Why the Euro Didn't Work

Paul Krugman has an excellent NYT Magazine article explaining the problems in the Eurozone.

Greece, with its long history of debt defaults and bouts of high inflation, was the most striking example. Until the late 1990s, Greece’s fiscal history was reflected in its bond yields: investors would buy bonds issued by the Greek government only if they paid much higher interest than bonds issued by governments perceived as safe bets, like those by Germany. As the euro’s debut approached, however, the risk premium on Greek bonds melted away. After all, the thinking went, Greek debt would soon be immune from the dangers of inflation: the European Central Bank would see to that. And it wasn’t possible to imagine any member of the newly minted monetary union going bankrupt, was it?

Indeed, by the middle of the 2000s just about all fear of country-specific fiscal woes had vanished from the European scene. Greek bonds, Irish bonds, Spanish bonds, Portuguese bonds — they all traded as if they were as safe as German bonds. The aura of confidence extended even to countries that weren’t on the euro yet but were expected to join in the near future: by 2005, Latvia, which at that point hoped to adopt the euro by 2008, was able to borrow almost as cheaply as Ireland. (Latvia’s switch to the euro has been put off for now, although neighboring Estonia joined on Jan. 1.)

As interest rates converged across Europe, the formerly high-interest-rate countries went, predictably, on a borrowing spree. (This borrowing spree was, it’s worth noting, largely financed by banks in Germany and other traditionally low-interest-rate countries; that’s why the current debt problems of the European periphery are also a big problem for the European banking system as a whole.) In Greece it was largely the government that ran up big debts. But elsewhere, private players were the big borrowers. Ireland, as I’ve already noted, had a huge real estate boom: home prices rose 180 percent from 1998, just before the euro was introduced, to 2007. Prices in Spain rose almost as much. There were booms in those not-yet-euro nations, too: money flooded into Estonia, Latvia, Lithuania, Bulgaria and Romania.

It was a heady time, and not only for the borrowers. In the late 1990s, Germany’s economy was depressed as a result of low demand from domestic consumers. But it recovered in the decade that followed, thanks to an export boom driven by its European neighbors’ spending sprees.

Everything, in short, seemed to be going swimmingly: the euro was pronounced a great success.

Then the bubble burst.