THE EURO: A DIVERGENT SYSTEM - FLAWED FROM THE START - Summary and Analysis of The Euro: How a Common Currency Threatens the Future of Europe - Joseph E. Stiglitz

Summary and Analysis of The Euro: How a Common Currency Threatens the Future of Europe - Joseph E. Stiglitz (2016)



The eurozone was a beautiful edifice erected on weak foundations. The cracks were clear from the beginning, but after the 2008 crisis, those cracks became fissures. By the summer of 2015, 16 years after the euro was launched, it looked as if Greece would have to exit. A huge creditor/debtor schism had opened up, and political power within the eurozone rested with the creditors, and Germany in particular. The crisis countries were forced into deep recessions and depressions. Europe had created a divergent system even as it thought it was putting together a convergent one.

Several features of the eurozone that were thought of as essential to its success were actually central to its divergence. Standard economics is based on the gravity principle: money moves from capital-rich countries with low returns to countries with capital shortage. The presumption was that the risk-adjusted returns in such countries would be high. But in Europe under the euro, movements of not just capital but also labor seem to defy the principles of gravity. Money flowed upward.1 In this chapter, I explain how Europe created this gravity-defying system. Understanding the sources of the divergence is essential to creating a eurozone that works.


One of the strengths of the eurozone was that capital and labor could move freely throughout the region. This is sometimes called the “single-market principle.” Free mobility was supposed to lead to the efficient allocation of labor and capital, thereby strengthening Europe’s prosperity. Each would go to that place where returns were highest.

As capital left the rich (capital abundant) countries to go to the poor (capital scarce), so the theory went, incomes across the eurozone would become more similar and the whole eurozone would work better. Natural market forces would result in convergence; if governments did their part—keeping low deficits and debts—the market would do the rest. The leaders of Europe should have known that there was a significant body of economic analysis—theory and evidence—showing that those expectations were wrong.

In fact, there was a real world example in plain sight: conditions in Italy were quite different from textbook economics. There are no government-imposed barriers to the movement of capital and labor between the north and south of Italy. There is the same legal framework. Yet, the south of Italy has had a persistently lower income than the north. Though there have been periods in which there was some convergence, in recent decades, it has not occurred.2


The previous chapter explained how a free flow of capital, combined with the creation of the eurozone, led to the euro crisis. Ever-foolish capital markets thought the elimination of exchange-rate risk meant the elimination of all risk and rushed into the periphery countries. In some cases, they created real estate bubbles. In all cases, they created upward pressure on prices and current account deficits that were not sustainable. One country after another went into crisis, as markets eventually realized that the current account deficits were unsustainable, and as real estate bubbles broke. But by then it was too late: money that should have gone into making these economies more productive went instead to financing consumption and real estate bubbles (in Spain and Ireland) and government deficits (Greece).

The previous chapter also explained how as prices in these countries increased relative, say, to those in Germany, imports increased relative to exports. Trade deficits became a regular feature of these countries’ lives. Internal devaluation was supposed to undo the damage that had been done.3 But as we saw, internal devaluation works, at best, slowly and can be very costly: Increasing wages and prices is far easier than the reverse.

The same irrational money that had created the euro crisis, realizing the enormous mistake that had been made, did what finance always does in such situations: it leaves.

Of course, this analysis does not describe all of the countries facing economic recession and large trade deficits. As we noted earlier, Finland has suffered from problems in a couple of its leading export sectors and from weaknesses in some of its major export markets. But even here, the euro is to blame for the prolonged downturn, because it has taken away the standard instruments by which it might return quickly to full employment with trade balance—and has put nothing in their place.


