January 2022

Public enthusiasm mingled with the adjustment required to adapt to a new monetary system. Conversely, Spain‘s political and business leaders greeted the euro with unrestrained joy. The then-prime minister, José María Aznar, hailed it as a “dream come true,” a sentiment echoed by most political factions. However, two decades on, a less optimistic assessment emerges: Spain, alongside other western Mediterranean and Greek nations, lags behind in growth.

The widespread elation of 2002 stood in stark contrast to economists’ critiques. Economic theories concerning “optimal currency areas” have been extensively studied. Numerous experts, including several Nobel laureates, cautioned that the eurozone nations lacked the necessary economic and political integration. In essence, they warned the EU was prioritizing a single currency without a unified economic strategy.

The United States, Switzerland, and the United Kingdom exemplify optimal currency areas despite significant cultural diversity and political decentralization. However, a key distinction lies in their fiscal structures: they maintain a central or federal government that levies and distributes taxes nationwide, balancing regional capacity and needs.

Should California’s economy outperform Texas’, Texans would purchase Californian goods. Simultaneously, the U.S. government would collect more taxes from Californians and allocate more funds to Texas. Consequently, the financial flow from Texas to California would be partially replenished through federal transfers. The eurozone lacks this mechanism, with the EU budget representing a mere 1% of its gross domestic product (GDP).

Theoretically, the solution involved compelling all eurozone governments to uniformly restrict their debt levels. However, this approach fails to establish inter-regional transfer systems and hinders less competitive states from using debt to fund investments and enhance competitiveness.

Economists propose an alternative: the European Central Bank could finance national debt by purchasing bonds – acting as a “lender of last resort”.rnrn

A policy deemed unacceptable by the institution’s initial two leaders, Wim Duisenberg and Jean-Claude Trichet, was implemented. Initially, the ECB strictly adhered to German monetary principles—in contrast to Anglo-Saxon approaches—rejecting central bank debt acquisition as a valid strategy. This is because government-assisted money creation can fuel inflation.

Recession in core nations, booms in the south

The eurozone’s infancy was marked by downturns in France and Germany. The ECB adapted its approach to aid these economic powerhouses, reducing interest rates. Simultaneously, the European Commission overlooked treaty violations and escalating debt accumulation by these nations’ governments. These low rates stimulated the German economy but fueled robust growth and price surges in peripheral nations like Spain and Italy, which would have benefited from higher rates. This inflation, particularly, eroded these countries’ competitiveness, making their goods pricier than those from central European states. “Peripheral nations outpaced Germany’s growth in the initial years,” partly due to “significant interest rate reductions,” explains Jordi Galí, an economics professor at UPF and researcher at the university’s Center for Research in International Economics.

Spain’s excessively low rates explain two early 2000s phenomena. First, a sharp price increase, wrongly attributed by many to merchant price-rounding practices. Second, decreased credit, triggering a housing boom—a period of widespread mortgages. Both resulted from economic overheating due to lenient ECB policies. “Effective monetary management could have curbed the 2000s’ excessive expansion, averting differential inflation [compared to Germany] and competitiveness losses,” notes Galí.

However, the 2008 financial crisis reversed the situation: peripheral nations suffered more severely than core European states. This time, the European Commission didn’t overlook the issue, imposing unprecedented austerity measures on governments when nations like Spain, Italy, and Greece required increased public spending to counter economic downturns. The ECB, meanwhile, initially lowered rates before raising them in 2011 amidst the crisis. Europe’s recession lingered far longer than in the rest of the world, severely impacting peripheral states, several of which—including Spain—required bailouts. In 2009, the US had already resumed growth, while Greece and Spain faced five more years of hardship.

“Peripheral nations’ recovery would have been faster with independent monetary policy and currency, mirroring the early 1990s,” claims Galí. “But I’m unsure if the ECB’s price stability achievements would have been replicated, as peripheral central banks might lack the same credibility in inflation control,” he adds.

Recent integration

The combined impact of the financial crisis and the COVID-19 pandemic has significantly strengthened the eurozone’s unity. The crisis concluded when, in 2015, the ECB’s then-leader, Mario Draghi, decisively addressed the debt restrictions and initiated a large-scale acquisition of governmental bonds. This action stabilized markets and enabled struggling nations, such as Spain, to secure loans at more favorable rates. The pandemic further advanced this integration with the release of European bonds financed by the EU’s budget. This move brings the European Commission closer to a federal government role, although the power to levy taxes remains absent. The Next Generation EU funds, a temporary program, set a precedent for transferring funds from wealthier, more competitive nations to those in need, mimicking the role of a potential European-wide governing body.

Further integration is possible, according to Galí. He stated, “This is primarily a political matter. It depends on the member states reaching a consensus on a more adaptable arrangement, which I anticipate they will.” In his view, the pre-pandemic framework, established during the debt crisis to alleviate pressure on peripheral debt markets, is outdated and lacks credibility. He characterized NextGen’s community debt financing as “a significant qualitative leap that could potentially form the foundation of a Europe-wide fiscal policy.” However, Galí also emphasized the need for fiscal adaptability amongst member states to achieve an optimal structure within a monetary union. The economic trajectory will determine the willingness of national governments to embrace flexibility in managing their shared currency.