The euro and the global crises: Finding the balance between short-term stabilisation and forward-looking reforms

by Joshua Aizenman

Vox
June 5, 2012

The Eurozone crisis poses the single greatest downside risk to the global economic outlook. Were the founders of the euro hopelessly optimistic? This column argues that such crises present an opportunity for institutions to be put in place that prevent short-sightedness and increase the stability of the monetary union.

It is a few years since the US-originated global crisis and the world economy now finds itself grappling with another crisis emanating from the OECD countries. The Eurozone sovereign debt crisis currently poses the single biggest downside risk to the global outlook. The crisis is rooted in the uneven growth performance of the different Eurozone countries, the unsustainably large public debts of some periphery countries, and the European banks’ exposure to these debts. These developments exposed the possible dynamic inconsistency of the euro project, dubbed by Pisani-Ferry (2012) as the ‘Euro Impossible Trinity’.

The short history of the euro project has been remarkable and unprecedented. Earlier concerns about the stability of the transition from national currencies to the euro, and scepticism regarding the gains from forming the euro, were deemed overblown during the 2000s. However, the real test of a currency union happens at times of sizable asymmetric shocks, like recessions impacting some states in the union, while other states boom. The slowing down of the periphery at a time when Germany kept growing awakened the market in 2010 to the growing debt overhang of the Eurozone’s periphery, and the incompleteness of the euro project. The resultant Eurozone crisis is testing the viability of the single currency.

Understanding the process that led to the vulnerabilities exposed by the global and the Eurozone crises is a pre-condition for grasping the necessary short-term stabilisation and reform. The generic answer to the timing of short-term stabilisation and forward-looking reform challenges is simple – it is best to enact the reforms in a forward-looking manner, during good times, reducing the cost of short-term stabilisations. In practice, unlike the generic answer, reforms are rarely enacted in a forward-looking manner during good times. In recent research (Aizenman 2012), I analyse the evolutionary aspects of economic changes – illustrated in the context of the formation of the euro and the global financial crises.

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