As the euro crisis emerged, money left the banking systems of the weak countries, going to those of the strong countries. As money flowed out of their banking systems, the banks in weak countries had to contract their lending. I refer to this contraction in lending as private austerity. The magnitude of this contraction is enormous and affects especially small and medium-size enterprises. Not surprisingly, countries where such businesses play a more important role are more adversely affected. (Large multinationals can borrow in international markets and thus are not as dependent on what happens within any particular country.) By 2013, the volume of small loans of less than €1 million—a proxy for lending to small and medium-size enterprises (SMEs)—was still far below its precrisis peak in all of the crisis countries: nearly halved in Portugal, down by two-thirds in Greece and Spain, and down by more than 80 percent in Ireland. But the decline was large even in many near-crisis countries: a decrease of a fifth in Italy, for example.4

By 2015, the European Commission was celebrating “green shoots” for the continent’s SMEs, which account for 67 percent of employment in the European Union.5 To many, the upbeat tone seemed premature, particularly in crisis countries. SMEs haven’t recovered in Greece, where more than a third continue to report “access to finance” as the single largest obstacle to doing business.6 Later, we shall see how the European Central Bank, headed by Mario Draghi, took forceful actions to restore confidence in the market for bonds, especially the bonds of the crisis countries; but while he may have saved the bond markets and the wealthy players in that game, back on Main Street, what he did seemed to have little effect.


The flow of money out of the crisis countries’ banking systems is understandable. Confidence in any country’s banking system rests partially on the confidence in the ability and willingness of the bank’s government to bail out banks in trouble. This in turn depends in part on the existence of (1) institutional frameworks that reduce the likelihood that a bailout will be necessary, (2) special funds set aside should a bailout be necessary, and (3) procedures in place to ensure that depositors will be made whole.7

Typically, banks benefit from an implicit subsidy in jurisdictions where governments possess greater bailout capacity. The link between confidence in banks and confidence in the governments under whose authority the banks operate can be seen in the close relationship between risk premiums on government debt and bank debt from the same country.8

Money flowed into the United States after the 2008 global crisis even though the crisis had been precipitated by failures in the United States’ financial system. Why? It was not that investors thought that American banks were better managed or that that they managed risks better. It was simply that there was more confidence in the willingness and ability of the United States to bail out its banks. (The government, with bipartisan support, had quickly put together a $700 billion bailout package in 2008, and it was clear that more money would be forthcoming if needed. The influence of Wall Street on the American government was palpable.)9

Similarly, today in Europe, what rational wealthy Spaniard or Greek would keep all his money in a local bank, when there is (almost) equal convenience and greater safety putting it in a German bank?10

The effects of capital leaving the crisis countries are significant: only by paying higher interest rates can banks in those countries compete, but higher rates puts these countries and their firms at a competitive disadvantage. A downward spiral ensues: as capital leaves, the country’s banks have to restrict lending, the economy weakens; as the economy weakens, so too does the perceived ability of the country to bail out banks in trouble; and that increases the interest rate banks have to pay, so the banks weaken further and capital is further incentivized to leave.11


The euro crisis has highlighted how the structure of the eurozone itself created divergence, but there would be divergence even in the absence of a crisis. The ECB sets a single interest rate for the entire region. But the interest rate set on, say, German government bonds, is not the interest rate that firms in France or Italy, let alone Greece, pay—or even that the governments in these countries pay. There is a spread in interest rates, reflecting differences in the market’s judgment of risk and the ability of the banks in each country to provide credit to the country’s companies. The poorer and more poorly performing economies, and the countries with greater inherited debt, will have to pay higher interest rates, and, especially because of the intertwining of banks and governments in the current eurozone structure, so, too, will companies in these countries. This gives the country and its companies a distinctive competitive disadvantage, again leading to divergence.

Fixing the problem

There is an easy solution to this particular problem: common comprehensive deposit insurance for all banks in the eurozone. With such common insurance, no one would worry about the loss of money in their bank account; there would be no incentive for money to flow from the weak countries to the strong.12

A banking union

Germany is worried that with common insurance, there would be a net transfer from strong countries (like Germany) to the weak, and as Germany constantly insists, the eurozone is not a transfer union—a federation in which money is transferred from one country or region within the federation to another. That’s why it insists, too, that if there is common deposit insurance, there has to be a common regulatory framework. And to ensure fair treatment of banks across the eurozone in the event of a default, there has to be a common procedure for “resolution,” that is, for dealing with banks in distress, where depositors are demanding back more money than the bank has liquid funds to pay.13

These three provisions—deposit insurance, common regulations, and a resolution procedure—together are called a “banking union.” And by 2014, there seemed to be broad consensus within the eurozone on the necessity to move forward with such a banking union if Europe was to prevent the increasing divergence that was emerging. But, Germany argued that one should proceed carefully and gradually. It demanded, before there can be common deposit insurance, there must be common supervision (that is, regulation). Subsequently, Germany seems to have backed off being willing to have common deposit insurance, at least anytime soon, even with common supervision and common resolution.

