The Euro Crisis: Perhaps the Currency Isn't to Blame?

Includes: EWP, EZU, FXE, IRL, UDN, UUP
by: Antonio Fatas

According to Paul Krugman, the euro is one of the main factors behind the crisis in Greece and other European countries. The fact that Greece (and Portugal, and Spain and Ireland) cannot devalue their currencies is having a negative impact on their growth which lowers tax revenues, increases government deficits and raises the possibility of default. Martin Feldstein goes one step further and argues that if Greece could devalue, they would easily avoid default.

I understand their argument, that exchange rate misalignments can have negative economic consequences, but I think that blaming the euro for the imbalances in government accounts is misleading.
The work of Reinhart and Rogoff, summarizing eight centuries of financial crises is full of examples of countries with flexible exchange rates where governments default. There are also plenty of cases of countries with fixed exchange rates and large devaluations that not only do not avoid default but might be responsible for it (as liabilities where denominated in a foreign currency).
Anyone who looks at the history of Greece (or any of the other Souther European countries) knows that crises come in variety of forms and the anchor of the European Union and the euro has led to additional constraints on the government that have probably avoided crises, rather than creating them. This is what Reinhart and Rogoff conclude:

Interesting recent cases include Greece and Spain, countries that appear to have escaped a severe history of serial default not only by reforming institutions, but by benefiting from the anchor of the European Union.

One thing that I am missing in the arguments of those who blame the single currency for the current European "crisis" (at least of confidence) is their recipe for the US in terms of exchange rate policy. The US government has debt levels that are likely to grow faster over the coming years (and decades) than in the case of Ireland or Spain (if we believe the OECD). The current US government deficit is similar and the projected US budgets for the next years in the US do not show a strong sense of restraint. There is no doubt that US fiscal policy is on an unsustainable path and there is a need to cut spending or raise taxes substantially over the coming years. In addition, the US has also displayed very large current account deficits in the last decades, a sign (according to them) of the lack of competitiveness of an economy. How will the flexibility of the US exchange rate help the US going forward? If their recipes for Southern Europe are applied to the US, what should the US dollar do over the coming years? Depreciate? Relative to which currencies? Who will engineer that depreciation?
As an academic, it is easy to find arguments against a certain exchange rate system (flexible or fixed). But we need to go one step further and suggest an alternative taking into account the empirical evidence we have accumulated over the last decades or even centuries. In my view, arguing that the euro is one of the key factors behind the Greek crisis ignores the economic history of these countries and the true trade offs that they face between different exchange rate systems.