A Centerless Euro Cannot Hold

CAMBRIDGE – With youth unemployment touching 50% in eurozone countries such as Spain and Greece, is a generation being sacrificed for the sake of a single currency that encompasses too diverse a group of countries to be sustainable? If so, does enlarging the euro’s membership really serve Europe’s apparent goal of maximizing economic integration without necessarily achieving full political union?

The good news is that economic research does have a few things to say about whether Europe should have a single currency. The bad news is that it has become increasingly 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 centralized 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 American Economic Review paper “A Theory of Optimum Currency Areas,” Mundell argued that as long as workers could move within a currency region to where the jobs were, the region could afford to forgo the equilibrating mechanism of exchange-rate adjustment. He credited another (future) Nobel Prize winner, James Meade, for having recognized the importance of labor mobility in earlier work, but criticized Meade for interpreting the idea too stringently, especially in the context of Europe’s nascent integration.

Mundell did not emphasize financial crises, but presumably labor mobility is more important today than ever. Not surprisingly, workers are leaving the eurozone’s crisis countries, but not necessarily for its stronger northern region. Instead, Portuguese workers are fleeing to booming former colonies such as Brazil and Macau. Irish workers are leaving in droves to Canada, Australia, and the United States. Spanish workers are streaming into Romania, which until recently had been a major source of agricultural labor in Spain.

Still, if intra-eurozone mobility were anything like Mundell’s ideal, today we would not be seeing 25% unemployment in Spain while Germany’s unemployment rate is below 7%.

Later writers came to recognize 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 late 1960’s that without exchange-rate movements as a shock absorber, a currency union requires fiscal transfers as a way to share risk.

For a normal country, the national income-tax system constitutes a huge automatic stabilizer across regions. In the US, when oil prices go up, incomes in Texas and Montana rise, which means that these states then contribute more tax revenue to the federal budget, thereby helping out the rest of the country. Europe, of course, has no significant centralized tax authority, so this key automatic stabilizer is essentially absent.

Some European academics tried to argue that there was no need for US-like fiscal transfers, because any desired degree of risk sharing can, in theory, be achieved through financial markets. This claim was hugely misguided. Financial markets can be fragile, and they provide little capacity for sharing risk related to labor income, which constitutes the largest part of income in any advanced economy.

Kenen was mainly concerned with short-term transfers to smooth out cyclical bumpiness. But, in a currency union with huge differences in income and development levels, the short term can stretch out for a very long time. Many Germans today rightly feel that any system of fiscal transfers will morph into a permanent feeding tube, much the way that northern Italy has been propping up southern Italy for the last century. Indeed, more than 20 years on, Western Germans still see no end in sight for the bills from German unification.

Later, Maurice Obstfeld pointed out that, in addition to fiscal transfers, a currency union needs clearly defined rules for the lender of last resort. Otherwise, bank runs and debt panics will be rampant. Obstfeld had in mind a bailout mechanism for banks, but it is now abundantly 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 labor-mobility criterion, is that currency unions cannot survive without political legitimacy, most likely involving region-wide popular elections. Europe’s leaders cannot carry out large transfers across countries indefinitely without a coherent European political framework.

European policymakers today often complain that, were it not for the US financial crisis, the eurozone would be doing just fine. Perhaps they are right. But any financial system must be able to withstand shocks, including big ones.

Europe may never be an “optimum” currency area by any standard. But, without further profound political and economic integration – which may not end up including all current eurozone members – the euro may not make it even to the end of this decade.