But the halfway house with common supervision and no common deposit insurance would be worse than no house at all. Common supervision would introduce a new kind of rigidity into Europe. Yet, as I explained in the last chapter, the eurozone’s lack of flexibility and ability to adapt to the specific circumstances of different countries presents one of the region’s key problems. Managing the banking system of any country is a delicate matter, especially in an economic downturn. Shutting down banks hurts not just the shareholders and bondholders of the banks but also borrowers—they may not be able to easily find another source of finance—and, in the absence of deposit insurance, depositors.

Forbearance—a slight easing of regulations in times of economic downturn, allowing banks that would have been normally shut down because of their weak balance sheet to continue operating—has been part of traditional central bank practice. Of course, had there been better regulation of banks before the downturn, there would have been less need for forbearance. But central bankers and regulators have to deal with the hand that they have been dealt.

For the eurozone, the worry is that the rigid application of rules will make forbearance more difficult. Decisions made in Brussels and Frankfurt may not be those best suited for the economies around the eurozone. Banks may be shut down, at great cost to their country’s economy. Bank regulators are typically not economists. They are just following rules. But this rigid application of rules, in the absence of common deposit insurance, may make it even riskier for depositors to keep their money in the banks of a weak country: it may exacerbate the problem of divergence.


Europe not only allowed capital to flow freely within its borders but also financial firms and products—no matter how poorly they are regulated at home.

The single-market principle for financial institutions and capital, in the absence of adequate EU regulation, led to a regulatory race to the bottom, with at least some of the costs of the failures borne by other jurisdictions. The failure of a financial institution imposes costs on others (evidenced so clearly in the crisis of 2008), and governments will not typically take into account these “cross-border costs.”

Indeed, especially before the 2008 global financial crisis, each country faced pressures to reduce regulations. Financial firms threatened that they would leave unless regulations were reduced.14

This regulatory race to the bottom would have existed within Europe even without the euro. Indeed, the winners in the pre-2008 contest were Iceland and the UK, neither of which belong to the eurozone (and Iceland doesn’t even belong to the EU). The UK prided itself on its system of light regulation, which meant essentially self-regulation, an oxymoron. The bank managers put their own interests over those of shareholders and bondholders, and the banks as institutions put their interests over those of their clients. The UK’s Barclays bank confessed to having manipulated the market for LIBOR, the London interbank lending rate upon which some $350 trillion of derivatives and other financial products are based.15

Still, the eurozone was designed with the potential to make all of this worse. The advocates of the euro said that it would enable financial products to move more freely, since the exchange rate risk had been eliminated. In their mind, financial innovation meant designing better products to meet the needs of consumers and firms. That’s the standard neoliberal theory. More modern theories emphasize imperfectly informed and often irrational consumers and firms operating in markets with imperfect and asymmetric information, where profits can typically be enhanced more by exploiting these market imperfections than in any other way. Nobel Prize-winning economists George Akerlof and Rob Shiller document this widespread behavior in their brilliant book Phishing for Phools—using the term for Internet scammers who systematically “fish for fools.”16 With financial products moving ever more easily throughout Europe, the opportunity to take advantage of a whole continent of people who might be duped into buying financial products that were not suitable for them proved irresistible.

Difficulties in regulation

Attempts to regulate the financial sector around the world have made it clear that such regulation is not easy. Well-paid lobbyists from the financial sector approach any or all with as large a gift or campaign contribution as the antibribery and electoral laws of that country allow.17 Not surprisingly, the financial sector exercises enormous political influence and is enormously successful in persuading politicians that they should not “overregulate.” Excessive regulation, these opponents claim, could stifle the financial system and thus prevent it from fulfilling the important functions that it must fulfill if an economy is to prosper. The result is that in most countries, the financial sector is underregulated.

