When the Euro was introduced, many analysts predicted that centralizing monetary policy over such an economically diverse area would make the common currency unsustainable and prone to financial collapse. Why they were right, why they’re being ignored, and what must be done about it.
In 1999, when the Euro was introduced into circulation, economists were divided as to whether or not the monetary union would be a lucrative alternative to the patchwork of national currencies that had covered western Europe up to that point.
On the pro-integration side of the spectrum, economists posited several reasons for their support of the Eurozone. Among the justifications was the fact that individual states would no longer be able to competitively devalue their own currencies at the expense of the EU as a whole. At the same time, the cost of exchanging currencies would be completely mitigated, as would much of the risk of investment across European borders.
The Eurozone dissenters, on the other hand, advanced a series of arguments roughly based on the economic theory of the “Optimal Currency Area” (OCA), coined by economist Robert Mundell. According to the principles of the OCA, a few quantitative preconditions exist for nations before they can efficiently share a common currency. Included in these preconditions are labor mobility, capital mobility, fiscal integration, and the similarity of business cycles throughout the region. As the European Union has grown increasingly integrated, capital has begun to flow freely across national boundaries, while labor has proved to be a bit more stubborn. Fiscal integration is limited, but existent and continually expanding through risk-sharing mechanisms such as the European Financial Stability Facility (EFSF). Business cycles in the Eurozone, however, are in no way synchronized.
European currency unionization has always had these theoretical pros and cons. In practice, however, the implementation of the common currency at first seemed to be a resounding success. It was when the PIIGS started to buckle under their own weight in 2008 that the logic of the Eurozone dissenters exposed the inherent weaknesses of the union. In fact, the underlying problems that the Eurozone faces now are, by and large, exactly those problems that original skeptics had predicted.
At the center of the skeptics’ arguments was the OCA belief that a common currency zone can only function when there is a consistent business cycle throughout the region. The Eurozone can hardly be said to meet this condition. Finnish Lapland, after all, does not grow and shrink at the same rate as Mallorca.
How is this violation of the OCA relevant? It comes down to this: since the advent of the Euro, monetary policy has been, out of necessity, centralized. Interests rates and all other monetary instruments are now vested in the European Central Bank (ECB), which can basically be viewed as a slightly less powerful European equivalent to the Federal Reserve. By controlling the money supply, central banks strive to jumpstart stagnant economies, or pop speculative bubbles in economies experiencing unsustainable growth. In 2007, before the financial meltdown, Spain, Greece, and Ireland were all experiencing massive real estate speculation that fueled growth in their increasingly unproductive economies. Directly after the introduction of the Euro in these countries, borrowing and consumption had skyrocketed to unsustainable levels. To make matters worse, national governments had just been stripped of their abilities to make corrective actions through the adjustment of interest rates. Meanwhile, the rest of the Eurozone was widely experiencing relatively modest, stable, export-led growth. When the market bubbles burst in 2008, the speculation-based economies in the PIIGS were sent into a downward spiral that the necessarily universal policies of the ECB failed to even partially mitigate through monetary policy. The effects of this failed monetary policy were especially acute in the cushy mixed economies of southern Europe, where needed austerity measures in the public sector added to the private sector woes. In mid-2007, directly preceding the financial crisis, booming, unsustainable economies such as Ireland and Spain had been operating under significantly lower interest rates than those of the United States, despite growing at a much quicker pace and in a much more speculatively based manner. This does not represent a policy failure by the ECB. It represents a structural problem within the Eurozone, in which the central bank is charged with the impossible task of setting interest rates for widely divergent economies. As the theories of the OCA had forewarned around the turn of the millennium, a lack of business-cycle cohesion throughout a currency union can and will have disastrous consequences.
It is inconvenient for EU leaders and fervently pro-European analysts to examine the flaws of centralized monetary policy, even though this issue has always been central to the economic debate. The preservation of the Eurozone is seen by many as a vital component to the unity of the EU, and thus continued fiscal integration is often seen as a way to save the Euro while fending off the creeping Euroskepticism that has begun to slowly take root on the continent. As a result, politicians and political economists have found it easier to create ever more complex means of fiscal integration in the Eurozone. These solutions will always be overshadowed, however, by the fact that monetary policy is and always will be severely ineffective over such a diverse economic area.
Despite these flaws in the Eurozone, dreams of currency unionization need not be scrapped altogether. Germany could easily share a currency with relatively stable countries such as Austria, Luxembourg, and the Netherlands. Likewise, France and Italy could be arguably decent candidates for a small-scale monetary union. The scope of the currency union, however, must be scaled back or divided up into areas that share business cycles in at least a basic sense.
It’s time to stop ignoring the economic debates that sprung up upon the proposition and introduction of the Euro. Common currencies are not meant for universal and expanding application; in the end, as the OCA implies, they must be separated into sensible, logical economic units, even if this sensibility comes at the expense of continued European integration. Perhaps just as important as the theory behind the Eurozone, however, will prove to be the practical ability of EU leaders and policymakers to separate into independent categories, the cold rationalism of the dismal science and the qualitative principles of European unity.
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