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Endgame For Eurozone
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The good news is economic research does have a few things to say on whether Europe should have a single currency. The bad news is it has become clear that, at least for large countries, currency areas will be highly unstable unless they follow national borders. At a minimum, currency unions require a confederation with far more centralised power over taxation and other policies than European leaders envision for the eurozone.
What of Nobel Prize winner Robert Mundell's famous 1961 conjecture that national and currency borders need not significantly overlap? In his provocative paper ‘A Theory Of Optimum Currency Areas', Mundell argued that as long as workers could move within a currency region to where jobs were, the region could afford to forgo the equilibrating mechanism of exchange-rate adjustment. He credited another (future) Nobel winner, James Meade, for having recognised the importance of labour mobility in earlier work, but criticised Meade for interpreting the idea too stringently, especially in the context of Europe's nascent integration.
Mundell did not emphasise financial crises, but presumably labour mobility is more important today than ever. Workers are leaving eurozone's crisis countries, but not necessarily for its stronger northern region. Instead, Portuguese workers flee to booming former colonies such as Brazil and Macau. Irish workers leave in droves to Canada, Australia, and the US. Spanish workers stream into Romania, which had been a big source of farm labour in Spain. Still, if intra-eurozone mobility were anything like Mundell's ideal, we would not be seeing 25 per cent unemployment in Spain, while Germany's rate is below 7 per cent. Later writers came to recognise that there are other essential criteria for a successful currency union, which are difficult to achieve without deep political integration. Peter Kenen argued in the 1960s that without exchange-rate movements as a shock absorber, a currency union needs fiscal transfers to share risk.
For a normal country, the national income-tax system constitutes a huge automatic stabiliser across regions. In the US, when oil prices go up, incomes in Texas and Montana rise, which means they contribute more tax revenue to the federal budget, helping out the rest of the country. Europe, of course, has no significant centralised tax authority, so this key automatic stabiliser is essentially absent.
Some European academics said there was no need for US-like fiscal transfers, as any desired degree of risk sharing can be achieved through financial markets. This claim was misguided. Financial markets can be fragile, and they provide little capacity for sharing risk related to labour income, the largest part of income in any advanced economy.
Kenen was concerned with short-term transfers to smooth out cyclical bumpiness. But in a currency union with huge differences in income and development, the short term can stretch out for very long. Many Germans now rightly feel any system of fiscal transfers will morph into a permanent feeding tube, much like northern Italy has been propping up southern Italy for the past century. Indeed, over 20 years on, West Germans still see no end to the bills from German unification.
Later, Maurice Obstfeld noted that a currency union needs clearly-defined rules for the lender of last resort. Or bank runs and debt panics will be rampant. Obstfeld had in mind a bailout mechanism for banks, but it is now clear that one also needs a lender of last resort and a bankruptcy mechanism for states and municipalities. A logical corollary of the criteria set forth by Kenen and Obstfeld, and even of Mundell's criterion, is currency unions cannot survive without political legitimacy. Europe's leaders cannot carry out large transfers across countries indefinitely without a coherent European political framework.
European policymakers often say that, were it not for the US financial crisis, the eurozone would be doing fine. Perhaps, they are right. But any financial system must be able to withstand shocks. Europe may never be an "optimum" currency area by any standard. But without further profound political and economic integration, the euro may not make it even to the end of this decade.
The author is professor of economics and public policy at Harvard University, and was chief economist at the IMF.
Copyright: Project Syndicate, 2012
(This story was published in Businessworld Issue Dated 16-04-2012)