Somehow, the banks’ money makes their arguments seem more cogent, in spite of the historical record showing the adverse consequences of underregulated banks—up to and including the 2008 crisis.18

This political influence on regulatory reform in Europe and the United States has meant that the reforms have almost surely not been sufficient to prevent another crisis; in certain areas, such as the shadow banking system, there has been little progress, and in other areas, such as derivatives, what progress there has been has been significantly reversed, at least in the United States.19

Fixing the problem

The threat of a regulatory race to the bottom is why there has to be strong regulation at the European level. But under Europe’s current governance structure, this will prove even more difficult than getting good regulation within a country. The UK has been vigorously defending its system of light regulation. It may have cost its taxpayers hundreds of billions of pounds, yet today policymakers focus on the potential loss of profits, taxes, and jobs from downsizing (or rightsizing) the financial sector. The losses of a few years ago seem ancient history, not to be mentioned in any polite conversation of regulatory reform.

There is a second problem with Europe-wide financial regulation and supervision—can it be sufficiently sensitive to the circumstances of the different countries? Earlier, we suggested that it was unlikely that banking supervision could or would be.

In the absence of an adequate system of financial regulation and supervision at the European or eurozone level, each country has a responsibility to its own citizens, to make sure that they are not taken advantage of by others selling flawed financial products. There is great inefficiency in having duplicative regulatory regimes. But the costs pale in comparison with the harm from inadequate financial sector regulation.

The principle of financial market liberalization—allowing financial firms and products to move freely across Europe—has to be replaced with a more subtle condition: no country can discriminate against the financial products and firms from another member country, but each could demand that banks be adequately regulated in any way it saw fit; it could demand that the banks operating in its jurisdiction be adequately capitalized in a separate legal entity (subsidiary) within its country—so that its citizens would be paid off in the event of a financial collapse, or if a suit was brought claiming deceptive practices, the firm had adequate net worth to pay off the claim. The country would have the right to ensure that its financial sector is stable, that it does what it is supposed to do and not do what it should not.20


An economic framework that combines free mobility of labor with country (place-based) debt21 creates divergence, just as we saw that free mobility of capital does. It also leads to the inefficient allocation of labor.22

This may sound surprising. After all, in standard theory, free mobility is supposed to ensure that workers move to where their (marginal) returns are highest. This would be true if wages were equal to the (marginal) productivity of a worker, for, by and large, workers will gravitate toward where wages are highest.

But individuals care about their wages after tax, and this depends not only on their (marginal) productivity but also on taxes. Taxes, in turn, depend in part on the burden imposed by inherited debt. This can be seen in the cases of Ireland, Greece, and Spain. All three countries are facing towering levels of inherited debt, a debt that had swollen through financial and macroeconomic mismanagement. In the case of Ireland, the European Central Bank forced the government to take on some of the debts of the private banks, to socialize losses, even though earlier profits had been privatized.23

When marginal productivities are the same, this implies migration away from highly indebted countries to those with less indebtedness, and the more individuals move out, the greater the tax burden on the remainder becomes, accelerating the movement of labor away from an efficient allocation.24

The fact that skilled labor is more mobile than unskilled creates another driver of divergence and inequality. When skilled workers leave, a country is said to be hollowing out: their departure lowers incomes and future growth prospects. Hollowing out robs these countries of the potential entrepreneurs who will start new businesses and the academics who will train a new generation of researchers. It impedes a country’s capacity to catch up. The poorest workers, who are stuck at home, wind up paying for the mistakes of their parents—or more accurately, of the bankers and politicians of an earlier era. They pay doubly if there is complementarity between skilled and unskilled workers (that is, if the productivity of unskilled workers increases when they have more skilled workers to work with). In this case, fewer skilled workers results in less pay for unskilled workers. This is undoubtedly happening in Greece and some of the other crisis countries.

And matters are further worsened by the interaction between capital flows and labor flows: decreased availability of loans to small and medium-size enterprises further diminishes opportunity in the crisis and near-crisis countries, encouraging even more migration, especially of those talented and more educated individuals who can get jobs elsewhere in the EU.

