Ashoka Mody on the Origins of the Euro and the Euro Crisis

The creation of the Euro may have been a mistake, and Europe should consider abandoning the currency as more crises loom.

Ashoka Mody is a professor of international and economic policy at Princeton University and formerly worked at the IMF and the World Bank. He joins the Macro Musings podcast to discuss his new book ‘EuroTragedy: A Drama in Nine Acts.’

Read the full episode transcript:

Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected]

Beckworth: Ashoka, welcome to the show.

Ashoka Mody:   Thank you very much, David. Thank you for having me.

Beckworth: I'm glad to have you join us. Your book was a great read. It's fascinating to go through it because we learn about the people, the personalities, the politics, the history of the Euro from way back in the '50s up to the present. So, I really enjoyed your book, but what led you to write it?

Mody:   So, I left the IMF in 2012. The last six years at the IMF, I had worked in the European department and I did what people call the bailout of the Irish economy. So I was a responsibility but Ireland during its main crisis years. I also was the IMF space in Germany at the same time. I was operationally involved in the Euro crisis in its darkest years. And so when I left the IMF, I thought I would write a book on the Euro crisis. I was going to write a book very much like an IMF economist with description of the crisis, monetary policy, fiscal policy. But as I started writing it, I said to myself, "This doesn't make sense. Where does this animal called the Euro come from?" And as I started digging into it, I found the history and the people fascinating. And so I spent maybe almost two years just on my initial chapters figuring out what the origins were, what this European project was about, where did the Euro fit in? And so the book became a history instead of just an economics book.

Beckworth: Yes, I encourage our listeners to get the book and warning; it is a big book, but don't be daunted by the size because it is really a page turner. It really is this, you learn about the people, the French presidents, the chancellors or Germany, the drama that goes on at a lot of personal failings, jealousy. I mean, it's a great novel almost, in terms of the interaction you... It's really refreshing to see this story told from this perspective and that made it really great and that's why I want to talk to you about today. And I want to spend some time on that early history, work our way through the emergence of the Euro has a long history behind it. One of the big takeaways I got from the book, before we get into the details, is how bold of an undertaking this was. I mean, you mentioned early in the book that there's never been anything else done like this, right?

Mody:   Yes. Yes. So there was really no good reason to have the Euro; that was the first thing that I learned. There were lots of stories about why the Euro was a good idea. More I probed into it, the more I said to myself, "No, none of this makes sense." And oddly enough, even the Europeans, for almost the first 10 or 15 years of playing around with the Euro idea, never gave a reason to explanation of why they wanted the Euro. It seemed mainly to be a combination of facts. One, they seem to think that survival of the European project needed something like the Euro; needed a single currency, but the real reason I realized quite quickly was the French. The French began to feel a severe inferiority complex relative to the Germans. The French had been falling behind the Germans for almost a hundred years by that point, and they realize that they wanted some parity with the Germans.

Mody:   In the initial postwar years, the French franc was repeatedly devalued and every time it was devalued, the French as a nation felt this extreme humiliation. The Germans did not make it any easier. The Germans made sure that each time the franc was devalued, there was sort of almost a mini celebration.

Beckworth: Eyes on newspapers-

Mody:   Into the newspapers and the newspaper people would play it up and make the French look even worse than the devaluation would imply. So the sense of humiliation was built on both sides. And so in 1970, when George Pompidou becomes president, he devalues the franc and he immediately starts a discussion on a single currency. And he couches it in very high minded terms as a matter of morality, sort of still bringing a little bit of the shadow of the war into the discussion; that the Germans sort of owe us something, that they have some responsibility.

Mody:   And the Germans, likewise, could never say no to the French because the Germans always felt very hesitant to turn the French down. And so the German response was, "Okay, well let's think about it." But very quickly, Willie [Brandt 00:06:13], who became chancellor at the same time as Pompidou, said, "Hold on. What happens if things go wrong? Who pays the bill for this thing?" What I realized was that this notion that Germany may end up paying the bills of other member countries came into the German consciousness right from the very start. And so you had this extraordinary dynamic that successive French presidents would want the single currency, and successive German chancellors and or the Bundesbank would say, "No, hang on, this is not a good idea." And that is how history would have evolved and, in my view, would have died in quiet death at some point.

Mody:   But then you have chancellor Kohl coming. Kohl is a really pivotal personality. One of the things I struggled with in writing the book was how much does an individual influence history? Is it history or is it the man who makes the history? And I felt in the end that Kohl actually is perhaps the only one in my book who really determined the course of European history. And he did so because he acquired extraordinary executive autonomy after the unification. He basically had the German people behind him. He disregarded his officials and he had the party machinery completely under his control. So, for the period of seven or eight years, Kohl could do pretty much what he wanted. And in that period, he used that authority to push the Euro. Mind you, Kohl himself understood all the problems with the single currency.

