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[...]Two questions are relevant today. One is whether weaker eurozone countries would be better off outside the monetary union with their own national currencies. This is not just an academic debate, given the increasingly vocal anti-euro constituencies in some member states. A second, more urgent question is whether a new eurozone recession would once again cause a crisis with highly uneven effects. The answer will help to set policy priorities in the event of an economic shock.
My answer to the first question is no, largely because the OCA theory disregards two key factors. For one thing, globalized financial markets and large short-term capital flows can cause wide exchange-rate fluctuations for countries with floating currencies – and for small, open economies in particular. As many emerging-market countries have demonstrated, such currency swings may affect a country’s ability to repay foreign-currency debt, and could force it to adopt a monetary policy at odds with its domestic objectives.
Furthermore, the OCA theory does not consider the stabilizing effect of central-bank credibility. It is difficult to imagine that Ireland, for example, would have avoided a financial crisis had it been able to devalue its currency sharply in 2008 – especially with debt denominated in euros and other strong global currencies. In the crisis years from 2008 to 2013, eurozone policymakers struggled with a “flight to safety” toward core members, as well as with increasing geographic “balkanization” of financial markets, with investors favoring their own countries’ government bonds. As a result, the ECB’s loose monetary policy was less effective than it otherwise might have been. In these circumstances, it is hard to believe that a national central bank could have secured lower risk premia through nationally targeted asset purchases if a macroeconomic adjustment program lacked credibility.
Advocates of reverting to a national currency often point out that Japan and the United Kingdom were more successful than Spain, Ireland, Greece, and Portugal in fighting the last recession. But this viewpoint fails to take into account that historically, these countries had been economically more volatile than Germany or France, and remained so after adopting the single currency.
As for the second question, a new eurozone recession would most likely have a less uneven effect than in 2008 or 2011. Today, almost all eurozone countries have current-account surpluses. Ireland is growing faster than China, while Spain and Portugal are also doing relatively well. And although robust house prices are fueling some of this growth, leverage is lower than it was ten years ago. The next recession in these countries is therefore unlikely to come with a nasty banking crisis that could make matters worse.
The eurozone’s three largest economies, on the other hand, pose a bigger recession risk. Germany and Italy have weak banking sectors and are facing a sharp cyclical slowdown, which in Italy is combined with very low long-term trend growth and high public debt. France also is growing sluggishly and has high private debt. A recession in the big three would drag down the eurozone’s smaller members, too.
The resulting eurozone-wide shock would require a common response, with countries coordinating monetary and fiscal policy to engineer the right stimulus. But such a coordinated fiscal stimulus would be difficult to implement unless Germany, the country with the largest fiscal capacity, took the lead. Moreover, policymakers would have to try to prevent another bout of balkanization of eurozone financial markets. As the last crisis showed, such fragmentation impairs monetary policy, limits risk sharing, and removes all the advantages of having a large, liquid, integrated capital market.
The eurozone’s real weakness is not the lack of exchange-rate flexibility, or its common monetary policy. Rather, it is the breakdown in risk sharing when the economy is hit by large shocks, combined with the absence of a common fiscal policy. That is the main lesson of the past 20 years.