Of course, in the short run, emigration may bring benefits to the crisis country: it reduces the burden of unemployment insurance, and domestic purchasing power increases as remittances from abroad (sent by the emigrants) roll in.25 But the outward migration also hides the severity of the underlying downturn, since it means that the unemployment rate is less, possibly far less, than it otherwise would be.26

These tax induced “distortions” in migration patterns are exacerbated by differences in government spending. Individuals care not just about their after-tax wages but also about publicly provided amenities. Countries with large inherited debts have limited public revenues to spend in providing these amenities; and this is even more true in the crisis countries where the Troika is forcing deep cutbacks in government spending.

Indeed, free migration, stoked by debt obligations inherited from the past and Troika policies imposed to ensure repayment, may result in depopulation of certain countries, in some cases exacerbating natural market forces trending in that direction. As we noted in the last chapter, one of the important adjustment mechanisms in the United States (which shares a common currency) is internal migration. If such migration leads to the depopulation of an entire state, there is some limited concern, but this pales in comparison to the justifiable worries of Greece and Ireland about the depopulation of their homelands, with its risk to their culture and identity.

Fixing the Problem

There is a partial economic fix to these problems, one that would also address some of the key macroeconomic issues raised in the last chapter. Eliminate place-based debt by creating eurobonds—bonds that are a common obligation.27 Germany has been adamantly against this and similar ideas, but it has never proposed an alternative way to cope with the inefficiencies in eurozone labor movement.

The reform would improve matters in several ways. Interest payments in the crisis countries would be much lower. Lower spending on debt service would allow these countries both to lower taxes and to undertake more expansionary fiscal policies, increasing incomes. All of this would reduce the magnitude of the forces for divergence—both outmigration of especially skilled labor and capital flight.


I have described perhaps the two most importance sources of divergence—capital flight and labor migration. But there are three more that deserve brief note.


As economies weaken, because of the fiscal constraints imposed by the convergence criteria,28 the governments of those countries are unable to make competitive investments in infrastructure, technology, and education. This is true even if the return on these investments exceeds by a considerable amount the interest rate the country has to pay to get funds. As a result, the gap between the strong countries and the weak in the level of these public services and investment, often complementary with private investment, increases.

This then interacts with the two forms of divergence already discussed: if these public investments are complementary with labor and capital—that is, they raise their productivities—then rich countries will have higher private returns to capital, even though they have a superabundance of private capital. If these countries have a more educated workforce (as a result of more investments by the public in human capital), the same results hold.

There is a long-standing anomaly in development economics: Why does capital seem to move from developing countries to those that are developed?29 Part of the answer lies in these complementary public investments, which increase the return to private investments.

Fixing the Problem

European-wide investment, financed by the European Investment Bank (EIB), Europe’s region-wide development bank, is a partial fix. But even though the EIB is the world’s largest multilateral lending institution, its resources are limited. What is needed is a further recapitalization of the EIB.

Some propose a related second fix: creating national development banks, whose lending for investment is off the country’s balance sheet and therefore outside the convergence criteria. But by pooling the risks of the different member countries, the EIB can obtain funds almost certainly at a lower rate than a development bank within a crisis country, and this is a major advantage. Indeed, some multinational development banks can borrow money at a rate lower than the rates at which any of their member countries can borrow.30 On the other hand, a national development bank may be able to discern among alternative SME borrowers, and thus be more effective in lending to SMEs. Some countries (such as Brazil) have found it useful to have both national and state development banks.

More broadly, limits on deficits should be revised to distinguish between consumption and investment expenditures, and to allow countries to borrow beyond the 3 percent limit for investment.31 After all, we have noted, such investments increase the economic strength of the country.


Contrary to the presumption in standard theory, countries do not necessarily naturally converge in technology (knowledge).32 The leading countries remain the leaders. East Asia is the exception, but countries in this region achieved convergence through active government policies, called industrial policies. They realized that what separates more advanced countries from the less advanced is a gap in knowledge, and knowledge does not, on its own, flow freely.33 Markets in knowledge are not well described by the standard economic model; economies in which knowledge is important are not, in general, efficient: markets invest too little, and often in the wrong direction.34 And, markets, on their own, do not necessarily eliminate the knowledge gap.