Mody:   And that is the great irony of history; that Kohl understood that if you have countries which are very diverse, then a single currency, a single monetary policy is a bad idea. Because a strong country has easy monetary policy, a weak country has tight monetary policy that increases, amplifies the divergence between rather than bringing them together. Remember there was a debate at one time that maybe the single currency will cause convergence, but a very simple logic says that the diversity will be amplified because the monetary policy will push them apart rather than bringing them closer. Kohl understood that completely. In a letter to François Mitterrand the French president, he says, "A single currency is like a bad speech you give on a Sunday and you get up on Monday morning and said, 'Now why did I say that?'" So the question is, why did Kohl do it?

Mody:   And there're lots of theories that there was a bargain at reunification. I claim that none of that holds up because that bargain, German chancellors went back on their bargains all the time. The French presidents went back on their bargains, but really no one could have stopped reunification. That the history is so powerful that reunification was a historically given fact. George Bush told Kohl very clearly that a reunified Germany was part of American foreign policy. Kohl knew he could buy Gorbachev, which he did.

Beckworth: And this is before, the Strausberg?

Mody:   Exactly. This is before the pivotal meeting in Strausberg.

Beckworth: Okay.

Mody:   So, before the pivotal meeting in Strausberg, Kohl meets with George Herbert Walker Bush. And, I forget the exact phrase, but basically Bush says, "Throw it deep," as far as unification is concerned. He warms up to to Kohl. And as Brent Scowcroft later says, "I saw American foreign policy being made at that dinner." Basically, at that dinner Bush decided a reunified Germany was important and as long as Kohl agreed to his commitments to NATO, which he readily agreed, they didn't care about what the French felt. And so there was no bargain at reunification. And then for 10 years, Kohl delivered on the Euro.

Mody:   I'll say one last thing on Kohl. Kohl not only delivered the Euro, he delivered it in a particular form. He gave the French the Euro they wanted, but on German terms. He repeated what every German chancellor or the Bundesbank insisted, single currency, yes, but Germany will not pay the bills. This is very crucial to understand what happened during the crisis because for 30 years, the German public was conditioned that Germany will not pay the bills. And for a German chancellor to overturn that requires enormous use of political capital that no German chancellor is willing to do. Number two, Kohl made sure that Italy became part of the Eurozone. Every member of the finance establishment in Germany opposed Italian entry. They knew that Italy could not survive in the Eurozone. Kohl, part of his being a pro European was more the better.

Mody:   And number three, Kohl created a rhetoric around the Euro, which over time has proven to cloud all sensible thinking. The Euro is a mechanism for peace. Kohl, in every speech he would, he would bring in that Euro is a mechanism for peace. Now think about it for a second. How can a single currency be a mechanism for peace? For those of your listeners who know the Indian subcontinent, there was West Pakistan and Bangladesh, which shared a currency. They went to civil war for it heaven's sake. And India and Pakistan have fought many wars, not because they don't share a single currency. A single currency has nothing to do with wars, but Kohl made it a part of the rhetoric and even today you will hear the Europeans say, "But, ultimately, it is a mechanism for peace." In what way? That's all Kohl's legacy. Kohl's legacy is the Euro, the countries that compose the Euro, and the rhetoric that accompanies the Euro. As some kind of a European project that is not subject to the normal criticism; a political and economic criticism.

Beckworth: Yeah. Helmut Kohl is a great example while your book is so fascinating. You learn about his unique personality and how, as you mentioned, he would often surprise his own finance minister, his own Central Bank governors. He would say one thing, and he did. He seemed to believe, this is the same point. In fact, all German chancellors said, "We're not going to do a bail out. We'll think about a single currency, but we won't do the bail out." He would hold the line until the very end, and he would shock his own people. But he was an amazing, colorful personality. 16 years as chancellor. Very powerful. Man, I think of it from 1982 to 1998-

Mody:   Yeah.

Beckworth: ... that's a long span. He goes through several of us presidents. Amazing story you tell about him, but I want to go back to a point you just mentioned about this peace dividend or this peace benefit from the Eurozone, and that's kind of the story I had heard too; it was all about peace. And one of the things you get from the book is maybe some people did think that and they definitely sold the package as a peace package. But if you look at least one side of this dimension, and it really is the French and the Germans, takes two to tango. And the French were very pivotal in this, but the French, like you mentioned, we're often pushing this just because of their esteem, their inferiority complex. They wanted parity with the Germans. The Germans had the great currency. They had structural reforms going on. Germany was thriving, and France continually had these... Every decade had a devaluation and they felt this need to push.

Beckworth: In fact, one of the other big takeaways I found from your book is, again, Germany was a part of the story, but if we can do kind of a ceteris paribus like we do in economics, France is kind of the villain here. France is kind of the catalyst. It was France who initially pushed for a single currency; we'll talk about it in a minute. You alluded to it already. And there was always the French president who had pushed the German chancellor; they were always pushing. And I want to just give one example you have in your book, a great conversation between Helmut Kohl and François Mitterrand. Here's François. He says, talking to Kohl, "It's necessary for you to commit to monitor union and call replies. Abandoning the Mark is a great sacrifice for Germans. Public opinion is not ready for it." And Mitterrand says, "I know it, but do it. European public opinion awaits it. You're moving towards German reunification. You must show you are committed to continue believing in Europe."

