Simon Johnson has an excellent summary in Economix of how Europe fell into the current mess. Deserves to be quoted at length. He writes,
The underlying problem in the euro area is the exchange rate system itself – the fact that these European countries locked themselves into an initial exchange rate, i.e., the relative price of their currencies, and promised never to change that exchange rate. This amounted to a very big bet that their economies would converge in productivity – that the Greeks (and others in what we now call the "periphery") would, in effect, become more like the Germans.
Alternatively, if the economies did not converge, the implicit presumption was that people would move; Greek workers would go to Germany and converge to German productivity levels by working in factories and offices there... In fact, the opposite happened. The gap between German and Greek (and other peripheral country) productivity increased, rather than decreased, over the last decade. Germany, as a result, developed a large surplus on its current account – meaning that it exports more than it imports.
The other countries, including Greece, Spain, Portugal and Ireland, had large current account deficits; they were buying more from the world than they were selling. These deficits were financed by capital inflows (including some from Germany but also through and from other countries). In theory, these capital inflows could have helped peripheral Europe invest, become more productive and "catch up" with Germany. In practice, the capital inflows, in the form of borrowing, created the pathologies that now roil European markets.
In Greece, successive governments overspent – financed by borrowing — as they sought to stay popular and win elections... In Portugal and Italy, the problem is a longstanding lack of growth... As financial markets become skeptical of European sovereign debt, these countries need to show that they can begin to grow steadily – and bring down their debt relative to gross domestic product (something that has not happened for the last decade or so)...
In Spain and Ireland, capital inflows – through borrowing by prominent banks – pumped up the housing market. The bursting of that bubble has shrunk their real economies and brought down all the banks that gambled on loans to real estate developers and construction companies. Their problems have little to do with fiscal policy. As conventionally measured, both Ireland and Spain had responsible fiscal policies during the boom, but they were building up big contingent liabilities, in the form of irresponsible banking practices.Paul Krugman highlights the importance of fiscal union in the success of any currency union. This is a throwback to something I had written earlier comparing the Eurozone crisis to a similar crisis among a few Indian states and about optimal currency areas. Anyways, Krugman writes,
Greece and Portugal are relatively poor, with GDP per capita of 82 and 77 percent, respectively, of the EU average; this means roughly 76 and 71 percent of the eurozone average, since the euro countries are a bit richer than the EU as a whole. Meanwhile, Germany is at 120 percent of the EU, or 112 percent of the EZ. But it’s no different, really, than the US situation. Alabama is at 74 percent of the US average, Mississippi at 67, with New England and the Middle Atlantic states at 118 and 116.
In other words, as far as underlying economic inequalities are concerned, the EZ is no worse than the US. The difference, mainly, is that we think of ourselves as a nation, and blithely accept fiscal measures that routinely transfer large sums to the poorer states without even thinking of it as a regional issue — in fact, the states that are effectively on the dole tend to vote Republican and imagine themselves deeply self-reliant.