centuries of “dictatorships, war, and misery.” Draghi has so much of his economics wrong—it is scary to contemplate the consequences if he has his politics backwards.

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Topics:  EU institutions

Tags:  euro, Mario Draghi, single currency, single market

Visiting Professor in International Economic Policy at the Woodrow Wilson School, Princeton University. Author of EuroTragedy: A Drama in Nine Acts

CEPR Policy Research