Beckworth: So, he's pushing them hard even though they both realize there's certain costs frictions involved in this. And so I see, stepping back to the big pictures, the French really pushed and pushed and pushed. Now I'm going to throw something else, a little more speculative history you don't have in the book, but one of the things that hung over their head, as you mentioned, was the long shadow of World War II. Many of these chancellors wanted to duplicate their concerns, seek forgiveness and World War II was hanging over them. And if you go back and look at Doug Irwin's work on the great depression and some others, they show how France hoarded gold.

Mody:   Yes.

Beckworth: The way they valued the currency and that contributed to the great depression. And again, this is a bit of a stretch here, but great depression helped contribute to the rise of the Nazis and you can trace this path down the World War II. So, France really does not come out looking nice out of the story. They have their fingerprints all over the Euro project.

Mody:   Yeah. So I think the French bureaucrats and politicians have a very diligist view of economics. Diligist is just is a word which signifies that select bureaucrats and politicians can make far-reaching economic policy decisions as a substitute for Market forces. And this is a very deeply rooted tradition in the French system. The Germans, in contrast, are much more Market-oriented. They believe in free trade. And for a very long time the Germans believed in floating of exchange rates. In fact, German intellectuals were much more active than even Anglo-Saxon intellectuals in the wake of Milton Friedman's ideas on the floating exchange rate. So there was also an intellectual clash. And so there've been the French presidents are sort of insisting on the Euro, or a single currency, is very much part of that tradition that we can somehow control the Market and we can make things work.

Mody:   And the Germans understood that if things go wrong then somebody has to pay the bills and everybody would look to them. And the shadow of the war is particularly important because the Germans, up until, I would say the early ‘90s, still had this lingering sense of guilt that they owe something. And so they're usually reluctant to push back and be seen to be not doing enough for Europe. That's why when Mitterrand says, in the conversation that you just read out, "All of Europe is waiting for you." It's not clear on what basis a French president determines what Europe is awaiting Germany to do, that instead of just his extrapolation is not uncommon for French presidents to make claims on behalf of Europe as though they represent Europe.

Mody:   The French have always, in fact, President de Gaulle, Charles de Gaulle once said, "More Europe for the glory of France." And while no French president will be ever so blunt, but all French presidents have believed in more Europe so that France can be more powerful and more glorious. If the French have had a very selfish attitude towards what more Europe means for them, sometimes their self interest has been in a broader European interest, but most of the time it's been essentially in the French interest.

Beckworth: This is interesting because typically, the story told, and I'm guilty of telling this story as well, is the reasons for the Eurozone crisis are the Germans. They're the ones... And there's some truth in this; they're the ones who shaped the culture of the ECB. They're the ones who don't want to rebel. It's true; those points are true, but they're there because in part, they got pushed there by the French. And the French, kind of the normal narrative, you don't hear a discussion about the French much until you read this book; you don't think about the older French really have their hands on this too. They too should receive some recognition for the crisis that Europe's in.

Mody:   Yeah. Thank you David. It makes me glad to know that you read the book that way, which is why, as I said, when you asked me why did I write the book, or at least the book that you see in front of you, I said to myself, "You really can't understand the Euro unless you know the history." And once you know the history, a crisis was inevitable. In other words, as you know, we never can predict when a crisis will occur, but once a crisis occurs, then we knew from first principles of how a single currency would operate; is that the divergence across countries would increase at that very moment that if Italy went into a crisis, the Italian economy, which is already inherently weak because of very low productivity growth, which the Italians have not been a problem, they have not been able to solve for half a century, that problem would be doubled and that they would go into an even longer recession which would leave very long-term scars.

Mody:   Whereas Germany would have a monetary policy that is relatively easy for them and; therefore, they would flourish. Germany is an inherently strong country. It does not suffer the ill effects of a tight monetary policy. Italy is an inherently weak country and so suffers doubly. And as I argue further in the book, and this is now a German legacy, quite rightly you point out, a monetary policy that has tended to be asymmetrically tight. What do I mean by asymmetrically tight? The ECB worries about inflation if it rises and so tightens policy, but if inflation falls, it says, "This is going to self-correct," and so it does not take action till it is too late. So it's always got this asymmetrical policy of fighting inflation but not fighting deflation, therefore, it tends to have an overall tight money policy.

Mody:   For that reason, the Euro tends to be also relatively strong currency relative to say, pretty much many countries except for Germany and the Netherlands and sort of like countries. So, you have a situation where you already have a weak country, Italy, it has a currency that's too strong for it. It has a monetary policy that's too tight for it. And so it is in a double squeeze. And this is on top of the fiscal austerity. So, Italy is... I say that Italy is the theater in which Euro tragedy has played out because Italy has all the pathologies running through it. It's inherently weak plus this policy structure is particularly hard on it.

Beckworth: Yeah. And you have a chapter in your book where you talk about Italy.

Mody:   Yeah.

Beckworth: You predict the crises we're now seeing because... The problem has been there all along, as you note, but we're seeing it manifest. And Italy's far more important than Greece and Greece caused problems. But if Italy goes under, the Eurozone days may be numbered.

