Introduction

Since the Euro’s introduction in 1999, economic outcomes across the Eurozone have diverged sharply rather than converged. Countries sharing the single currency have experienced radically different growth paths, employment outcomes, and trade balances. Germany and the Netherlands have emerged as persistent winners, while southern economies such as Italy, Greece, Spain, and Portugal have struggled with stagnation and high unemployment.

From a trade perspective, this divergence matters because exchange rates are meant to act as a balancing mechanism between nations. In the absence of perfect wage and price flexibility, currency movements normally correct trade imbalances. The Euro, by fixing exchange rates among structurally different economies, dramatically inhibits the balancing of trade at the national level.

Diverging economic performance within the Eurozone

Measured from 1999, Germany’s real gross domestic product (GDP) growth has far outpaced that of southern Eurozone members. The gap widened significantly after the 2008 global financial crisis and the 2012 Euro crisis, as credit tightened and structural misalignments hardened. Contrary to expectations, poorer economies did not catch up through faster growth, capital inflows, or productivity convergence.

The architects of the Euro expected economic structures to converge over time, transforming a politically motivated union into a smoothly functioning economic one. Instead, convergence has proved elusive. Germany has operated close to potential output, while others have persistently underperformed, undermining both the economic theory and the political rationale behind monetary union.

Empirical evidence suggests the Euro has generated substantial and lasting exchange rate misalignments. A study by the Center for European Policy estimates that in 2017 German GDP per capita was €3,390 higher than it would have been without the Euro. Cumulatively since 1999, Germany gained €1.9 trillion, or €23,000 per person.

Italy’s experience stands in stark contrast. The same study estimates that Italian GDP per capita in 2017 was €8,700 lower than it would have been outside the Euro, with a cumulative loss of €4.3 trillion. The Organisation for Economic Co-operation and Development (OECD) purchasing power parity models suggest a 12% gap between the appropriate exchange rates for Germany and Italy. The International Monetary Fund (IMF) estimates Germany’s real effective exchange rate to be 15%-30% undervalued, while Italy’s is up to 10% overvalued.

Sharing a currency with weaker economies has therefore given Germany and the Netherlands an exchange rate that is cheaper than their fundamentals justify, boosting competitiveness and suppressing adjustment.

Unbalanced trade

The most visible manifestation of this misalignment is Germany’s external surplus. Prior to the Euro, Germany ran an average current account deficit of 0.7% of GDP. Between 2000 and 2018, it averaged a surplus of 5.25%, rising to 7.2% of GDP after the global financial crisis.

In 2018, Germany recorded the largest current account surplus in the world in nominal US dollar terms, exceeding China’s – despite having an economy only about 30% the size of China’s. These surpluses have persisted for 17 consecutive years, accumulating to US$3.5 trillion. Germany’s net international investment position rose from zero in 2003 to around 60% of GDP.

This persistence is striking because Germany has been near full employment, precisely the phase of the business cycle when imports should surge and external surpluses should shrink. Cyclically adjusted estimates suggest the underlying surplus may be as high as 8.5% of GDP, pointing to structural rather than cyclical forces.

Germany’s surplus

One-third of Germany’s surplus now comes from within the Eurozone. Although this share has declined over time, its absolute size remains large. This is particularly problematic given the weak performance of Germany’s Euro-area partners. If ever there were a time for Germany to run deficits with its currency-sharing neighbors, it would be when those neighbors are struggling to grow.

Instead, fixed exchange rates and divergent productivity trends mean that competitiveness adjustments occur through inflation and wage differentials – mechanisms that are slow, painful, and politically destabilizing – rather than currency movements.

The most rapid growth in Germany’s surplus has come from outside the Euro area, notably with the United States, the United Kingdom, and other non-Euro EU members. From a global perspective, this is where the Euro becomes a systemic issue rather than an internal European matter.

Germany’s surpluses now rival – and in recent years exceed – China’s. Yet unlike China, Germany does not intervene directly in currency markets. The Euro’s external value is market-determined, but it reflects the combined competitiveness of all Euro members. Germany’s advantage arises because the Euro is held down by weaker economies sharing the currency.

Monetary policy amplifies this effect. To prevent deflation and support southern Europe, the European Central Bank has maintained exceptionally loose policy. Taylor Rule estimates suggest a six-percentage point gap between the interest rates appropriate for Germany and Italy. What is necessary for the South is excessively stimulative for the North, further weakening the Euro and reinforcing German surpluses.

Why does it matter?

By locking parts of southern Europe into an overvalued exchange rate, the Euro has produced extraordinarily high unemployment, income stagnation, and fiscal stress. Seven years after the Euro crisis, unemployment remains 18% in Greece, 13% in Spain, and 10% in Italy, compared with just 3.2%-3.3% in Germany and the Netherlands.

The human cost is severe. Greece’s real economy in 2018 was the same size as in 2000 and Italy’s economy was no larger than it was in 2004. High debt levels make ‘internal devaluation’ through deflation financially dangerous, risking defaults rather than adjustment. Unsurprisingly, these outcomes have fueled populism, political extremism, and declining faith in the European project.

At the same time, northern Europe relies on external demand to absorb its excess production. Patience among trading partners is wearing thin. While China is currently the focus of trade tensions, the Euro’s role in generating persistent, asymmetric imbalances may attract increasing scrutiny.

Three possible paths forward could be continued imbalance and rising populism; tighter monetary policy leading to defaults in the south; or an orderly restructuring or break-up of the Euro into northern and southern blocs. No option is attractive, but the Euro, as currently designed, poses the greatest single threat to the sustainability of the global trading system.

A multilateral trading system depends on exchange rate flexibility among major economies to ensure fairness. By binding structurally divergent countries into a single currency without adequate adjustment mechanisms, Europe has created a distortion that rivals – if not exceeds – more familiar forms of trade manipulation. In the long run, confronting this reality may be less costly than continuing to ignore it.

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