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The debate surrounding the future of the euro has prompted widespread discussions over the strengths and weaknesses of the single currency system.
On one side of the argument are people like Nobel-prize-winning economist Paul Krugman, who claim that the structural flaws of the monetary union help trap weaker economies into a recessionary cycle where economic shocks lead to falling wages and unemployment, depressing activity further.
Others, such as the Financial Times’ Martin Sandbu, suggest that the sceptics misunderstand that the euro was first and foremost a political project rather than an economic one – and its weaknesses a result of the compromises necessary to win and maintain the support of the public across its member states. For Sandbu, the political benefits of a single currency are greater than the economic strains it creates.
A single currency needs three things, to a greater or lesser extent, in order to work:
- An independent central bank
- A banking union
- Political or fiscal union
How do the euro areas stack up against each of these?
Independent central bank
The first thing that is absolutely necessary for maintaining a currency union is a central bank with a mandate from member states to ensure price stability but an independent board given the freedom to achieve this without political interference.
In practice, the role of a central bank within an incomplete monetary union (e.g. one where there is a common currency but no political or fiscal union such as the Eurozone) is an extremely challenging one. It not only has to deal with economic divergence within the currency union, with countries growing or contracting at different rates, but it must also take into account different fiscal reactions by member states (how government’s use their own balance sheets to react to circumstances).
What this means is that the interest rates set by such a central bank are frequently too low for fast growing economies within the union, and/or too high for laggards. This has the effect of fanning growth in countries that are already seeing robust performance and holding back recoveries in damaged states.
As the economist Maury Obstfeld, who will take over from Olivier Blanchard as chief economist at the International Monetary Fund later this year, wrote in a 1997 paper:
If a country suffers an economic downturn while growth remains strong elsewhere, its currency cannot depreciate to lower its relative prices and spur demand, nor can it devalue … If the local downturn is persistent, the country will suffer a protracted bout of unemployment above the EMU average. The high unemployment will persist while the national price level falls, and the limited scope for labor to migrate to other euro-zone countries will lengthen the adjustment process.
Of course, its job is made even more difficult by the different sizes of member states. For example, the European Central Bank (ECB) is far more likely to have policy rates appropriate for large Eurozone economies such as Germany and France than it is to set policy for smaller countries such as Greece or Portugal.
As such, the trade-off for having a fully independent central bank with a price stability mandate is that it has to be equally disinterested in the special pleading of each individual member states. Depending on the severity of the need – Greece’s current situation, for instance – that can lead to a great deal of criticism.
To safeguard the price stability mandate of the central bank it is crucially important to break the link between banks and member states so that banking crashes do not morph into sovereign debt crises (and vice versa).
Not only that, but it is also critical for ensuring that a bank failure doesn’t risk cross-border contagion as doubts about the stability of institutions freezes interbank lending, triggers deposit flight and causes cascading defaults.
Moving responsibility for potential financial support and bank supervision to a shared level can reduce fragmentation of financial markets, stem deposit flight, and weaken the vicious loop of rising sovereign and bank borrowing costs. In steady state, a single framework should bring a uniformly high standard of confidence and oversight, reduce national distortions, and mitigate the buildup of concentrated risk that compromises systemic stability.
Effectively it means establishing a supra-national banking regulatory regime (a single supervision mechanism) supported with a common system for winding up failed financial institutions in an orderly manner (a single resolution mechanism). These must be backed by union-wide financial stability fund that can be used to recapitalise banks in order to prevent liquidity crises from becoming solvency ones and averting contagion within the wider financial system.
A centralised deposit guarantee would help prevent depositors from withdrawing their funds in the face of uncertainty around institutions facing difficulties.
These are seen as crucial steps for ensuring financial stability prevent national regulators from washing their hands of cross-border problems that can ultimately pose systemic risks. This was most apparent in the euro crisis as cross-border bank lending from core countries such as Germany and France to the periphery caused sharp debt build-ups in the latter that left both sides vulnerable to economic setbacks.
Achieving a banking union, however, means the agreement of members of a currency union to pool the risk of their banks collectively as well as ceding responsibility for oversight of national banking systems to supra-national bodies. So to some extent it means giving up a degree of sovereignty.
For countries used to a close relationship between banks and the state this could be a concern (for example, those that have escaped public debt crises in the past through financial repression). Moreover, there are concerns that tying countries together through mutualisation of banking liabilities before ensuring they are on a path towards long-term economic convergence could mean that the risks being assumed are asymmetric (that is, some countries in the currency union would be taking on more risk than others).
The most contentious point in debates about optimal structures of monetary unions is whether they require full political and fiscal integration. By that people mean the establishment of a union-wide legislative body, such as a parliament, that has the ability to force financial transfers between member states.
Such a federal system would be most easily implemented in areas that already have high labour mobility as well as public sector institutions that are similar both in the tasks they perform and the efficiency with which they perform them. However, when a common currency is being implemented on a collection of nation states that have a long history of fractious relations with one another and significant cultural, political and institutional differences.
Furthermore, given the differing social and economic circumstances faced by each member state even within a federal structure it can be optimal to allow them some degree of autonomy over spending. Yet, if a fiscal union implies full risk-sharing across member states, that autonomy must be constrained to prevent excessive risk taking (for example, heavy government borrowing by one state) that impose large liabilities on the taxpayers of its fellow members.
The United States overcame this problem by allowing state legislators to set spending priorities but insisting that they run balanced budgets. In other words, the mutualization of liabilities rests with the federal government.
But that is not the only potential model. Another way of achieving a stable settlement is to insist that member states follow strict economic convergence criteria that limits their budget deficits and debt-to-GDP ratio. If all states within a currency union can be compelled to remain within those limits then the degree of federal-level assistance that will be required during normal times should in theory be minimal.
All of these options require a significant erosion of sovereignty and, indeed, accountability of national governments to their local voters. Moreover, traditional arguments frequently assume that economic convergence will beget political institutional convergence – an assertion that is yet to be proven by the lived experience of existing currency unions.
Instead, the reality appears to be that causation runs in quite the other direction: politics both leads and limits the extent to which all aspects of integration can be achieved. As such, if there is sufficient political will to ensure its survival even the most flawed single currencies may be able to overcome what appear to be existential crises, but where that will fails even an optimal currency area is unlikely to sustain.
Author: Tomas Hirst is editorial director and co-founder of Pieria magazine and was previously commissioning editor, digital content at the World Economic Forum. His work has been featured in The Times, the Guardian, Prospect Magazine, the Financial Times and Quartz.
Image: An employee counts Euro notes at the Bank of Taiwan head office in Taipei May 10, 2010. Global policymakers unleashed an emergency rescue package worth about $1 trillion to stabilise world financial markets and prevent the Greek debt crisis from destroying the euro currency. REUTERS/Pichi Chuang
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The views expressed in this article are those of the author alone and not the World Economic Forum.
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