Mody:   So, just give you some numbers. The Italian sovereign debt is two and a half trillion euros, which is the same size as the German sovereign debt and the French sovereign debt. Italian bank assets are somewhere in the range of 80% of bank assets in France and Germany. Italy, in terms of financial size, is about eight times that of Greece. So, just think about it. Handling Greece was hard enough. There was a moment, in fact, at the peak of the Greek crisis where rating agencies were almost ready to downgrade Germany because of the financial commitments that Germany might need to make towards Greece and other periphery countries.

Mody:   If Italy had a crisis, Germany would almost certainly be downgraded. And with that, the financial bailout, the fund with the European stability mechanism, would ipso facto be downgraded. In other words, the financial structures that the Eurozone authorities have created in response to the crisis in Greece, Ireland and Portugal will come under extraordinarily severe strain if Italy goes into a crisis. That is why I say Italy is the fault line of the Eurozone and Italy is the fault line of the Eurozone. It's a tragedy because Italy should not have been in the Eurozone. Everybody understood it.

Beckworth: Why did Helmut Kohl invite them in? What was his thinking?

Mody:   One of the sort of problems that has arisen in Europe is this notion called pro-Europeanism. You're a pro-European if you believe that more is better. And so, more countries in the Eurozone is considered a good thing. I quite honestly... Kohl made his decision so close to himself. So the metaphor I use is US presidents in the conduct of the Vietnam war. So, reading Daniel Ellsberg's work where Ellsberg says, "They had such extraordinary executive autonomy and they made their decisions pretty much with a handful of advisors." So, you don't really know what they were thinking when they were making their decisions. But Kohl was a little bit like that. Somebody was going to have to write a good biography of Kohl to understand what it was he was thinking.

Mody:   My sort of genetic interpretation is that Kohl was already the chancellor of German unity. I think the silent call of history called him and he felt that if he left a legacy of expanded Europe, a Europe that carried his imprint in sort of a very large scale way, he would be remembered in history as having done a very heroic task. And I think that motivated him to considerable extent.

Beckworth: Yes. And he just passed away last year,

Mody:   Yeah.

Beckworth: ... so some biographies will be written probably more so now that he's passed. But it's interesting he also was an academic or was an academic. He had a PhD in history, so maybe he was thinking about these grand visions of history leaving a long lasting legacy, being the Charlemagne, maybe mean the great reunifier of Europe.

Mody:   Exactly. Look, I'm not a historian enough to sort of reach that conclusion, but certainly everything in my book, everything that I've written leads a serious historian to ask that question. In fact, I was just talking recently to a young German historian and he paid me a very high compliment. He said, "Your book will now require a new biography of Kohl. You've sort of given up new path to understanding re-interpreting Kohl, who he was, and what motivated him."

Beckworth: Yeah. Very interesting discussions on Kohl. Now, I want to step back and look at some of the early developments in Europe that led up to the creation of the Euro. And you have a chapter early on about taking three leaps in the dark.

Mody:   Yes.

Beckworth: And the first two leaps were good, solid ones. There's a third leap, which is where they pursue monetary integration, at least the early stages of it, where they get into trouble. So, just to summarize, the first leap was the treaty of Paris in 1951 were the coal and steel community is formed, and that also is French-motivated, that Robert Schumann was a foreign minister became president.

Mody:   No-

Beckworth: Just a foreign-

Mody:   ... yeah, just foreign minister.

Beckworth: ... just foreign minister. But he moved motivated that and then John Monnet authored the planned, and he became the first president of this organization called the High Authority that oversaw this European Coal and Steel Community, and that was a pretty ambitious project because that did mean giving up some of your sovereignty, right?

Mody:   Yeah, yeah.

Beckworth: And that also lead to demise too, right? That people were getting uncomfortable with-

Mody:   Exactly.

Beckworth: ... turning over power.

Mody:   Exactly.

Beckworth: Okay.

Mody:   Exactly. So, the treaty of Paris and the Schumann Declaration that that led up to the treaty of Paris, I say in my writings, was the only French-led initiative that that was successful. It was a very magnificent gesture on the part of the French. Remember now we are talking about May, 1950s is the Schuman Declaration.

Beckworth: Yeah.

Mody:   The shadow of the war is still at this point very deep. Germany is considered an outcast in the international community. And I think what Schumann and Monnet saw quite correctly is that that was not a reasonable position to leave Germany in. And Germany needed to be brought back into the fold of nations. And the best way to do it was in some kind of cooperative way. And I think that that was a very wise vision and it was; therefore, the correct vision historically. It led, again, as you noted in the book, Coal and Steel Community itself was not particularly successful. But what that initiative did was it established the principle that Europeans will sit around conference tables and debate and discuss their issues and in a sense have their disagreements that around conference tables rather than on battlefields.

