Reforming the Eurozone


A recent report from the “4 Presidents” (Juncker, Draghi, Dijsselbloem and Tusk) calls for renewed efforts to reform the Economic and Monetary Union. Too little attention has been paid by the media to this endeavour. In part, because events in Greece have taken the central stage. And in part because of its apparent lack of ambition. Yet, the long overdue reform of the Euro Zone will be key to ensure its survival and will eventually determine the success or failure of the Juncker Commission.

What is a currency for?

The idea of creating an European monetary union started to be seriously considered in the 1960s and 1970s. In this period the Commission of the European Communities issued a series of analytical reports to understand what the necessary ingredients of such a monetary arrangement were. Meanwhile the academic world started to develop the so called Optimum Currency Area theory. The founding father of such theory is considered to be Robert Mundell who in 1961 published a paper entitled “A theory of optimum currency areas“.

The main issue that both the analysis of the European Commission and of the academia were trying to address was essentially the following: how do balance of payments crisis get resolved? Such crisis occurs when a country is unable to pay for essential imports and/or service its debt repayments.

There are two ways of looking at this problem. One is the most common and consists in considering balance of payments between countries. Imagine an unforeseen shock that reduces economic activity in a country, as a consequence national income falls. As this happens the resources to pay for imports and to service existing debt decrease. A process of devaluation is set in motion, in other words the country’s assets lose value compared to those of other countries. If the country has monetary sovereignty, the standard response will be a mix of fiscal and monetary expansion. It will utilize its Central Bank as a lender of last resort to cushion banks’ losses and to limit the borrowing costs for both the private and the public sector. Simultaneously its currency would depreciate as confidence declines and capital leaves the country. This would both limit imports and expand exports. The country would absorb foreign income with which pay down its liabilities. A combination of greater public and foreign demand will offset the falling domestic private demand.

If the country however does not have monetary sovereignty, because for example it has pegged its currency to another, then fiscal and monetary expansions will be off the table as well as currency depreciation. In such case the devaluation will occur through domestic prices and costs and it is therefore normally referred to as internal devaluation. Prices will have to fall relative to those of the country’s trading partners. For prices to fall, costs must fall. Costs are mainly constituted by workers’ salaries that need to be reduced. This will happen willingly or not: in the first case through wage renegotiations, in the second through a period of high and persistent unemployment which reduces the cost of labour. Historically there are very rare cases of successful internal devaluations, this is because the “political support” runs out before the process is over and the country is forced to abandon the peg or default on its external debt or both.

But the problem can be also looked from a regional point of view that is within countries. If you think about it, from the perspective of trade balances, regions (or States belonging to a Federation) are like countries within a fixed exchange rate regime. They trade with one another, some are in surplus, some in deficit and when a shock occurs they do not have any sort of monetary sovereignty.

So would regions be better off with their own currency? And what about provinces within regions and municipalities within provinces? Of course such monetary fragmentation would be unworkable. Economists have therefore tried to establish what are the characteristics that an economic entity should have in order to successfully share a currency, or in jargon to form an Optimum Currency Area. There are many such characteristics but the main ones are: factor mobility (labour and capital should be able to move freely across regions); similarity of business cycles and industrial structures (ideally regions should have similar economic features), prices and wages flexibility and a common fiscal capacity.

When the Commission started analysing the possibility of forming a monetary union, it studied the way Member States were resolving their internal balance of payments problems and it turned out that a fundamental aspect was the common fiscal capacity. In the words of the MacDougall report, published in 1977:

As well as redistributing income regionally on a continuing basis, public finance in existing economic unions plays a major role in cushioning short-term and cyclical fluctuations. For example, one half to two-thirds of a short-term loss of primary income in a region due to a fall in its external sales may be automatically offset through lower payments of taxes and insurance contributions to the centre, and higher receipts of unemployment and other benefits. If only because the Community budget is so relatively very small there is no such mechanism in operation on any significant scale between member countries and this is an important reason why in present circumstances monetary union is impracticable.

When “impracticable” things happen

It might not have escaped you that the Euro Zone does not have a common fiscal capacity.

The founders of the Euro Zone disregarded most of the warnings about the absence of the minimum standards of an Optimum Currency Area: the Member States did not have high labour mobility nor did they share common industrial structures and the strong welfare state and labour institutions meant that prices and wages were not flexible. However, as the MacDougall report pointed out, the single most important feature for a functioning economic and monetary union was the common fiscal capacity. Such Euro Zone “treasury” would have redistributed income across the currency area to make up for trade imbalances and sudden economic shocks; the same thing the central fiscal authorities of the Member States were doing vis-à-vis their own regions.

The sour consequence of these missing elements is that when the 2008 shock hit, several Member States of the Euro Zone fell into a balance of payments crisis and in the absence of fiscal transfers, these “regions” of the Euro Zone have been undergoing a process of internal devaluation ever since.

What’s next?

The report of the 4 Presidents is admittedly only a starting point for the future discussion. It does however focus very much on “structural reforms” (ie. improving prices and wages flexibility) and on the “deepening of the single market” (ie. improving factor mobility). The report considerably underplays the issue of common fiscal capacity which is actually only mentioned at the end of the paper in a rather convoluted question: “Is a further risk-sharing in the fiscal realm desirable? What would be the preconditions?“.

The caution of the Commission is understandable. The EMU was set up almost 20 years ago and no consensus was ever found to complete its architecture along the lines of what the same Commission was suggesting in the 70s.

Will the Member States in the face of the most prolonged and painful economic crisis since the end of the II World War be more willing to compromise further to complete the Euro Zone? Or will the “too-little-too-late” approach continue indefinitely?

Unfortunately the ongoing fight among Euro Zone Members on how to solve the Greek crisis, the increasing political support for Euro-sceptic parties and the blame game which has been dominating the European policy arena in the past years offer no reasons for optimism.

The situation sadly reminds us of what Nicholas Kaldor, former Cambridge University Professor of Economics and UK Government official, wrote in 1971:

“(…) it is a dangerous error to believe that monetary and economic union can precede a political union or that it will act (in the words of the Werner report) “as a leaven for the evolvement of a political union which in the long run it will in any case be unable to do without”. For if the creation of a monetary union and Community control over national budgets generate pressures which lead to a breakdown of the whole system it will prevent the development of a political union, not promote it.”

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