What were we thinking?

When I wrote, on Thursday, that "[a]pplying all this Optimal Currency Area theory to Europe yields a clear picture", I admit I felt more than a pang of guilt. After all, it seemed like a rather easy thing to say, with 20/20 hindsight. Was I saying that all those British Tories were right when they spent the 90s revelling in the prospect of the failure of the Euro? (Here's Thatcher speaking in 1990.) Or was it a matter of pure dumb luck that they turned out to be correct, with the truth being apparent only with the information we have today? 

I think that, in setting up the Eurozone the way we did, we made two errors in judgement that were only moderately forseeable/avoidable. (As an aside, I write "we" here not because I personally helped in the drafting, but because I learned about Optimal Currency Area theory well before the start of the Euro crisis and I don't recall being particularly bothered by the implications of the theory for the single currency. I agreed with it as a matter of policy and assumed that the economics would work themselves out. To be precise, I thought that the Eurozone was probably larger than optimal, but that this would never lead to serious problems because - in this case fortunately - in Economics it is almost always impossible to prove what would happened if a different decision had been made. Sometimes, the absence of counterfactuals is a good thing. Since I happily joined the lemmings running towards the cliff, it is only right and proper that I should write "we" even though I was 10 years old when the Maastricht Treaty was written.)

The first error was that we underestimated the potential size of the asymmetries. We never thought that it was still possible in this day and age for a European economy to shrink by 20% in a year or two. Instead, we thought of these asymmetries in terms of a spread in GDP growth of maybe 5%, at most. Instead, the current crisis gave us an EU-record of -17,7% real GDP shrinkage for Latvia in 2009 and a maximum Eurozone growth spread, last year, of 14,5%-points. (The difference between Estonia, which went from a 14,3% real shrink in 2009 to 7,6% growth last year, and Greece.) I went back to 1820, and I couldn't find a single year when the Dutch economy shrunk by double digits in peace time. Even before the Great Moderation, we had gotten used to real GDP growth in the range of -1% to +5%, not -15% or + 7%.

The second error was to underestimate the vast amounts of money it would take to sort such a problem out. Admitting Greece (or even Italy) into Eurozone there was always going to be a potential for bailouts from the North.  But the unpredicted (though not necessarily unpredictable) development was the vast amount of borrowing by banks from the Centre to the Southern Eurozone countries. That is what Krugman is talking about when he is talking about current account imbalances. Phrasing it in terms of macroeconomics is unhelpful. It's about banks lending money, and doing it at rates that were much too low. That was stupid, and they deserve to be punished for it much more than they are, but they can't be because then we'd bankrupt the entire European banking sector. So we're bailing out the Greeks and the others, just like the Irish bailed out their own banks. When it all began, we assumed - implicitly perhaps - that spectacular failure of the kind now observed in Greece would result in a country leaving the Euro. "If € 100 bn can't fix it, it won't get fixed." Instead, we find ourselves spending much more than we ever thought possible, because the alternative is another banking crisis. We underestimated how expensive it would be to bail out a failing Eurozone country, and we underestimated how much we would be forced to keep bailing.

When we used to apply Optimal Currency Area theory to the Eurozone, we always knew it was too big, but we assumed we'd never get caught. Historically, that was not an unreasonable assumption. There's a distinct question whether the US is the optimal size for a single currency. Maybe the Heartland, the East Coast and the West Coast should each have their own currency. But there's no way of knowing, so no one ever raises the question. (Except me, just now.) It was reasonable for us, in 1990 or 2000, to assume we'd never get caught either. But instead, the sheer size of the North-South lending in 2000-2006 and the sheer size of the current crisis have conspired to make this the one case out of a hundred where politicians get exposed for not taking economic theory to its logical conclusion. No one will ever know for certain whether the Obama stimulus was too big, too small or just right, but the history books will forever say that it was a mistake to let Greece into the Euro.