There is a new conventional wisdom about the euro, driven in part by the recent entry of Croatia into the euro zone with much cheer and little disruption: The currency works fine, thank you, and the euro crisis of 2011 is a distant memory.
The core difficulties of the euro arise when two circumstances coincide: There are deflationary pressures, and economic conditions vary greatly among the nations of the euro zone. The good news is that neither of these circumstances currently prevails. That is also the bad news.
Inflation rates have been high, especially in the euro zone, and are expected to be higher than 9% for December 2022. Inflation brings problems of its own (more about that later), but in the short run it does not lead to huge unemployment and loan defaults. If anything, it helps out some debtors.
During the 2011 crisis, there was massive deflationary pressure on the Greek banking system, endangering its solvency. The Greek government’s deposit guarantees were not entirely credible either, so many people withdrew their deposits, increasing pressure on both the government and the banks. Whatever problems euro zone nations may have today, they are not those.
A second issue in 2011 was that some nations were doing much better than others. Germany had a relatively strong economy, while Greece and Italy’s were relatively weak. Greece, Italy and some of the other “periphery” nations would have preferred a weaker euro, to boost their exports, but the strength of Germany and some of the other more prosperous euro-zone nations limited euro deprecation.
Today, problems in the euro zone are more evenly distributed. Current data indicate a shallow rather than deep recession, but countries such as Germany still face real challenges. The euro, in turn, has been relatively weak, which has limited some of the downside risk faced by the euro-zone economies.
Then there is the Russian attack on Ukraine, which has caused high inflation, high oil prices and political uncertainty. But these are not the kind of problems that endanger the euro zone. If anything, the Ukraine war increases the political gains from using the euro and makes the currency union stronger.
Unfortunately, those mechanisms postpone but do not eliminate the core problems with the euro zone. First, if the zone works better in inflationary times, politicians committed to it will become more attached to higher rates of inflation. That will make it harder for the European Central Bank to achieve its goal of price stability.
There is currently a convenient (and correct) scapegoat for such inflation — namely, Russian President Vladimir Putin. The German public is hardly happy about current inflation rates, but so far no major German leader is screaming that the inflation rate must be brought down under 2% immediately. That is the right response now, but over time there is the risk that the higher inflation rates will be tolerated or even institutionalized past the point where they are appropriate.
The second problem is this: High inflation eventually brings a process of disinflation, and during those disinflations real interest rates are often high. The ECB hikes nominal interest rates, and as inflation diminishes those rates rise in real, inflation-adjusted terms. In other words, some deflationary pressures are brought to bear on the system.
Those deflationary pressures are exactly what the euro zone does not handle well. Italy in particular faces ongoing fiscal problems, and if its government had to borrow at much higher real rates of interest, its current fiscal path may not prove sustainable. It might be forced to cut government spending and/or raise taxes, which would lead to the kind of downward spiral that characterized the earlier euro-zone crisis.
Diverging economic fortunes for euro zone nations may reemerge as well. At some point, Germany will get over its current contractionary pressures, but Italy has not grown much in per capita terms for 25 years. It is easy enough to imagine a 2024 with Germany in a robust recovery but Italy continuing to stagnate. That could result in a euro much too strong for the Italian economy, just as it was more than a decade ago.
In short, there is still reason to worry whether the euro zone will allow for robust economic growth. Inflation papers over a lot of problems, including the dysfunctionalities of the euro zone — but never for too long.
More From Bloomberg Opinion:
• Euro Inflation Slows Enough for the ECB To Breathe: Marcus Ashworth
• The Euro Is Facing a Make-or-Break Year: Richard Cookson
• How to Fix the Euro Zone Without Setting Off Alarms: Leonid Bershidsky
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Tyler Cowen is a Bloomberg Opinion columnist. He is a professor of economics at George Mason University and writes for the blog Marginal Revolution. He is coauthor of “Talent: How to Identify Energizers, Creatives, and Winners Around the World.”
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