Indeed, it has been well known that increasing returns to scale associated with innovation (an investment in R&D yields disproportionately greater expected returns the greater the sales) gives big firms an advantage over small firms. There can be economies of scope, where research in one area has benefits for others and spillover from one firm to another, reflected in clustering. The consequence of such economies in scale and scope is that countries with technological advantages often maintain those advantages, unless there are countervailing forces brought about by government policies.

Policies aimed at closing the technology gap are, as we have noted, called industrial policies—even when they apply to other sectors of the economy, like the service sector. But European competition laws prevent, or at least inhibit, such policies.35 The rationale for such a law is understandable if one believed that markets on their own converged: one would not want to give a leg up to one firm from one country through the artificial prop of government support.36

If natural market forces do not lead to convergence, but instead to divergence or at least the sustaining of advantages, then the prohibition against industrial policies simply preserves and exacerbates differences. A cynic might say that this was the intent of the law: to preserve power relations. But I am convinced that the rule in Europe was driven more by ideology and misguided economic beliefs than narrow self-interest. The predominant view in neoliberal policy circles at the time the euro was founded—a view since largely discredited—was that market forces would on their own lead to convergence; industrial policies were neither needed nor effective.

Of course, technological divergences in turn exacerbate all the other divergences noted earlier. If German technology is better than that of Portugal, capital will flow from the capital-scarce country to the capital-rich, and so, too, will skilled labor.

Fixing the problem

Again, there is an easy fix to this problem of divergence: rather than discourage industrial policies, the eurozone should actively encourage such policies, especially for countries that are lagging behind. Such active policies hold out the promise of real convergence.


Finally, there is a divergence in wealth. I described in the last chapter how, when the exchange rate is set for the eurozone as a whole to have balance, Germany runs a trade surplus and the periphery runs a deficit. Running a trade surplus simply means lending to the rest of the world; running a trade deficit means borrowing. This is perhaps the most disturbing aspect of the eurozone’s divergence: some countries, most notably Germany, have increasingly become creditor countries, some debtors. This creates a divergence in economic interests and perspectives: it makes it all the more difficult for a common currency to work for the benefit of all.


Chapter 3 showed the magnitude of the divergences that have opened up in Europe. Some of these, as I have explained, are the natural result of the eurozone as it was constructed. But some are a result of the policies that the eurozone has adopted in response to the crisis.

For instance, we noted the outflow of more talented people from a country with a high level of place-based debt. Austerity has exacerbated the outmigration from the poor countries of both capital and labor: austerity, as I explain in later chapters at greater length, leads to deeper and longer recessions, and investors don’t like to invest in countries in a recession, so money flows to where economic conditions are better. So, too, high unemployment induces outmigration, leaving a greater debt burden per capita on those who remain behind. So, too, cutbacks in public services associated with austerity and the underinvestment by the government—for example, in infrastructure, technology, and education—make living and investing in the afflicted countries less attractive.

Making matters even worse, the policies of the Troika in Cyprus and Greece have encouraged the further capital flight out of the banking systems of those countries—or any seriously afflicted country. The Troika has shown that, no matter what an individual government says about deposit guarantees, even for small depositors, the Troika is at least willing to consider significant haircuts (where depositors will get back only a fraction of the value of their deposits), if it can’t figure out a better way of saving the banks. It has also shown that to enforce its wishes, the Troika is willing to take actions that force the temporary shutdown of a country’s banks—obviously making the retention of money in the country’s banks even more risky, and encouraging money to move to stronger banks in Germany and elsewhere.

Recent efforts to resuscitate the eurozone economy have created potential new sources of divergence, the significance of which we will be able to ascertain only over time. Under policies announced in early 2016, the ECB can buy corporate bonds, but the corporate bonds that it can and is likely to buy are those of large German and French corporations, again giving them an advantage over companies in other countries.