Mody:   And that was a very major achievement. That achievement ran out very quickly. And again, the key point over there is it ran out because there was an overreach. There was an overreach to try to create a European authority, which subordinated national authorities. One of the messages in my book is that the nation state in Europe remains well and alive. At no stage through this process do I see any sign that the nation states of Europe are willing to give up their coal sovereignty. By coal sovereignty, I mean tax and spending decisions and defense decisions, not even in the deepest shadow the word were they willing to do. The only country at that point in the early years that was willing to do that to some degree with Germany, because Germany desperately wanted to be part of an international process, but no other country, including France, was willing to give up those core functions of sovereignty. Which is why the third leap becomes particularly ironic because the third leap to the Euro... The second leap is to the treaty of Rome. The treaty of Rome-

Beckworth: Which is the European common Market.

Mody:   ... which is the European common Market. And I say... And again, that was not a French/German initiative, that was an initiative of the Dutch and the Belgians. That, in some sense, was the high point of post-war Europe.

Beckworth: And they should have stopped there.

Mody:   And they should have stopped there.

Beckworth: Okay.

Mody:   The way I write the book, I say that by the early '60s, the principle purpose of post-war Europe was complete. The peace parenthesis, so to say, had closed. There was a peace parenthesis from 1945 to 1965. That parenthesis, the Europeans had done a great job, they had brought themselves around conference tables and they had created an open common Market and that was a great achievement. There was no reason to belittle that achievement, but somehow they developed this notion that they could not just be a glorified free trade zone.

Mody:   I don't know where this phrase comes, but successive European leaders repeat that being a glorified free trade zone was somehow letting themselves down. And that then combines with the history that we just discussed, where the French presidents then start pushing for the single currency. And that's where the third leap begins; that there's one desire for more Europe. There's one desire coming from the French for a single currency and the two blend. So, these two parts in history blend, and somehow the single currency is tacked on to what was otherwise a very successful European experience up until that point.

Beckworth: Yeah. So the third leap, the defining moment is at the Hague in 1969. There's a meeting there and then out of that comes the Werner committee Report, which recognizes that a monitoring union would be incomplete. Even says, if we go ahead, this will be an incomplete monetary project.

Mody:   Yes.

Beckworth:Because there won't be; it's simply that you can't credibly commit to fiscal integration and we don't have labor mobility, all those other things you need, so it's not going to work. And what's interesting is you highlight in your book about this report from the Hague meeting is that they should have looked at that and said, "Okay, stop. This is not going to work." So, back in the early '70s, they saw the warning signs, but instead they saw that as a sign of inspiration, "Hey, let's use that as an impetus to move forward." And all of a sudden you start hearing these ideas that you used the word here, it would be the leaven, the yeast that would cause Europe to form it and transform it into political union. So it actually would... It wasn't a hindrance, it a way to get to the end goal.

Mody:   That so right. Again, everything that you said is 100% how I wanted to write the book; that the Werner Report clearly understood all the problems. Remember, in terms of the intellectual history, all of the Werner committee Report does not cite the work of Robert Mundell or Peter Kenen, the two great theorists of the optimal currency area. They had already written their papers by then.

Beckworth: Instead, they were aware of their work.

Mody:   So my sense is that anyone writing it was aware of the work. Certainly, the people who were on that committee and who are on the staff knew of that work. The report itself does not cite them, but the report is written in a way that it acknowledges the principles. And again, when a committee report says you need a community budget, what people today call a fiscal union, the phrase they used was, "You need a large community budget." And they say, "It's impossible under current political conditions to have a large community budget." This, ironically, is the same discussion we are having 50 years later.

Mody:   And one of the things is that the contradictions are so inherently built into the system that you have this groundhog day type discussion. Every few years, somebody will start a discussion on Eurozone budget and it would be as if this has never happened before and there will be a flurry of immediate interest and I, who have now been following this for several years every time this comes up, I sort of glaze over this discussion because I know how it's going to end. So anyhow, on the Werner committee Report it says maybe this will be a spur to political union. And that is where this other completely wrongheaded idea develops; that monetary union, we create the pressure to create a political union and this becomes again embedded in the European psyche.

Mody:   So when I started writing this book, whenever I would be sort of questioning the premise, people would say to me, "No, no, no, you don't understand Europeans. This is a political project." And I would say, "What is the political project, what is the project over here, what is the path that leads to political union?" You can't just make a claim that we will eventually have a political union. How do we get from here to there? A political union would require that the Bundestag, the German parliament, and the national assembly, the French parliament in effect become like state legislatures. Like the legislatures of Connecticut and New York.

Beckworth: Right. Not going to happen.

Mody:   And the other federal government, which then administers a European budget and there's a European cabinet. That is what political union means. But they play around with these words political union as though there is some mystical notion that there will be a political union to which everybody will agree. And that notion is so deeply embedded in the European psyche that we will somehow give up on national identities and overcome them, and having overcome them, lead to this nirvana place where we are all United.

Beckworth: Yeah. I'm an American across the Atlantic. You've thought about this a lot more. You've traveled the world more than I have more scholarly. But my simple read is, History is against... There's so much deep and long history in Europe that would ever prevent that from happening. And that's why you see this cycle, as you mentioned, this groundhog where they repeat. And that's another interesting lesson I learned from your book; is that when the Eurozone crisis did erupt, 2010, 2011, 2012, there were all these people saying, "I told you so and I was the first one to tell you so." And these were people trying to take credit. "I warned you, back in '98, I warned you."

