When I looked at the possibility of European Monetary Union being undone, I pointed out that the strains and stresses the Eurozone is currently subjected to are already making the entire project fray at the edges. The current member nations of the Eurozone are too diverse to form an optimal currency area and labor mobility is much too low for it to function as a balancing force. The United States in its history has had periods of monetary strain too, when asymmetric shocks hit certain parts of the country much harder than others. For instance, a drought could depress the agricultural states, while the eastern seaboard still had strong economic growth. This led to conflict between the regions over the then-equivalent of money supply, namely gold. The stock of money could be expanded or decreased by adjusting the gold reserves and the areas that were in recession obviously sought relief. While these conflicts did take place, they concept of the Union was never questioned as a result. The United States was a solidly established country, with strong domestic support. The big glaring exception to this is the Civil War, but that was fought over the issue of slavery, not money supply.

The European Union lacks such strong domestic support. The "politics first" way in which the monetary union was conceived and implemented has led to irrational economic decisions within monetary union which have sewn the seeds of its eventual demise. Not all choices being made necessarily have to be economically rational; it would be nice, but reality is seldom that kind and the political reality especially can impose constraints on the freedom of action. As long as this is realized and the consequences of the irrational choices are not too grievous, it need not be fatal. Look at it as a tactical retreat to win the wider war. But the European Project as it has been in the last 20 years or so has increasingly become a plaything of the European political elites. They found themselves on autopilot towards "ever closer union" and they never stopped to question why. Post-war Europe certainly needed reconciliation between Germany and the countries it had invaded, but by the 1980?s the European Project had acquired completely new dimensions. The political elites went along with it partially out of inertia, and partially because it was a rich source of cozy jobs. It also provided a structure for them to solidify their hold on power, moving ever further from the pesky electorate that so often inconveniently ruined their domestic plans. And so the European Project steamed merrily into the turbulent waters of monetary union. The political decision for monetary union had long been made, but the consequences were certainly not understood by the politicians. Huddled in their Reality Distortion Fields they had no clue what they were letting themselves in for. More importantly, they were (and are) under the impression that political fixes can counteract the weight of economic reality; if it works in backroom deals in parliament, why should it not work in the economy?

However, a semblance of macroeconomic rigor had to be maintained. So in the Maastricht Treaty, in which monetary union was formalized, contains a number of convergence criteria that aspirant countries have to meet in order to be allowed in. The buzzword here is convergence. If the economies converge sufficiently, then they can be joined in monetary union. But they way these criteria were drafted they ended up as being coincidence criteria rather than convergence criteria. They converged much as a stopped clock converges with the time of day. Sure, it'll be briefly right, but it does not mean the clock can be relied on to show the time. It's the convergence of two elevators, one going up, the other going down. Real convergence can only happen over time, and it needs to be measured over time. The Maastricht criteria did no such thing, and even then they were subject to political fudging. The criteria were:

1. Price stability. Inflation rates had to be no more than 1.5% over the average of the three best performing countries over a period of one year. For a supposedly irrevocable monetary union, one year of roughly similar inflation is hardly convergence.

2. Government deficits and borrowing. The budget deficit should not exceed 3% of GDP and national debt should not exceed 60% of GDP. Since neither Belgium nor Italy would have had any chance of meeting the 60% criterion, this rule also gives a passing grade if the national debt is being reduced. And the 3% of GDP budget deficit rule has been fudged in many countries, by counting one-off privatization revenues as structural.

3. Exchange rate stability. Within the precursor to monetary union, the European Rate Mechanism the aspirant countries' currency had to maintain their pre-set bands. Britain almost wrecked its economy by trying to stay within the ERM in the early 90?s by trying to create artificial convergence. A very deep and painful recession was the result.

4. Convergence of interest rates. The yields on long-dated government bonds had to be within 2% of the average of the three best performing countries. This is virtually a consequence of point 1 above, although bond markets tend to be harsher than politicians. But once it was clear that political considerations would allow countries like Italy to join, the great convergence play in the bond markets was on.

None of these criteria actually measures real convergence, for that could only be observed over much longer periods of time with a number of business cycles to go through. These criteria were a political fig leaf, prone to and designed for easy and expedient manipulation.

The European Central Bank's key role is to keep inflation under control, targeting a rate of 2%. The Federal Reserve in the US has a less specific goal, as it has to keep prices stable while also taking economic growth into account. Looking at the US experience and contrasting it with the situation in Europe is instructive. How diverse is the US economy by region? It is very diverse, but it does rise and fall on the same business cycle. The Bureau of Labor Statistics has a wealth of information on regional inflation data and it's available online. It has data going back to 1915 for various conurbations, and a second set of series for larger regional areas since 1967. Using the numbers for the All Items CPI series, this graph shows that inflation did vary by region, but the moves were very highly synchronized. There's a striking divergence at the very end of the series though, as the brown line representing San Francisco, Oakland and San Jose spikes upward. This is the internet bubble and most of this rise is due to the housing component in the area. I also plotted the largest dispersion over time by taking the highest inflation rate and the lowest, and looking at the difference between the two. This graph shows two lines, one for all regions, the other excluding Silicon Valley. In post-war America the dispersion of inflation rates has been fairly low. It was only the high inflation period of the early 1980?s where the dispersion ticked up to around 4%. But with 13.5% national inflation, the difference between 15.8% inflation in Los Angeles and 11.4% in New York matters not so much. Both are way too high, and the monetary response is obvious (and Paul Volcker certainly applied it). Had the national average rate been 3% with individual regions fluctuating between 1% and 5%, then the situation changes. You don?t want to push the 1% regions into deflation, yet the 5% regions are in danger of spiraling out of control. But this situation has not arisen in the US aside from the internet bubble in Silicon Valley. Arguably the area would have benefited from higher interest rates when its inflation started to creep up as much as it did, and in that sense it's a small-scale failure of monetary policy there.

The situation in Europe is more difficult to assess, simply because data is harder to come by. I managed to scrounge together some data on Harmonized Inflation in Germany, France and Italy from various sources. Unfortunately, the amount of history is limited. Still, the graph shows that as recently as 1996 there was an almost 5% inflation differential between Germany and Italy. The last time there was a regional differential this big in the US was in 1917. It is completely unrealistic to assume that the Italian and German economies have become sufficiently similar to share the same interest rate simply because the Italians managed to get inflation down to something reasonable in the late 1990's. And the divergence is growing again as Italian inflation is almost 2% higher than German inflation. In other words, real interest rates are 2% lower in Italy than in Germany. This is exactly the opposite of what is required, as the German economy flirts with deflationary oblivion and the Italian is doing relatively OK by European standards.

Right now, the one-size-fits-all interest rate in the Eurozone is clearly and painfully inappropriate for many parts of the continent. There is no convergence, nor has there been any. These are the fault lines which lie under the exterior of European Monetary Union. The sad thing is that there were pre-programmed.

Tomorrow I will have a follow-up, focusing on the growth gap between Japan, Germany, Europe and the US.