Monday, November 24, 2014

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.

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    1. CommentedMATTHEW M

      I being just a CPA saw many years ago that a single currency based on exchange rate adjustment was a fool's folly. A common Treasury with common bond authority and a normalized taxing structure rooted in a union/confederation is the only way to structure the EU.

      Why is it just know that renowned economists are saying such?

      Why do we not see anyone talking about all the current EU control mechanisms being called out for the failures that they are? Banks loaded with bad debts due to poor credit management/business practices go to the sovereigns for bailout. Then, the nation and its taxpayers are loaded with toxic debt. Then, the larger nations bail them out, creating the cascade, contagion so feared.

      Take the recent Spain "bailout". Where is the money coming from? the ESM, which does not even exit yet. Who are the funds really going to, recapitalization of the Spanish banks. Or will the banks simply buy Spanish bonds to fund the government.

      And Italy, 20% of the EU gets set up to fail, since it must borrow above 6% but loan out to Spain at 3%????

      Where are the truth tellers?

      The real issue and answer lies in the fact that there is no such thing as free market capitalism anymore. He who took the risk, the banks, are not bearing the loss. In the Eu and in the US. And the FED and ECB and other central banks are aiding and abetting in this criminal manipulation of markets.

      A bank crisis has lead to a sovereign crisis (bankrupting whole countries) and is now headed for a continental crisis, then on to a global one.

      And again, I ask where are the dissenting voices?

      Make those who took the risks suffer the loss and consequences.

    2. CommentedElizabeth Pula

      Short term, and superficial thinking established the EU. The founding of the US union was based on lengthy, probing debate using philosophical, and longterm political principles and thoughts. Of course, it really helped that there was a lot of undeveloped and unsettled free land too. The short-term fixes have a bit of history that prove the short fixes wrong. "Coherent political framework" can not survive based on money/financial factors alone.That coherent political framework also needs some real principled foundation, whether democratic or not. And "labor-mobility criterion" only work to the advantage of certain investing and business groups regardless of effects on populations and any national, or multi-national economies.

    3. Commentedpeter fairley

      Isn't it true that labor laws in many EU countries make rigid, high pay, high benefit 'worker aristocracies' such that employers can't fire their aristocrat workers and hire cheaper immigrant workers from Portugal or anywhere else in the EU?

    4. CommentedOliver R

      It seems to me that regardless of whether or not the Euro area was an optimal currency area upon its conception, it is now too late for any country to back out. The repercussions of a Euro area breakup, although hard to calculate, would most likely be catastrophic. Southern European countries could suffer runs on their banks, forcing them to impose strict requirements on bank withdrawals, which would cripple their economies. Germany and a few other northern European economies would see their exchange rate soar due to their large current account surpluses. And then there is the extremenly difficult process of restablishing national central banks and minting national currencies.
      Although part of the reason for Mrs Merkel's current intrasigence with regards to loosening the noose of austerity surely stems from her desire to retain the support of German voters, will it not be worse for her and her party in the long run if the Euro collapses and Germany suffers as a result?

    5. CommentedHamid Rizvi

      It was a grand idea that sought to take advantage of the power of a financial union in achieving economies of scale. However, in haste the union that was to be was anything but. Any, union that that stipulates a selective set of standards without due regards to the underpinnings and fundamental social, financial and ideological requirements is but a system doomed to collapse of its own dead space.

      There, are many factors besides worker mobility and system of taxation that would need to be integrated across a dissimilar set of groups and people's. History tells us regional loyalties don't necessarily translate into a cohesive integration of any sorts let alone mere currency. It's a pontoon bridge at the mercy of the next big wave!

    6. CommentedRoman Bleifer

      The question is not whether we should sacrifice for the generation of the single currency. There are laws of development, and they are not dependent on whether we like them or not, whether we recognize them or not. The development of multi-variant. Europe can extend the integration and maintain itself as a global center of development. Europe can not do this and become a second-rate province of the world. The first path is the path of development. The second path is the path of expansion and self-destruction. Which of these paths will resolve itself europe Europeans. Europe can now provide a high standard of living due to its leading position. Turned into a province, it will be able to provide a second-rate quality of life of the province. And it will be significantly lower than that of the leading countries and regions. In making its choice, the Europeans have it all taken into account.
      So far, European integration is largely reduced to unification. Enhanced integration potrebtset transfer of certain powers of the center. This can be called some form of confederation. Europe needs to consolidate resources and efforts to solve its problems. Necessary to develop a strategy for the EU budget and turn into an instrument of development, rather than eating up. Europe needs structural reforms in the economy. ( )
      In Europe does not have much time to choose the path of its development. Global crisis will not give a lot of time.

    7. CommentedMichael Griffin

      Periodically, I see suggestions from different people that the EU be broken up into two or more smaller currencies. Given the observations in this article, one has to ask (non-rhetorically) what EU countries get along well enough with each other for membership in one of these currencies to work?

        CommentedMATTHEW M

        Perhaps the real reason for disintegration lies in these EU nations have always been nationalistic and at their root essentially tribal.

        Trying to unite sects, tribes, different cultures, religions, languages with people that have been at war for 1,000 years was a grand experiment that is now unraveling.

        Sharing "money" with historical enemies really is an example of utopian hubris. Thatcher warned as such.

        The question to ask is: who orchestrated the 2008 financial toxicity that will singlehandedly take down Europe (other than UK, our most favored ally, with its own currency and stronger financial system) and crimp China's ambitions?

    8. CommentedColombo Colombo

      I am surprised that such a famous economist as K. Rogoff publishes such an article.

