When 11 European countries adopted the euro in 1999, a number of prominent American economists, including Milton Friedman and Martin Feldstein, warned that a common European currency would be a costly economic policy mistake. Now events are proving how prescient those warnings were.
Over the past two decades, Europe's economic performance has lagged far behind that of the United States. In 2010, the Eurozone experienced a major sovereign debt crisis centered on Greece. Now, a new crisis seems looming, centered on France and Italy, whose economies are many times larger than Greece's.
Underlying the warnings of American economists was the belief that the various eurozone countries did not constitute an optimal currency area: they did not have the labour mobility and wage and price flexibility that the United States enjoys, nor did they constitute a political union that would allow for a fully functioning monetary and fiscal union.
European policymakers recognized that, given the euro's structural weaknesses, for it to thrive, member states would have to adhere to the strict rules on economic policy stability set out in the Maastricht Treaty: they had to keep budget deficits below 3% of GDP and public debt-to-GDP ratios below 60%. They were also to aim for price stability.
Unfortunately, the Maastricht Treaty was violated by the so-called Eurozone periphery countries, especially Greece, Italy and Portugal. These countries ran budget deficits several times larger than envisaged in the Maastricht Treaty, and public debt levels rose to well over 100% of GDP. The reason their budgetary policies went awry was because for many years the markets were unable to discipline them. Instead, the markets financed these governments' budgetary excesses at abnormally low interest rates.
The 2010 eurozone debt crisis exposed fundamental structural weaknesses of the euro as markets became unwilling to finance ultimately unsustainable budget deficits. That is, countries with severely deteriorated public finances found it extremely difficult to restore public debt sustainability by resorting to austerity measures. Peripheral eurozone countries, trapped in the euro's straitjacket, could not resort to printing money or devaluing currencies as a means to offset the effects of austerity-induced demand contraction and boost exports. The end result was a severe recession in the eurozone periphery in general, and in Greece in particular. Despite massive support from the IMF and the European Central Bank (ECB), Greece was forced into extreme fiscal austerity and experienced an economic downturn on the scale of the Great Depression of the 1930s.
Fast forward to the present, and France and Italy, the second and third largest countries in the eurozone, are conceptually in the same position as Greece was in 2010. Their public debt-to-GDP ratios are close to their all-time highs: 110% for France and 140% for Italy. Both also have budget deficits well above the Maastricht 3% of GDP. These deficits will likely continue to drive their debt levels up. Like Greece, trapped within the restrictive framework of the euro, these countries risk plunging their economies into recession if they undertake severe austerity measures.
Making matters worse is the collapse of France's political center and the rise of fiscally irresponsible far-left and far-right parties. Pre-election pledges from both extreme parties could lead to increased public spending that will only worsen France's already-running budget deficit. This is recognised by the market, with French-German government bond spreads rising to their highest since 2012.
ECB chief economist Philip Lane has been adamant that the ECB will not need to intervene in the French government bond market. But this is similar to what eurozone economic policymakers were saying on the eve of the Greek crisis. Given the size of the French and Italian government bond markets, it is very likely that the ECB will have to intervene in these countries' government bond markets on a much larger scale than it did in Greece over the next year to prevent the collapse of the single currency.