Beckworth: And what your book shows is, no; they weren't the original critics. The original critics go back as far as Milton Friedman. And even the organizers, again, this report from 1970 understood it. I want to quickly touch on... You mentioned Nicholas Kaldor earlier.

Mody:   Yeah.

Beckworth: He criticized... You also mentioned your book, which is fascinating. Samuel Brittan of the Financial Times-

Mody:   Exactly.

Beckworth: ... in 1970, he criticized it. I want to touch on Robert Mundell. So, Robert Mundell in the early '60s, he wrote the optimal currency ideas down in several papers, but he also though, ironically, was a proponent of this single currency, right? So, you think his work would imply caution, but he actually used it to promote it, right?

Mody:   Yeah. Look, I have never been able to figure out why he was for the Euro. There were two very important American scholars Robert Mundell and also Robert Triffin at Yale, very much in favor of single currency. My own sense is that they were not thinking so much in terms of economics. There was some broader idealism of sort of a world government that was at least, if not more important, than the economics that they were basing their reasoning on. One of the themes in Robert Mundell's work is that a single currency reduces transactions costs.

Beckworth: Yup.

Mody:   And so, I was giving a talk just the two or three days ago at a conference in London. And inevitably, one of the people in the audience asked me, "Do you believe that the Euro did some good?" And I say, "No." And I say no because... I said, "I've actually thought about this. What is it that it could have done that was good?" And so the main thing was this notion that transactions costs are reduced-

Beckworth: Because you have the same current.

Mody:   ... because I have the same currency and; therefore, I don't have to change the currency. Maybe the volatility of the exchange rate is also part of that same package. Now again, the history is so clear. 1982 Otmar Emminger, president of Bundesbank says, "I understand that transactions costs are reduced, but I also understand that they are trivial in terms of their quantitative magnitude." He says, "I see people all the time hedging their currency bets to trade. And no one seems to complain about it." And the fact of the matter is that you look at now what actually happened, there were people like Andy Rose of Berkeley who predicted that because transactions costs would be reduced, there would be more trade between European countries. That's simply not happened.

Beckworth: That hasn't happened.

Mody:   It's not only not happened; it's going the other way round.

Beckworth: So, trade between Eurozone countries have actually declined?

Mody:   So, take Germany.

Beckworth: Okay.

Mody:   In 1999, France was Germany's single leading trade partner. The share of German exports to France have steadily fallen. The share of German exports to Italy have steadily fallen. The share of German exports to Czech Republic, Hungary and Poland; three European countries, but who do not have the Euro, have steadily increased. The share to China is skyrocketing. The share to America for heaven sake is also increasing. And so the Germans are selling where people are buying their stuff. They are not selling to France because they share the same currency. The Germans trade with Switzerland which has a different currency.

Mody:   The notion that these transactions have any material significance in terms of determining trade was simply never valid. Again, 1993 Barry Eichengreen, the Berkeley economist, wrote a very important article in the Journal of Economic Literature in which he said, "I challenge anybody to show me that these costs are meaningful. History has amply borne that out; that the transactions cause benefits, if they exist, are minuscule." Therefore, I conclude that the Euro could never have done any economic good. It could not have done any political good. It could only create divisions. Again, back to Kaldor, who you mentioned, Nikki Kaldor, perhaps one of the great economists of the 20th century. Kaldor's great insight was not just economics where he did not just warn that the single currency will not work for diverse countries. His greater insight was, oddly enough, a political one.

Mody:   Kaldor said that because it will amplify the differences across diverse countries, it will create political divisions. And he ended somewhat dramatically with this well-known biblical phrase, "A house divided against itself will not stand." When I give my talks now, I say, "Kaldor's ghost is stalking the Eurozone as we speak.2 Because what the crisis did was it increased the divergence, as the economics would predict, and it deepened the political divisions. So, all this talk about this being a political project was inherently intellectually wrong. And so, not only was the economics wrong, the politics was also wrong.

Beckworth: Yes. So, someone else who wrote about this, in terms of the history of thought, we mentioned Friedman, Mundell, Kaldor. And there were a number of academics who wrote about this in the '90s as it was getting closer.

Mody:   Yes, correct.

Beckworth: And in what you saw, there's in fact an article, I'll mention it in a minute, but there's an article that summarized the Europeans are much more sanguine about it. Even the academics, they're buying into the narrative, while the Americans were a little more skeptical. You see like Eichengreen and others. And Martin Feldstein had a... I think it's a fairly well known 1997 foreign affairs article.

Mody:   Yes.

