Is this another hit for the grand European project?
Paul Donovan, senior global economist at Swiss bank UBS, has just published a 16-page note entitled “How to break up a monetary union.” The central contention: the eurozone just doesn’t work.
By “does not work” Donovan means a single interest rate policy doesn’t seem to be equally appropriate for all areas; the eurozone is not an optimal (single) currency area. A one size fits all approach just doesn’t apply.
Here’s the summary:
The euro stays
We do not believe that European Monetary Union will break up. The costs of breaking up the Euro, at this stage, far exceed the benefits. Far better, in our view, to default within the Euro than to incur the political, economic and possibly social costs of trying to survive outside.
Monetary unions do break up
Notwithstanding the fact that we think the Euro survives intact, it is relatively clear that (in economic terms) the Euro does not work. That is to say, parts of the Euro area would have been better off (economically) if they had never joined. This is not an argument for departing, but it raises questions about the factors that make monetary unions economically successful, and what happens when those factors are absent.
This is where things get interesting.
Donovan gives two examples of failed monetary unions; the permanently-failed Czech-Slovak monetary union in the 1990s, and the temporarily-failed US monetary union during the Great Depression.
In the US case the dollar monetary union “effectively ceased to exist” in the 1930s, according to Donovan. States transferred deposits out of local banks and into New York-based institutions, suggesting an NY dollar was worth more than say, a dollar in Michigan or Ohio.
It was only by rebuilding the union via new or adapted financial institutions, like the reorganised Federal Reserve, that the US was able to effectively resurrect the dollar union, Donovan says.
And in this, there may be some parallels to Europe:
That the Euro area is not an optimal currency area is generally agreed upon. The European economies are sufficiently diverse that external shocks hit different economies with differing degrees of severity. The asymmetrical nature of any shock is also likely to persist for longer. This is something that has been well understood for some time. Indeed, fourteen years ago UBS economists concluded that “a monetary union extending beyond the core six [European] economies would not work properly in economic terms.” The analysis identified those economies that could realistically be called an optimal currency area, those economies that could satisfy the Maastricht criteria (on a relatively liberal interpretation), and those economies for which there was a strong political will in favour of monetary union. The analysis suggested that Greece, Spain, Italy and Portugal failed to meet real economic or financial criteria. Ireland and Finland were felt to meet the financial and political criteria, but also failed to meet the real economic test. The Venn diagram UBS originally published is replicated [here], for the benefit of those with an interest in economic history.
Here though is where Donovan might get a little contentious.
Where many would argue the United States had strong cultural and political ties to help it recreate a fragmented monetary union post-Depression, Donovan thinks cultural and political unity aren’t necessarily required for a functioning monetary union.
What’s needed, he says, is “economic community” — in other words, stronger areas subsidising the weaker ones. In the eurozone case, that would be Germany subsidising places like Greece:
Germans should pay for Greek pensions
The concept of fiscal transfers across different regions within a monetary union normally suggests a degree of political union, though this does not have to be the case. What it does suggest, at least for now, is that popular complaints in Germany (and elsewhere) about paying for social security in other parts of the Euro area appear misguided. Monetary unions entail sense of economic community. This means that wealthier areas should, indeed must subsidise those parts of the monetary union that are at an economic disadvantage. Fiscal transfers are the price that has to be paid for a monetary union of any meaningful size.
In conclusion then:
The most optimistic scenario for the Euro probably lies in some kind of parallel to the experiences of the US in the 1930s. Then, a fragmented banking system, with powerful regional central banks, failed to deal properly with an asymmetric shock to the economy (and to the financial system). The problem fostered significant regional differences in economic performance. This motivated financial reform, and a greater fiscal transfer mechanism to turn a sub-optimal currency area into a sub-optimal currency area with the mechanisms to smooth the consequences of shocks.
Writing in the Financial Times in December 2001, then EU Commission President Prodi declared “I am sure the euro will oblige us to introduce a new set of economic policy instruments. It is politically impossible to propose that now. But some day there will be a crisis and new instruments will be created”. This may not be the crisis, but it has probably brought Europe closer to the point where institutional reform is required. For any monetary unions to survive, the costs must not persistently outweigh the benefits.
Full note in the Long Room.
Related links:
The fate of the eurozone – FT
`Italy’s worse and Germany stole our gold’ – FT Alphaville
When to sell the euro(zone) - FT Alphaville