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The Euro was a constructivist enterprise from the beginning, with all the attendant problems of such efforts. No one had ever invented a currency in that way, and the ECB was in unchartered waters from the beinning.

Mundell claims authorship and based his recommendation on the theory that Europe was an optimal currency area. Accepting for the sake of argument the idea of an optimal currency area, it is now obvious that Europe was not. So the premises were wrong.

Some years ago, at a Cato monetary conference, I predicted the Euro would end in country bailouts. I was rebuked by a Eurocrat with whom I attended graduate school. He argued that it would NEVER happen because it was expressly forbidden. Imagine that, it was forbidden. I must look for his email address to ask if he is prepared to eat a plate of crow.

The EU leaders will stick with the Euro until it threatens to tear apart the EU itself. Then they will confront a very unpleasant decision. In case you haven't noticed, the Fed is backing the Euro and so the American taxpayer is also on the hook.

In last week's Barron's, I predicted a Euro domino might fall in 2011. Ireland seems the most likely candidate at the moment, but any of the PIIGS plus Greece are candidates.

The common currency has little to do with sovereign default problems. Political will to put into practise the Maastricht Treaty on excessive deficit and debt, and consequently a ban on the blanket guaranteeing of bank liabilities, would have prevented the crisis. There would have still been a banking crisis in Ireland, probably also in Spain, but for instance the Greek spending boom would have been effectively preempted, and now Ireland would have a much lower deficit.

The real trouble is not with the euro, but of financial origin: German and French banks are exposed to losses on Irish and Greek bonds, so that in order to improve their balance sheets without recapitalizing the banks (German voters don't like the idea), they prevent their debtors to fail by using the common policy tools of the European Union, at present mainly the ECB and the newly created EFSM.

There is indeed a problem with monetary policy. The ECB is forced to assure price stability. Any financial crisis, or sovereign crisis, would put a downward pressure on monetary multipliers. In order to prevent this from affecting (unavoidably) the price level, the ECB has to cut interest rates to zero and monetize everything. Besides, the ECB has never had any restriction on monetization of assets other than treasuries, and can monetize treasuries from all the member countries, even the ones with low credit ratings (although with a haircut).

In this way, the ECB has monetized toxic waste like Sirtaki bonds with the excuse of stabilizing the price level. This has created an attempt of bailout by monetary means which was not supposed to be one of the ECB policy goals. But price stability is one target, and with one hundred types of bonds to monetize, there are ninetynine degrees of freedom left to create distributional (injection) effects. Moreover, in this period inflation is not really an issue, so that relative price effects can be huge without affecting absolute prices. The economy cannot be jump-started, but the fall can be manipulated.

"Some years ago, at a Cato monetary conference, I predicted the Euro would end in country bailouts. I was rebuked by a Eurocrat with whom I attended graduate school. He argued that it would NEVER happen because it was expressly forbidden."

I think it is a widespread mentality among european bureaucrats to believe that something does not exist only because there is a law saying it shall not exist. Moral hazard by the possibility of EU-level bailout of sovereign was probably assumed not to exist because there were laws such as the Maastricht Treaty.

Instead of reading Hans Kelsen, they should read Bruno Leoni: legal effectiveness is key, validity is just a tool to foster effectiveness when institutions are credible.

Some people in the Eurosystem, like Otmar Issing (link to his IEA Hayek speech below), actually knew from the start that this will happen one day - it was alway much less about the economics and more about EU state building:


The Euro enabled the countries at the periphery to borrow at interest rates not much less than Germany's. Not just the governments, but also the banks.

Except in Greece, this crisis was primarily a banking crisis. There were no controls on banks' borrowings. Wolfgang Munchau of the FT has been on point.

What sort out outcome can you expect when some people get together to promote free trade and movement of people between nations and they put in place a socialist central government to run it?

Good point, Rafe.

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