Beckworth: Where he says, "Look, this is a bad and a dangerous idea." So, I'll read a quote from his article, I think, that underscores your point that this didn't push Europe towards political union but pushed them away from each other. He says, "Monnet was mistaken. If the European monitoring Union does come into existence, as now seems increasingly likely, it will change the political character of Europe in ways that could lead to conflicts in Europe. What are the reasons for such conflicts? In the beginning, there would be important disagreements among the European monetary union member countries about the goals and methods of monetary policy. These would be exacerbated whenever the business cycle raised unemployment in a particular country or group of countries. These economic disagreements can contribute to more general distrust among the European nations."

Beckworth: And he goes on to talk about looking at the extreme limit, you talk about strife. I mean, strong divisions. The whole point, and this is why they only should've taken two leaps in the dark, not that third one, is to bring them together in the common Market if free trade zone makes sense. But the currency union, and this is the big point for your book, is defeating that whole purpose. It's actually... And as you've seen, I remember you're in the news, the Greeks hated Germans when Angela Merkel... You even mentioned in your new book, Angela Merkel practically became chancellor of Europe for a few years there when they were doing the bailouts and organizing lending. I mean, and that seems very imperialistic very... Here are the Germans. They are coming back by other means. So, if anything, it's created more divisions than it has in terms of unity.

Mody:   Yes. You made a number of interesting observations. Martin Feldstein's article flashes out and echoes a lot of what Kaldor said in 1971. So, it was a very consistent theme Kaldor and Feldstein removed by a quarter century essentially their identical view. And as you rightly point out, European scholars, even when skeptical had by the late 1990s essentially decided, look, this thing is going to happen. There's no point in trying to be overcritical. Maybe we can see if we can make it happen a little bit better.

Mody:   Therefore, what happened and continues to happen even today, is that everybody who is critical of the Europe project and is not a European, is quickly dismissed as an Anglo-Saxon. Well, he's an Anglo Saxon. He doesn't understand how Europe works. Even I, who don't have an Anglo-Saxon origin and was routinely regarded in Europe as an Anglo-Saxon. And so, the notion of disregarding... And I thought very hard about this. I use the word group think, and I make the claim that the group think began sometime after the Werner Report in 1970, but was really made legitimate by Helmut Kohl. And so anybody who did not believe in Euro project was a nationalist, was an anti-European. And so, the association of any criticism immediately was that this is somehow posing some grander European design.

Mody:   Therefore, it becomes extremely hard to criticize the European project. That is why I've taken so much time to write the history to document that at each step, the evidence was there. Well, you mentioned that the book reads like a drama. Part of the reason for that is a very sort of conscious decision I made to never write the history looking ahead. So, if I was writing about an event, I ask myself, what did the people at the time know about the theory, about the event, about each other and only about that. I avoided the temptation of looking ahead and said, "They should have known." I say, "This is what they did know. This was part of the received body of knowledge at the time they made that decision," which is why it begins to have a little bit of a mystery thriller quality in terms of the writing of the text. Yeah.

Beckworth: No, it is a fascinating story you're telling. As you said, the narrative of being pro-European, this group think is so strong, the narrative is so strong that it's striking as you read through your book and you think through all that they went through, there were warning signs. It's not intellectual ones, but on the ground as you mentioned. France itself had to devalue almost every decade, right? Because of a fixed exchange rate regime. The snake at first and then there's the European monetary system.

Mody:   Yes.

Beckworth: I mean, they had firsthand experience that pegging to another region, it would not work. Then other one that really kind of blows my mind is the big 1992 EMS crisis, right? Well, great Britain did learn a lesson.

Mody:   Yes.

Beckworth: Great Britain got burned, they said okay, they wiped their hands and they said, "We're not going to join the Euro," but the rest of Europe they kind of brushed off their shoulders and they continued down the project. And then the final one, which I hadn't thought until I read your book, is the unification. The unification of Eastern and Western Germany itself was a currency union brought to fruition. And East German's currency was brought in at a too high a value and it harmed East Germany for a decade, right?

Mody:   Yeah. There's a very beautiful story about that. Again, this is an example of an executive decision that Kohl took despite the advice of everybody else. The German Mark was trading at about seven Marks to one West German Mark. The East German Mark was about seven to one West German Mark. There was some concern that the West Germans wanted to give the East Germans a fair deal. So there was a devolving compromise that East German Marks would be converted into West German Marks at three to one instead of seven to one. This would have given the East Germans something of a wealth benefit. But completely out of the blue, without consulting the governors of either the West or the East German Central Banks, Kohl announces a one to one transfer. So, each West German Mark at this point becomes equal to a one East German Mark. That means that the salaries in East Germany, where productivity is maybe one quarter, become the same as the salaries in West Germany.

Mody:   Fascinating story is that George Akerlof and Janet Yellen were two younger scholars, one of whom was Andy Rose, wrote a paper immediately thereafter saying, "This is going to destroy East German industry because the productivity is so low, the wages are so high. This thing is not going to work." Kohl then invited Akerlof and Yellen to Bon to visit them.

Beckworth: Really?

Mody:   This is a story that professor Akerlof told me.

Beckworth: Interesting!

