The Plight of the Hapless EMU
By Paul Krugman

(FORTUNE Magazine) – In the seven long years since the signing of the Maastricht treaty started Europe on the road to a unified currency, critics have warned that the plan was an invitation to disaster. Indeed, the standard scenario for a European Monetary Union collapse has been discussed so often that it sometimes seems as if it's already happened.

The story goes like this: A year or two after the introduction of the euro, a recession develops in part of Europe. This creates friction between countries with weak economies and populist governments (read: Italy or Spain) and those with strong economies and steely-eyed economic discipline (Germany). The weak economies want low interest rates and a smidgen of inflation; Germany is set on price stability at all costs. The result is a ferocious political argument and perhaps a financial crisis.

Well, here we are, right on the brink of the creation of "euroland," and none of these problems have come to pass. Unfortunately, a whole different set of problems is arising. Instead of a fight between hard-nosed Teutons and dissolute Latins, what is shaping up is a conflict between euroland's central bankers and leftist, reflation-minded governments all across the zone--with the most leftist and reflation-minded government of all being, yes, Germany's.

But let's back up a bit and recall the fundamentals of EMU, which are more political than economic. The ultimate if rarely acknowledged goal of a unified currency is to move Europe toward political union. But euroland is anything but ready to think of itself as one nation. After all, these countries couldn't even agree on a set of heroes to put on their currency, so the euro notes will bear pictures of bridges, gates, and windows. Not real bridges or gates, mind you, but imaginary ones that might come from any European country. (One bill was redesigned because a bridge on it was--mein Gott!--recognizably French.)

It may seem odd to try to run a common currency without a common government, but Europe has some experience here. For almost two decades, under the European Monetary System, most European nations have maintained surprisingly durable fixed-exchange rates between their currencies, which basically means adopting a common monetary policy. Europe managed this by using a bit of neatly calculated hypocrisy. Although the EMS in principle treated all countries equally, in practice Germany ran it: The Bundesbank set interest rates, and other central banks kept their currencies pegged to the deutsche mark. This arrangement met two seemingly irreconcilable demands: the Germans' insistence that their beloved Bundesbank keep its hand on the monetary tiller, and that any institution must look like an association of equals, not a new, um, Reich. The Europeans, they are a subtle race.

But come actual monetary union, this subtlety would no longer have worked, because a truly unified currency needs something--a European Central Bank--explicitly in charge. How to set this institution up to treat each country equally, yet satisfy German demands for monetary rectitude?

The answer was to put the new system on autopilot, programming it to do what the Germans would have done if they had still been in charge. First, the new central bank, the ECB, would be made as free as possible from political influence. Second, its mandate would be price stability, period--not squishy things like employment or growth. Third, the first head of the ECB would be someone more German than the Germans: Dutch stable-price stalwart Wim Duisenberg, who headed the Dutch central bank. Finally, Germany insisted on a "stability pact" that limited the ability of individual euroland governments to run budget deficits.

And so there it was, a neatly wrapped package, ready for delivery on Jan. 1, 1999. But a funny thing happened on the way to EMU: Europe's economic and political complexion changed, and the biggest shift came in Germany itself.

The first sign of change came in France. Once notorious for its deficit spending and over-optimistic monetary policy, by 1997 France had acquired a near-Germanic devotion to sound money. Then came the election in June 1998 of Lionel Jospin, a Socialist who promised to reduce unemployment. Jospin's government promptly reopened the issue of who would head the ECB and introduced a French candidate. After a confused interlude, Duisenberg either agreed or didn't agree (I can't get it straight--they really are subtle, these Europeans) to hand over the reins to his French successor halfway through his eight-year term.

Now, the French left is not what it used to be--Jospin's government has been quite prudent fiscally and monetarily. Nor is there any discernible difference between the Dutch and French heads of the ECB. But France was only a warm-up for the big event: the ascent of Germany's new Chancellor, Gerhard Schroder, a Social Democrat. And it turns out the German left is what it used to be. The new rulers of Germany have no patience with Maastricht ideology, which says that all good things come to those who have balanced budgets, sound money, and free markets.

Schroder and his party are probably half right. Not about free markets: The modern German economic miracle is the fact that, given the country's ludicrous overregulation, there are any jobs left. But even those of us who do believe in supply and demand are a bit perplexed by European monetary policy. Over the past few years the inflation rate in euroland has steadily dropped, normally a clear indicator of excess capacity in the economy; consumer prices in Germany and France have actually been falling of late. Euroland as a whole has double-digit unemployment, and growth is slowing as the Continent feels the effects of the world financial crisis.

The actual situation as EMU begins, then, is nothing like what we all imagined. Instead of a situation in which some countries want tight money while others want a boost, the whole region is a prime candidate for lower interest rates--and all of the major governments agree that the central bankers should imitate Alan Greenspan, loosen up, and make everyone happy.

But EMU wasn't designed to make everyone happy. It was designed to make Germany happy--to provide the stern anti-inflationary discipline that Germany had always wanted. What if the Germans have changed their minds, and realized that they--like everyone else--are more worried about deflation and would very much like the central bankers to print some more money? Sorry, too late: autopilot engaged; no course changes permitted.

Of course, that isn't literally true. The Bundesbank could have lowered rates, and nothing in the ECB charter forbids monetary easing. Which is why many economists are tearing their hair out wondering why it isn't happening. But remember, the point of the setup was to create an institution that can say no--that will not give politicians what they want, even if what they want is entirely reasonable.

So the euro-pessimists who believe that the whole experiment is doomed have a new argument. Europe is not about to rip itself apart because it cannot agree about monetary policy. In fact, everyone but the central bankers now agrees about monetary policy. The danger is instead that Europe will become Japanese: that it will slip into deflation, and by the time the central bankers loosen up it will be too late.

These Europeans, they are a subtle race. And this time they may have subtled themselves into a very tight corner.