Winner of the New Statesman SPERI Prize in Political Economy 2016

Sunday 24 February 2013

Is a monetary union without fiscal/political union doomed?

This seems to be a very common view at the moment. The view that the Eurozone will have to move to fiscal union, which implies some form of political union, comes from two directions.

1) Those working in the political unions that are the United States or the United Kingdom, know combined monetary and fiscal unions can work. From this perspective, the monetary only union of the Eurozone was a largely untried experiment, and it appears to be failing. (For just one example of this view, see Acemoglu and Robinson here.) Let me rephrase that: it is failing. The perpetual crisis of the markets may be over as a result of OMT [1], but the crisis that is unemployment in the periphery just gets worse. (Kevin O’Rourke puts it bluntly but accurately here.)

2) Within the Eurozone itself, there has always been a powerful lobby for further integration. It is therefore not surprising that actors like the Commission see further integration as the longer term solution to the Eurozone’s problems.

Yet we should be very cautious about making generalisations from a single observation. It may be worth reminding ourselves about why the Eurozone has not been a fair test of monetary union without fiscal union:

The crisis of competitiveness was partly a result of a mistaken belief in the market that default risk on everyone’s debt was similar to German debt, a mistake that is unlikely to occur again in decades. In the years before the recession, no attempt was made to use fiscal policy to offset overheating in periphery countries. (For more on why countercyclical policy is key, see Antonio Fatas here.)

2) In probably only one case, Greece, was there a clear problem of underlying fiscal excess. Yet instead of recognising the need for default early on, the union made a futile attempt to avoid it by replacing private debt with intergovernmental lending, which had disastrous consequences. This major and avoidable error produced the worst moment of the crisis, when Greece was threatened with exit. It continues to impose a disastrous degree of austerity on Greece.

3) The fiscal position of other Eurozone economies became critical because the ECB refused to act as a lender of last resort. If the ECB had introduced its OMT programme two years earlier than it did, the crisis might well have dissipated very quickly. This is hardly wisdom from hindsight, as anyone reading Paul De Grauwe (or indeed this blog) will know. Market reaction always had much more to do with the ECB than the fiscal position of the countries involved, an observation that inspired my first blog post and which research confirms.

4) The current double dip recession in the Eurozone is largely about a collective failure of fiscal and monetary policy. The position of the Eurozone would look significantly better if the ECB acted more like the US Fed, and if Germany and other fiscally untroubled economies were less obsessed with austerity. Neither has much to do with the absence of fiscal union.

To use evidence from one very badly designed test case to condemn the whole concept of  monetary union without political union is far too hasty. It is also potentially very dangerous. We should not forget that monetary union itself was encouraged by a belief that the fixed exchange rate regime that preceded EMU was untenable because of market pressure. (For more on the origins of the Euro see Harold James here.) The lesson of Eurozone failure so far is mainly about bad design, rather than disproof of concept. If this failure leads to a fiscal and monetary union imposed from above on an unwilling electorate, by an elite that played such a big part in creating the current failure, we may go on to find out that a badly conceived political union could be even more disastrous than a badly designed monetary union.

[1] The ECB’s programme to become a conditional lender of last resort


  1. > Within the Eurozone itself, there has always been a powerful lobby for further integration.

    There are all sorts of monied interests that share the interest, but alas, no consumer - except perhaps some free rider - who ought to desire the same.
    By kleptocracy, of kleptocracy and for kleptocracy.

  2. A monetary union without fiscal union is predictably unstable and for very understandable reasons, that one size monetary policy does not fit all.

    And so it has been shown in the Eurozone.

    I suppose that is how you define 'worked.' It works for some, just like justice, these days.

  3. "We should not forget that monetary union itself was encouraged by a belief that the fixed exchange rate regime that preceded EMU was untenable because of market pressure."
    This failure was proof that the Euro was not ready for prime time. These pressures could not disappear just because they were camouflaged. Euro should have been a recognition that over a few business cycles, the participating economies had proved to be so correlated that there was a de facto fixed exchange rate between them and that it was time to give a common name to what was now a single currency. Of course, at that point, it would have made no difference whether you keep multiple names or only one...

