If you want to understand the backdrop for the problems in Cyprus, or the political chaos in Italy, or the continued problems in France, or really anything that's happening in Europe you ought to look at this February 1 David Beckworth post. It's got two key charts that explain an awful lot.
For starters, here's the success of German monetary policy:
Germany's central bank is doing exactly what a central bank should be doing. It's stabilizing the flow of nominal spending throughout the economy, and when things go off track they "make up" for past mistakes. Guaranteeing a steady path of nominal spending and income doesn't guarantee prosperity. But it puts elected officials in a strong position to make policy that's designed to translate nominal spending into real output. In Germany's case, that's primarily meant policy changes aimed at boosting the share of the population that's interested in doing formal paid work.
Now here's the failure of monetary policy in the rest of the eurozone:
What you see here is a central banking disaster. Nominal spending flows fall, and then instead of re-converging to the old trend they flatline. Under those circumstances, it's essentially impossible for realistic policy reforms to gain traction. Countries with lots of inefficient policies are faced with the greater and more immediate inefficiency of massive excess capacity that totally swamps the possibility of efficiency-enhancing reforms.
But the bigger problem here is that Germany and the non-Germany eurozone have the exact same monetary policy. It's made in Frankfurt by the European Central Bank and the revealed preference post-crisis is to stabilize the German macroeconomy and let the chips fall where they may for the rest. That's a huge problem. If Ben Bernanke stood up tomorrow and announced that he's no longer interested in the inflation and output situation in the United States and is going to instead focus on German economic data and performance, there'd be a huge crisis here in America. After all, a country who's central bank isn't trying to stabilize its economy has a huge problem. And that's essentially the situation facing Italy and France and the rest right now. Their central bank has abandoned stabilizing their economies in favor of stabilizing Germany. Who wants to invest in a country like that? And what set of policies is going to succeed?
To be sure, this is all understandable from the German viewpoint. Why should Germany accept a perpetually overheating economy to suit the needs of sundy Greeks and Cypriots? It's a good question. But to have a workable monetary union, the monetary authority has to try to stabilize spending throughout the monetary union area. If you want the eurozone to work, there's no other choice.
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