Mody:   And so they toured around the area and they landed up in Kohl's office in Bon and Kohl spoke for whatever 60 to 90 minutes. He did not even listen to one word of what they had to say. This is typical Kohl. This is... When professor Akerlof told me the story, I said, "This is how I ever read about Kohl. He did not listen to anybody. He had this great vision that he understood the course of world history and he was just writing that history." And he promised the West Germans that they would not have to pay for East Germany and that the East Germans would have these blooming landscapes. So he had this phrase, "That there'll be blooming landscapes in East Germany."

Mody:   It's taken quarter century. There are some parts of East Germany today that have done well, but East Germany is where the alternative for Deutschland Party, the alternative for Germany Party has its strongest roots. That is where the sense of grievance is still the deepest. And so, amongst Kohl's legacies, in fact, is the rise of populism. The phrase that we call populism today is also part of what Kohl's legacy for Germany is.

Beckworth: And that should have been a lesson in itself, right? Unifying two economies together under a common currency and one region with low productivity having the same currency. It caused damage. I mean, for multiple decades, not just one decade and that should have been... All these warning signs.

Mody:   It was not only... Again, the president of the Bundesbank, Karl Otto Pöhl, made exactly the observation that you are making in real time. He said, "Look, we are already seeing the effects in East Germany. If you tried to do this for Europe, we will have these problems multiplied several times." So, it was not a hypothetical.

Beckworth: Right. I was reading your book on the reunification problem and I was thinking these thoughts, this is a great reason not to do a common currency. And the next few pages over, you tell the story here of the Bundesbank president saying the same thing. One other interesting story you pull out about Kohl is that when they reunified, the Bundesbank president and then the Eastern German president, they both got together and said, "We need to take our time and the process of converging and getting rid of the old Eastern German currency." And they said this on... It was February, 1990, they got together, made this announcement. And then Kohl, soon after that, he appends and then said, "No. By July, we're going to have to have this fixed."

Mody:   In the story, it's even more dramatic. As they are making that announcement, as the two governors are making that announcements in the steps of the East German Central Bank, nearly simultaneously-

Beckworth: Really?

Mody:   ... Kohl is making the-

Beckworth: Wow! Okay.

Mody:   ... nearly simultaneously. And the irony is that Karl Otto Pöhl had met with Helmut Kohl. The Bundesbank president had met with Kohl maybe just a few days earlier and Kohl did not even tell him that he was doing this. And Pohl goes out and makes this public announcement and he's under guard within seconds. This was Kohl's pattern. Kohl's pattern very much that he would do whatever he wanted.

Beckworth: All right. Well we're running out of time but in the time we have left, I just wanted to maybe bring us up to the current situation. And we've had other guests talk about what's going on in the Euro crisis. I think our listeners know, so you can read the book, and I encourage you to read the book. It's a really great read. Hopefully you can tell from my enthusiasm. It really was a page turner, but moving forward, right? What do we do moving forward? And here's one scenario I want to throw out there and you can criticize it as well as come back with a maybe a better one, but something that struck me, I had this notion before, but reading your book I think reconfirmed my priors on this. And that is this observation in your book that your guide as far as it should have gone, maybe in the '60s with the free trade arrangement, maybe they could've gotten deeper free trade agreements.

Mody:   Exactly.

Beckworth: So, the European union could exist without a Euro. So, why not, moving forward, have multiple currencies in the EU? So, and I know that the danger of doing this is the financial crisis it would precipitate, but here's how you can minimize it. You could have Italy, Greece, the periphery, they keep the Euro, but have Germany and the other core countries adopt Deutsche Mark 2.0 or something. Could you go down that path?

Mody:   Yeah. So, that's pretty much where I end the book. That's exactly what I end the book. I say, "For the Southern countries; the Italy's of the world, to leave the Euro would be very expensive because their debts would then convert. It would remain in Euros, but they would pay in Liras and they would not be able to pay. They would default on their Euro debts. That would create cascading defaults, especially because as we discussed, Italy is very large and that could create a crisis greater than Lehman Brothers crisis in my view. Therefore, the least painful way to break up the Euro is for Germany to exit the Euro. And if Germany exits the Euro, very likely the Netherlands and Austria and others will follow, perhaps in some kind of a single currency of their own, perhaps in independent currencies. It doesn't matter.

Mody:   That would cause the Euro to depreciate substantially. That would give the Southern countries some relief. If it gives them some relief, they use it well, that's good. If they don't use it well, they blow it up again and do not deal with their long-term productivity issue, the benefit that they get from the devaluation of the Euro will be short-lived. They will go from one crisis to another like they did. I suspect that the pressure will keep getting relief from the top. The best countries will keep leaving till you would just multiple currencies.

Beckworth: Okay.

Mody:   That, I see, as the only sort of reasonable way of breaking this up. It would still be disruptive, but would much less disruptive than an Italian exit.

Beckworth: Yeah. Okay. With that, our time is up. Our guest today has been Ashoka Mody. Thank you for coming on the show.

Mody:   Thank you very much, David. Thank you. It's a great pleasure talking to you.

About Macro Musings

Hosted by Senior Research Fellow David Beckworth, the Macro Musings podcast pulls back the curtain on the important macroeconomic issues of the past, present, and future.