      1. The policy of intra-European workers' flows was already applied during several years by diverse governments, in particular by the UK, officially from 2004. 70 % of the 4 million jobs created between 1994 and 2010 benefited to foreigners according to Duncan Smith (in charge of the work department). The workforce was maybe of "better quality ", but it also reveals the incapacity of the country to improve the professional skills of the working population, although the number of recipients of the "Employment and Support Allowance" (not the "job seekers'a llowance") fell from 1,76 millions to 810 000 between 1997 and 2008. On the other hand, Poland for example certainly took advantage of it and also of facilitated relocations therefore.
      In Germany, the coming of very numerous immigrants from Eastern Europe in the 1990s coincided with a continuous increase in unemployment.
      2. Declared shortages of very qualified workers led the German government in 2011 to allow in turn workers from countries admitted in 2004 without restriction. But Germany still has a rather important reserve workforce, those who alternate between mini-jobs and inactivity.
      Besides, can we imagine that flows from Southern Europe will resolve the problems of these countries ?

      2. Fiscal transfers in favour of several European countries have been very high since their integration in the EU. Spain, Greece and Portugal received for example 87,2 Mrds€ within the "structural funds" and 132,5 Mrds€ within the the European "public funds" over the period 2000-2006. The 10 countries admitted in 2004 received only 15 Mrds€ of "structural funds" and 21 Mrds€ of "public funds", but during the following period, they got a total amount of 185,5 Mrds€ of "structural funds" and 314 Mrds€ of "public funds".

      3. A more integrated political union does not thus seem necessary, in particular since the "Lisbon Treaty". The Gordian knot being the role of the ECB, Germany has actually been trying to protect itself from more integration, however accepting concessions. But what would be the most likely options if decisions were taken by the Council of Ministers with a qualified majority ? Would they be optimal ?

      4. An exchange rate policy is on the contrary required, so much more as the foreign trade is an exclusive domain of the EU, but the € seems to resist all disorders. Then how leading an optimal exchange rate policy ?

    9. CommentedAndrew Cole

      Sometimes the devil is in the detail.
      -The obstacles to freedom of movement are not simply language. There is an institutionalised apartheid in the EU with 3 or more tiers. Most East european members cannot migrate to France/Germany etc but can migrate to places like Sweden or UK.
      - The EU is not a full free trade area. Again France/Germany do not allow other EU ownership of service or energy sectors with a devastating impact on the UK.
      - There are other examples (like the location of key institutions, key personnel in them etc) here but the key point is that a group of nations are overtly cornering benefits for themselves and have broken the political probability of a democtratic union in the process.

      It begs the question does Germany want to lead a complete solution to the euro crisis when any such solution I have seen requires a reduction in the dominant German trade surplus. There is an unpleasant pattern emerging that their leadership wants to prevent a solution.

    10. CommentedKir Komrik

      Thank you for lending your voice to a much needed set of observations regarding the EU. I am dismayed that we are not learning from history and like a rookie using something like a Maastricht Treaty to try to create a political union. You can read all about this at Every ounce of experience in history tells us this cannot work. I was especially relieved by the comment:

      "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"

      Which is a gross understatement. After crossing the Hudson I think General Washington would have agreed. These kinds unions don't work and its elementary knowledge.

      A strong federal construction must exist in Europe for any common currency to work because:
      1.) any viable currency must have the full backing of law.
      2.) no viable currency will last in a legal framework in which symmetry does not exist.
      3.) all of the Masstricht provisions regarding centraliized economic policy are ultimately voluntary, which won't work either.

      The EU needs to act with abandon but deliberation in creating a political, federal union, which is what they should have done to start with.

      This also vindicates my numerous statements regarding the Slaughter Fallacy and how multilateralism and "disaggregated" states are no better a global governance solution than the EU is.

      You can read about this Fallacy at Global leaders need to sit down and have a nice big cup of come back from Oz and take stock of the vast experience we all have which points us to federalism, and imo, to General Federalism.

      The EU will fail if a federal legal system with federal fundamental law is not established very soon.

      - kk

    11. CommentedPascal Lieblich

      It is difficult to achieve significant labor mobility between areas where different languages are spoken. If Europe is serious about working towards greater labor mobility, maybe national authorities should start experimenting with monetary incentives for people to move from a high to a low unemployment area, in lieu of of giving those same people unemployment benefits. That could help, though I am not sure it would result in a happier society.

    12. CommentedZsolt Hermann

      Thank you for the interesting review article.
      Clearly more and more studies, articles are suggesting what looks logical even without deep economical expertise: without a stable foundation the building can easily collapse.
      There cannot exist a stable economical or financial system aiming for any kind of union without an integral, united structure below it, supporting it.
      They say economics are the representation of the relationships in between humans, thus in order for an economical system to function we have to fix human relationships first.
      One of the greatest lessons of the global crisis has been how much we have evolved into a closed, integral, interdependent network, not only in Europe, but all over the world.
      We already have an intermingled, multi level overlapped system, but we still try to ignore it.
      Our day to day lives are already globally intertwined, we consume the same products, soak in the same culture through the same media channels, connect through the same social networks over the internet, and we could continue the examples for pages.
      Our feelings of individual, national identity, the necessity of being separated, isolated is simply psychological fueled by activists, politicians seeking some personal agendas. We do not have to throw away our characteristics, traditions but above them we have to find the common ground we can conduct our global lives on.
      The sooner we accept the global, integral reality of our times, the sooner we can rebuild our global human systems to support a true economical, financial structure, supported by appropriate supra-national political structure.
      But the first step is the understanding of the reality we live in, and how we could adapt t it in a way that can provide a sustainable future for all of us. The rest is easy.