That the eurozone has not been working as planned seems clear. Not surprisingly, this has spurred reforms. They have created a €500 billion (about $550 billion) eurozone-wide safety net for countries and banks in difficulty.37 We have discussed, too, the proposed banking union—and explained why the current halfway house may be worse than nothing.

There are two other reforms, one eurozone wide, one part of the most recent program for a crisis-afflicted country, which are worse—large movements in the wrong direction.

First, we noted earlier how Germany misdiagnosed why the eurozone wasn’t working the way it was supposed to: they blamed fiscal profligacy, so they doubled down on that theory, requiring even more binding commitments of the eurozone members on their deficits and debts, with stringent penalties for those that didn’t comply. This was called the Fiscal Compact, and portends an era of even weaker eurozone performance.

The second was part of the new program introduced for Greece in the summer of 2015. We noted that the Troika consistently underestimated the magnitude of the downturn that the policies they had imposed generated, and thus overestimated the improvement in the fiscal position. In effect, the actual austerity imposed was somewhat softened by the realities within Greece.38

The bad news is that the Troika is headed toward a policy which insists that the budget numbers they set out actually be realized: if expenditures turn out larger or tax revenues smaller than originally anticipated—say, because a downturn was greater than originally anticipated—expenditures have to be cut back further and taxes raised further. This will be a strong automatic destabilizer. As the economy weakens, tax revenues will be less than anticipated, and so Greece will be forced to increase taxes even more, further weakening the economy.39

How free mobility encourages “reforms” that lead to greater instability and inequality

We’ve focused on the changes to the stability of the European economy arising from the creation of the eurozone and the policies that the eurozone has adopted in response to the crisis. But there are other factors at play in Europe, and they are resulting in an economic system that may be still less stable. Most importantly, progressive taxes and broad welfare benefits act as strong automatic stabilizers; as tax systems have become less progressive through much of Europe and welfare benefits have been trimmed, one would expect more economic volatility.

Free mobility of labor and capital have contributed to this untoward trend. Just as we noted earlier that there was a regulatory race to the bottom, so, too, for taxes. Countries compete to attract firms, capital, and highly skilled workers, and one way that they do so is through lower taxes. With such easy mobility, it is similarly hard to have very progressive taxes. Rich individuals threaten to leave and locate themselves and their businesses elsewhere.

Luxembourg and Ireland provided the worst examples, effectively giving some of the largest multinationals a free pass on taxes—a legal way of avoiding paying the taxes that they should have paid.40 With free movement of goods, firms can locate in a low tax jurisdiction within the EU but sell their goods anywhere in the EU.

The resulting reduction in progressivity in the tax-and-transfer system meant that inequalities of income and wealth within most of the eurozone countries increased41—compounding the effect of the divergence among countries to which the structure of the eurozone has contributed in so many ways.


Tinkering with an economic system can be dangerous, unless one really knows how it works. And since economic systems are constantly evolving, knowing how they work is truly difficult. The founders of the euro changed the rules of the game. They fixed the exchange rate and they centralized the determination of the interest rate. They created new rules governing deficits and new rules governing the banking system. Hubris led them to believe that they understood how the economic system worked, and that they could tinker with it in these major ways and make it perform better.

Europe thought it had a better understanding of markets, and that markets were increasingly sophisticated—witness the “advances” and “innovation” in financial markets—and the two together would result in a better working economic system. A larger market, with better rules, and a single currency would lead to an even better economic system. It hasn’t worked out that way. I have explained how, with the best of intentions, Europe created a more unstable and divergent economic system—one in which the wealthier countries get wealthier and the poorer countries poorer, and in which there is greater inequality within each country.

Details matter. One can’t simply say, free capital movements lead to increased efficiency. One has to know what happens when a bank goes bankrupt. Who picks up the tab? One can’t simply say, free labor movements lead to increased efficiency. One has to know something about the design of the tax system, and who pays for a country’s past debts.

And above all, one has to know about monetary policy and central banking. Well-designed central banks can lead to increased stability and a better-performing economy. A poorly designed central bank can lead to higher levels of unemployment and lower levels of growth. The next chapter looks at the mistakes the eurozone made in the construction of its central and most important institution, the European Central Bank.