The uncertainty concerning Greece and the stability of the euro are the result of a design fault in the eurozone. Surprisingly, the solution appears in every economics textbook dealing with the theory of the optimum currency area. ‘One way or another, Europe will have to accept the far-reaching coordination of monetary and economic policy as the logical consequence of a single currency. One simply cannot survive without the other’, says Steven Brakman, Professor of International and Monetary Economics at the University of Groningen. ‘Supporters of the euro must put this difficult message across much more strongly, and opponents need to be honest about the system they aspire to if the euro is withdrawn, and what the consequences could be.’
An optimum currency area comprises a number of countries with very similar economic structure and development. These countries respond to economic opportunities and problems in much the same way, dispensing with the need to adjust the exchange rate and enabling them to introduce a single currency. Brakman: ‘In this respect, the substantial economic differences between the seventeen countries in the European Monetary Union mean that the eurozone is not actually an optimum currency area. The current monetary union was primarily a political project. After the fall of the Berlin Wall, people in Europe were afraid that Germany would become too big and powerful. The euro was intended to draw Germany into Europe.’
The basis for the EMU (and the eurozone along with it) was set out in the Maastricht Treaty in 1991. Criteria for countries wishing to join were agreed. One of the better known rules is that the government deficit may not exceed three percent of the gross domestic product. However, ‘Maastricht’ forgot one important element, and this is now at the root of the Eurozone’s downfall. The mutual exchange rate mechanism was discontinued without introducing an alternative to counterbalance the effects of economic differences after countries joined. Brakman: ‘At the time, many economists thought that an optimum currency area would evolve of its own accord. But it doesn’t work like that. This omission will continue to plague the eurozone system until it is sorted out properly. We need to come up with instruments to counterbalance the loss of the exchange rate mechanism, such as a highly flexible employment market or a European system of levying taxes.’
Before the euro, adjustments to the exchange rates between European currencies corrected any economic differences between the countries. If after conversion, the same product (a Big Mac for example) cost more in Rome than it did in London, this was a sign that the Italian currency was overvalued. Devaluation was the solution. The theory of the optimum currency area put forward by the Canadian economist and Nobel Prize winner, Robert Mundell, explains how withdrawing mutual exchange rates will only work if another mechanism is put in place to counterbalance the effects of economic differences. Brakman: ‘This is a tricky issue in Europe. The decision to prop up the Greek economy with money from the eurozone rescue fund proved unpopular. Employment migration could help, but the arrival of more Poles in the Netherlands shows how easily this leads to social unrest. Paying out German or Dutch unemployment benefits in Greece might help, but try explaining that.’
The commitment to one or more currencies cannot therefore be seen separately from the rest of the policy. Another classic economic theory is the policy trilemma, which claims that every government has three primary wishes, only two of which are possible at any one time. The first wish is for fixed exchange rates to control uncertainty for international trade. The two other wishes are independent monetary policy to combat unemployment, and economic integration of capital movements, which ensures that the available money is optimally invested.
Brakman: ‘If you want to combine fixed exchange rates and free capital movements, you have to forget independent monetary policy. Reducing interest rates is no longer a tool for tackling unemployment, as the money simply flows into high foreign interest rates. This free movement of capital is inextricably bound with the basic principle of European economic cooperation. As the exchange rates have already been replaced by a single currency, the stability of the euro can only be guaranteed by granting the member states monetary autonomy. The ultimate consequence of this observation is that the European Central Bank would become the only authority in the eurozone with the power to formulate monetary policy. This is the price of stability for the euro. Policy will have to be coordinated: power must be transferred to a single European authority.’
According to Brakman, current public debate on the eurocrisis is too ambiguous. Opponents of the euro often blame the euro’s failure to thrive on huge cultural differences within the euro area. ‘This is a perfectly legitimate argument, but they do not explain what they plan to do. In this respect, they really need to stop mincing their words.’ Brakman thinks that many eurosceptics conveniently forget the turbulent times before the euro, when speculative attacks were made on the French Franc and the Italian Lire. ‘Do eurosceptics want to split the euro into a Neuro (a joint currency for the northern EU member states) and a
(a joint currency for the southern EU member states), or do they intend to introduce floating individual exchange rates? What would the consequences of these actions be?’
It is clear that withdrawing the euro would be an enormously expensive move, although nobody knows exactly how expensive. ‘It’s been estimated that the immediate cost to the Netherlands would be 200 billion euros, simply as the result of a 25% drop in imports and exports.’ If the euro is to survive, it is time that its supporters started pressing the case for more policy coordination. Brakman, himself a supporter: ‘We have no choice if we are serious about continuing the advantages of a single currency.’
Steven Brakman is Professor of International and Monetary Economics in the Faculty of Economics and Business of the University of Groningen. Together with fellow professor of Economics, Harry Garretsen, he recently published an extended version of this argumentation in the form of a chapter for the Jaarboek Overheidsfinanciën (Yearbook of public finance).
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