Why Only Full-blown Political Union Can Save the Euro

Posted on 18/11/2010


Brian Lenihan (Irish minister of finance)

Brian Lenihan, Irish Finance Minister Image by nerosunero via Flickr

The recent financial problems plaguing peripheral members of the Eurozone such as Greece, Ireland and Portugal, are seen by some as the unfortunate consequences of the banking crisis and consequent recession, by some as just desserts for profligate government tax-and-spend policies over the previous decade, and by others as unfair punishment being meted-out by the bond vigilantes to innocent governments and the citizens of their countries.  I see things slightly differently, believing that the current crisis is a kind of Greek tragedy (sorry for the pun), the inevitable consequences of the signing of the Maastrict Treaty in 1992.  The surprise is not that the crisis has occurred, but when, how and which countries would be the victims.

In 1961, the economist Robert Mundell, later to win the “Nobel” Prize in Economics, published a paper in the American Economic Review entitled A Theory of Optimum Currency Areas.  In the paper he proposed the conditions necessary for a given region to operate with a single currency.  The necessary conditions are as follows:

  • Mobility of capital across the region in question. In order for the central bank to successfully implement its monetary policy across the currency area, capital needs to flow freely within it, particularly within the government bond markets and across the banking sector, as these are the transmission mechanisms by which monetary policy affects the real economy.
  • Mobility of labour. If labour is mobile, then regions within the currency area can respond to economic shocks via the migration of the unemployed from high-unemployment regions to low unemployment regions.  Without labour mobility, then high levels of unemployment are likely to persist within regions that economically underperform the currency area as a whole.
  • Intra-regional fiscal transfers. Fiscal transfers act to slow the economies of strongly performing regions while boosting the those of underperforming regions, thus acting as automatic stabilisers for the regions in question and helping the various economies of the currency area to converge.
  • Correlated business cycles. If the regions of a single currency area lack correlated business cycles, then the foreign exchange rate and monetary policy is likely to be unsuitable for some or all members for most of the time.  Consequently, the monetary policy and FX rate is likely to exaggerate these effects.

With regard to the Euro, it is clear that the Eurozone fails on a number of these tests.  Firstly, although EU citizens have freedom of movement across the union, the cultural differences between the member states and language barriers that exist means that pan-European movement of labour is relatively low, especially compared to the United States.  There have been a number of young Eastern European moving north-west to find work, but I would expect the number of Greek, Irish and Spanish unemployed currently seeking work in Germany and Scandinavia is negligible.  Secondly, it is clear that the business cycles of the Eurozone are only weakly-correlated.  The ultra-low interest rates required to stimulate the French and German industrial heartlands during the past decade have proved far too low for peripheral economies, stoking asset-price bubbles and over-exuberant lending.  The divergence continues today, with Germany now enjoying strong export performance and the periphery stuck in recession.  Thirdly, and perhaps most critically for the Eurozone, there are virtually no fiscal transfers between high-growth and low- (or negative-) growth regions.  Although Eurosceptics rail against EU spending, the total EU budget is only around 1% of GDP, completely insufficient to make meaningful fiscal transfers.

Only large fiscal transfers can offset these inherent weaknesses (low labour mobility, weakly-correlated economies), and fiscal transfers will inevitably require full political & fiscal union. Why?  As we have seen in recent weeks, the EU is largely powerless as a decision-making body when it comes to large and significant matters – all the power rests with the heads of government of its member states.  In order for meaningful fiscal transfers to occur, significant budgetary power (included that to issue debt, raise taxes, etc) will need to be endowed upon the politicians of Brussels, and additional power for Brussels will mean less power for the nation state, driving the Eurozone towards the inevitable full-blown political and fiscal union the a single currency has always implied.