Hayek’s Overinvestment Theory and the Stability of the Euro Area

Abstract

In the face of rising inflation and envisaged interest rate increases by the European Central Bank, concerns about the stability and possible breakup of the euro area are growing. The paper scrutinizes the stability of the euro area based on Mundell’s theory of optimum currency areas and the overinvestment theory of Hayek. It is argued that idiosyncratic business cycles which became amplified by uncoordinated fiscal policies were at the roots of the European financial and debt crisis. Since then, the monetary and fiscal rescue measures have led to growing disparities in the euro area, low growth, and rising inequality, contributing to growing political instability and undermining the credibility of the European Central Bank. A return to a stability-oriented monetary policy is recommended to stabilize the euro area in the long term.

I met Jesús first in 2014 in Leipzig, Germany. I had invited him to give two presentations at Leipzig University. They were very well received and Jesús distributed his books and papers to our students. We were inspired by his outstanding thoughts and personality. The topics of the presentations “The Austrian Business Cycle Theory Explanation of the Current Economic Situation” and “The Austrian Defense of the Euro with a Criticism of the Current Antideflationist Paranoia” remain very topical today. I remember that we discussed at dinner the role of the euro for macroeconomic stability in Europe and the possibility of negative interest rates. Jesús argued that the euro could contribute to fiscal discipline in Europe and that negative interest rates were under free market conditions impossible.