Can European Monetary Union be undone?
The strains on the euro have been there right from the start, but tectonic plates of European politics and economics are close to producing an earthquake. It's not going to be the Big One yet. To throw in the towel so soon after the euro's creation is politically unthinkable, even if it were economically rational to do so.
This begs the question whether it was economically rational to create the monetary union in the first place. Actually, there are two aspects to this question: is a monetary union economically desirable in Europe, and what structure should it have? The advantages of having a single currency are fairly obvious to anyone who travels quite a bit throughout the continent. It has certainly made my life a lot easier, since the only foreign currencies I now usually carry are the British Pound and the US Dollar. The benefits are also obvious in business and finance throughout the continent. By removing exchange rate risk, the euro allows European consolidation of previously fragmented industries. But this is where the first signs of trouble begin to show: politics. Obviously. Although extremely pro-European in the abstract, once it comes to the sale of a Big Domestic Company to some foreign competitor, the politicians start to protest.
But in the most immediately visible impact, having a single currency is a good thing. It also gives Eurocrats a nice warm fuzzy feeling for having taken yet another step on the path of Ever Closer Union. But a currency is the lifeblood of the economy, and in an ideal world, the currency decision would be a purely economic one. So when should countries merge their currencies? When the benefits of having a single currency and monetary policy outweigh the disadvantages. These disadvantages result from having a single interest rate for the entire area. If the regional differences are too big, then different parts will end up either being overstimulated or being driven into the ground by the prevailing interest rates. Under multiple currencies, these differences would be adjusted by fluctuations in interest rates and exchange rates.
The exchange rate is the external value of the currency, reflecting supply and demand. The interest rate reflects domestic supply and demand for a currency, usually managed by a central bank. Both in a sense are prices, and prices carry information on supply and demand. The price signals of currency fluctuations reflect the relative demand for currencies, and thus convey information about the economies. This information is an amalgam of the labor market, producitivity, tax rates, business climate, government policies, literacy rates, education levels et cetera. By moving to a monetary union, the fundamental information will still exist, but it can no longer express itself in the exchange rate, so it is going to have to find other means. Unemployment could be one of those means, if the cost of labor is structurally higher in one part than another. Adjustment of wage levels is the flip side, but generally much harder to achieve. It's easier to fire people (even in places like Germany) than to cut their wages.
Europe is naturally not the first area to implement a monetary union. There is another large economy, with big regional differences, that has a single currency: the United States. In a highly interesting paper, Hugh Rockoff of the National Bureau of Economic Research examines the question of how long it took the US to become an optimal currency area. In other words, how long did it take until the benefits of having a single currency in the US outweighed the disadvantages? The question itself may seem strange, because nowadays we have a mental mapping of currencies to countries. A country has a currency. It does not occur to us that a single country would have more than one currency; at least officially, because in many poorly developed economies a second parallel currency operates on the black market. It's usually the US dollar.
The answer is actually surprising. Depending on how you measure it, the US may not have been an optimal currency area until the 1930's. It was only when regional differences became smaller due to automatic stabilizers in the form of transfer payments such as unemployment benefits, but also due to higher labor mobility and tighter overall intergration of the economy with the advent of the telephone, radio and faster travel. Even now, regional difference obviously persist, but they tend to be cyclically aligned. The flexibility of the economy is also important, as it needs to adjust to an interest rate that may not be optimal for a particular region.
In the case of European Monetary Union, the regional differences now are much larger than they were in the US of the 1930's. Labor mobility is negligible across national borders. An unemployed plumber in Paris is not likely to move to Munich which may have a shortage of plumbers. Moreover, the disparity in economic structures and levels of development is also substantial. Is the Greek economy really sufficiently similar to the Belgian to have the same currency and interest rate?
Some countries in the current European Monetary Union could certainly be called on optimal currency area. Germany with the Benelux countries are close enough in that regard, and adding France might also work. Beyond that, it becomes harder to see an economic rationale for other member countries. But the project of monetary union was only partly about economics; to a larger degree, it was about politics. And with any politically-driven process, rational economic decision making, as it might happen in a free market, goes out the window in order to advance the Grand Schemes of politicians. This is what happened in Europe. when the idea of monetary union was born, the drivers were Germany and France, and they were none too keen on having a large group of countries join them. So they came up with the Maastricht criteria and the Stability Pact, which they thought would be harsh enough to keep party-crashers like Italy out. But it soon became obvious that by fugding the numbers sufficiently and some real reform too, Italy was going to make it. The political pressure was too big, so Italy had to join. But if Italy were allowed to join, then Spain must join too. And Portugal. And then Greece.
Thus the Big EMU came into existence. I am fairly certain that the current EMU does not constitute an optimal currency area, and the pressures are showing. The title of this post refers to the question whether EMU can be undone if the pressures become large enough. Monetary unions have been dissolved before, most recent when Czechoslovakia split apart. The Czech and Slovak economies were tightly integrated, albeit in a highly inefficient communist-imposed system. Still, having had the same currency for almost half a century (or even going back to 1918, if you count the First Republic), the split did occur, and both countries have been the better for it. The divergences in the two countries' situations were too big to accomodate a single currency, so breaking up was the sensible thing to do. Ironically, both countries may yet end up with a single currency again by the end of the decade, if both do join EMU.
So monetary union is not immutably set in stone. It can fail. And given the economic malaise in the EU, the regional economic, fiscal and structural disparities in EMU, the chances are significant that a major break could occur in the next ten or fifteen years, with the emergence of a smaller core monetary union, and reappearance of some previously extinct currencies.
Posted by qsi at October 22, 2002 09:23 PM
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Purely from an ivory-tower academic standpoint, the current EMU does not come close to an optimal currency area. And in the real world of subsidies, budget deficits, ethnocentrism and demographics, the problems will be much, much larger.
Labor mobility is the most obvious problem, because Spanish plumbers are unlikely to pick up and move to Ireland where jobs are plentiful. There's just no way to have a single monetary policy that suits the simultaneous needs of Ireland, Greece and Spain.
The less obvious problems are much worse. Beyond the insoluble but ignored problems of French farm subsidies and ballooning German deficits lies the ticking, ticking, ticking time bomb of demographics. In a couple of decades, Spain will become the oldest country on earth. When that occurs, Spain will be every bit as bankrupt in terms of economic vitality as Japan is presently (Japan is the oldest country on earth at the moment, with a labor force shrinking around 2% per annum).
What happens then? How can Spain possibly hope to make good on its social promises to its retired elderly? By importing more muslims from third world countries?
For now, and forever more, short the Euro.