Illustration by Sam Island
What’s So Special About the Euro Currency Area?
Now that the Greek election failed to solve anything, Europe is back to the same problems it faced before.
Not the ones predating Sunday’s election, which resulted in the formation of a coalition government of Greece’s pro-Europe parties. But the difficulties that existed before 11 sovereign nations scrapped their currencies and adopted the euro on Jan. 1, 1999, with the goal of bringing peace and prosperity to the continent. The idea of one monetary policy for all was unworkable then, and it’s unworkable now, primarily because the countries never had a mechanism for dealing with a crisis.
I’ve lost count already of all the crises within a crisis since Greece first revealed the true state of its finances almost three years ago. All the summits, one-on-one meetings, academic research and unsolicited advice haven’t done anything to fix the underlying structural problem. Seventeen different countries with 17 sovereign governments, 17 unique cultures and at least 17 languages are ill-suited for a monetary union.
Robert Mundell, the father of the euro, clearly thought differently. He won the Nobel Prize in Economic Sciences in 1999 for “his analysis of monetary and fiscal policy under different exchange rate regimes and his analysis of optimum currency areas.”
Even by Mundell’s standards, the European Monetary Union looks suboptimal. Although the euro area can boast of a single currency, a single central bank committed to price stability (too committed, some say) and free trade among its members, it lacks labor mobility, mechanisms for fiscal transfers in the case of shocks to individual countries, and a common federal fiscal policy. With the minuses offsetting the plusses, one wonders why he was so keen on the idea. Mundell was traveling and didn’t respond to my e-mail inquiry.
Even some randomly selected groupings produce a better fit than the countries using the euro, according to Michael Cembalest, chief investment officer at JPMorgan Chase Bank. There is far greater harmony among “the 12 countries on Earth located at the latitude of the 5th parallel (north)” and “the 13 countries on Earth whose names start with the letter ‘M,”’ he says in a recent report.
Given the dissimilarities, “Europeans suspended belief” to embark on a currency union, says Michael Bordo, a professor of economics at Rutgers University in New Brunswick, New Jersey. “They wanted to move to the free mobility of labor and goods, in which case they would not need fiscal federalism.” For example, if a shock to one country causes wages to fall, in theory workers move to higher-wage countries while capital flows back to the low-wage nation. “It’s an equilibrating mechanism,” Bordo says.
In the real world, German capital flowed south. The peripheral countries, blessed with unnaturally low interest rates, went on a borrowing and spending spree, which pushed up relative wages and prices and made them less competitive. The common currency prevented the necessary adjustment through devaluation. The common man didn’t want to leave his country of origin. And the common burden fell on Germany.
German Chancellor Angela Merkel wants greater fiscal integration for the euro area. If only everyone could be more like Germany, everything would be fine!
I can understand why Germany would like to dictate fiscal policy to profligate spenders, such as Greece. What about the obligations that go with it? A fiscal union would include a mechanism for fiscal transfers, such as those between the 50 U.S. states and Washington. For the foreseeable future, those transfers will be going from Germany to the peripheral countries.
“It’s a temporal problem,” says Dino Kos, a managing director at Hamiltonian Associates Ltd., an economic research and advisory firm in New York. “Germany is talking about what system to put in place for the long run, when the economy is in a steady state, countries are converged and markets are calm.”
Ah, now it makes sense, unless it’s all a game of chicken.
Solving the crisis is, well, a problem for the countries in crisis. Although 25 of the European Union’s 27 members (the U.K. and the Czech Republic were holdouts) signed a fiscal compact in January to enforce budget discipline, it will be years before the countries’ legislatures ratify it. So that’s a non-solution for the current debt, banking and economic mess.
And each “solution” -- the 100 billion euros ($127 billion) for Spain’s banks last week, a favorable Greek election outcome this week -- produces shorter and shallower relief rallies in financial markets. In fact, European stock markets shot up at the start of trading on June 18, then immediately headed down.
If European nations weren’t willing to sacrifice sovereignty when the countries were more or less on an equal footing -- having met the criteria outlined in the 1992 Maastricht Treaty on debt, deficits and inflation -- it’s hard to see them taking the plunge now. Decisions made under duress tend to be short-term fixes, not long-term solutions. Which is why things will probably sputter along for a good while longer.
The real problem, of course, is that the euro area was always a political ideal designed to constrain Germany’s imperialist tendencies and prevent World War III. To a certain extent, the economic justifications were just that, nothing more.
How will it end? Badly -- and unfortunately not anytime soon.
(Caroline Baum, author of “Just What I Said,” is a Bloomberg View columnist. The opinions expressed are her own.)
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