  4. "The crisis of competitiveness was partly a result of a mistaken belief in the market that default risk on everyone’s debt was similar to German debt, ..."

    I would put this differently. Before the euro was introduced, wide spreads in sovereign debt yields showed that the market was pricing something correctly, but what? I don't think it was so much literal default risk, as exchange rate risk. Some European countries had persistently higher wage/price inflation than others, so they paid higher nominal yields. It's just Fisher's Rule.

    What the markets really got wrong post the introduction of the euro wasn't so much default risk pricing as the belief that wage/price inflation would converge across the euro-zone. In other words they bought into the magical thinking that says that sharing a currency with Germany will make you more German.

    In reality, as I think we know, it takes a strong economy to run a strong currency. A strong currency doesn't make your economy strong. In fact, if you have high "folk" expectations of wage/price inflation, leading to high nominal wage settlements, while Germany has an obsessive "folk" fear of inflation, and acts accordingly, a shared currency is going to be a disaster.

    So I would go far further than this columnist. The common currency really is a flawed concept so long as different participants have differing expectations of wage/price inflation and the freedom to indulge them. To persist with a common currency ignores a bit too much reality.

  5. You have to make a distinction between the EZ in its current form and in general or more specific the former larger DM zone.

    1. First problem is things have completely ran out of control. It is much more difficult to bring order in the huge mess it is in than set up things from the start.
    2. Larger DM zone worked well. Not only because economies were more similar (important but not the only factor). Countries will simply stick to their obligations. Something the South (incl France) always had more problems with. If all countries had stuck to Maastricht. Italy at least would not have been in this position. And the rest of the PIIGS would most likely be much better off.
    3. You approach this issue again (wrongly) as a typical economist. This is primarily a political issue in the EZ (and likley would be in any new single currency zone).
    A political union whatever the incompetents dealing with the matter state is simply at least as unsustainable as the monetaty union now.
    No way the South will become accountable in a Northern way, no way the North will allow long term transfers ala to Southern Italy and Spain to take place. There is not a popular platform in neither of the two. And it simply doesnot look there will be any in my lifetime. It simply fall apart with the next election (and if not with the one after that).
    4. Role ECB. It is simply set up to avoid transfers in any form (direct/indirect; implicit(via CB)/explicit).
    This is the only way a monetary union is basically acceptable with the populations.
    So it is simple stick to that or the union will come under stress and if it is long term and clearly visible stress it most likely will fall apart.
    5. The EZ can only work if member countries keep out of trouble (and donot look to drop the bill with somebody else as it looks now). Half of the union stepped over that line.
    Look at Italy >50% is now Euro-sceptic and this is a country that basically caused the problems themselves. 120% debt; red tape galore; corruption/inefficient government; North/South divide for more than a century, all without properly adressing things.
    6. Another issue is that enforcing it against countries will appears to be not working and a transfer of powers to a central whatever seems politically totally unacceptable.

    The main issue is political and you should start from there. That gives the limitations for the solutions. Assuming that everything will go is simply completely denying political reality.
    Simply looks that what is necessary to solve the crisis and make it work in the future is politically not possible. So they have a problem and a huge one.
    -Population will not turn. They are Euro-sceptic and increasingly so and caused by a lousy economy (that likley will remain that way). Warnshots have been given and politics still went along (which means that next times in the ballotbox it is likley Euro-sceptic) (and not only in the polls).
    -Structure is institutionally unstable. For a political union ALL need to agree, if one says no there is a huge problem (like with 17 countries with huge conflicts of interest).


Unfortunately because of spam with embedded links (which then flag up warnings about the whole site on some browsers), I have to personally moderate all comments. As a result, your comment may not appear for some time. In addition, I cannot publish comments with links to websites because it takes too much time to check whether these sites are legitimate.