Thursday, April 24, 2014
Exit from comment view mode. Click to hide this space
1

Europe is Not the United States

CAMBRIDGE – Europe is now struggling with the inevitable adverse consequences of imposing a single currency on a very heterogeneous collection of countries. But the budget crisis in Greece and the risk of insolvency in Italy and Spain are just part of the problem caused by the single currency. The fragility of the major European banks, high unemployment rates, and the large intra-European trade imbalance (Germany’s $200 billion current-account surplus versus the combined $300 billion current-account deficit in the rest of the eurozone) also reflect the use of the euro.

European politicians who insisted on introducing the euro in 1999 ignored the warnings of economists who predicted that a single currency for all of Europe would create serious problems. The euro’s advocates were focused on the goal of European political integration, and saw the single currency as part of the process of creating a sense of political community in Europe. They rallied popular support with the slogan “One Market, One Money,” arguing that the free-trade area created by the European Union would succeed only with a single currency.

Neither history nor economic logic supported that view. Indeed, EU trade functions well, despite the fact that only 17 of the Union’s 27 members use the euro.

But the key argument made by European officials and other defenders of the euro has been that, because a single currency works well in the United States, it should also work well in Europe. After all, both are large, continental, and diverse economies. But that argument overlooks three important differences between the US and Europe.

First, the US is effectively a single labor market, with workers moving from areas of high and rising unemployment to places where jobs are more plentiful. In Europe, national labor markets are effectively separated by barriers of language, culture, religion, union membership, and social-insurance systems.

To be sure, some workers in Europe do migrate. In the absence of the high degree of mobility seen in the US, however, overall unemployment can be lowered only if high-unemployment countries can ease monetary policy, an option precluded by the single currency.

A second important difference is that the US has a centralized fiscal system. Individuals and businesses pay the majority of their taxes to the federal government in Washington, rather than to their state (or local) authorities.

When a US state’s economic activity slows relative to the rest of the country, the taxes that its individuals and businesses pay to the federal government decline, and the funds that it receives from the federal government (for unemployment benefits and other transfer programs) increase. Roughly speaking, each dollar of GDP decline in a state like Massachusetts or Ohio triggers changes in taxes and transfers that offset about 40 cents of that drop, providing a substantial fiscal stimulus.

There is no comparable offset in Europe, where taxes are almost exclusively paid to, and transfers received from, national governments. The EU’s Maastricht Treaty specifically reserves this tax-and-transfer authority to the member states, a reflection of Europeans’ unwillingness to transfer funds to other countries’ people in the way that Americans are willing to do among people in different states.

The third important difference is that all US states are required by their constitutions to balance their annual operating budgets. While “rainy day” funds that accumulate in boom years are used to deal with temporary revenue shortfalls, the states’ “general obligation” borrowing is limited to capital projects like roads and schools. Even a state like California, seen by many as a poster child for fiscal profligacy, now has an annual budget deficit of just 1% of its GDP and a general obligation debt of just 4% of GDP.

These limits on state-level budget deficits are a logical implication of the fact that US states cannot create money to fill fiscal gaps. These constitutional rules prevent the kind of deficit and debt problems that have beset the eurozone, where capital markets ignored individual countries’ lack of monetary independence.

None of these features of the US economy would develop in Europe even if the eurozone evolved into a more explicitly political union. Although the form of political union advocated by Germany and others remains vague, it would not involve centralized revenue collection, as in the US, because that would place a greater burden on German taxpayers to finance government programs in other countries. Nor would political union enhance labor mobility within the eurozone, overcome the problems caused by imposing a common monetary policy on countries with different cyclical conditions, or improve the trade performance of countries that cannot devalue their exchange rates to regain competitiveness.

The most likely effect of strengthening political union in the eurozone would be to give Germany the power to control the other members’ budgets and prescribe changes in their taxes and spending. This formal transfer of sovereignty would only increase the tensions and conflicts that already exist between Germany and other EU countries.

Exit from comment view mode. Click to hide this space
Hide Comments Hide Comments Read Comments (1)

Please login or register to post a comment

  1. Commentedparthasarathy Shakkottai

    An excellent article.
    “Koo suggests a form of quasi-monetary sovereignty. One way to solve this eurozone-specific problem of capital shifts would be to prohibit member nations from selling government bonds to investors from other countries. Allowing only the citizens of a nation to hold that government’s debt would, for example, prevent the investment of Greek savings in German government debt. Most of the Greek savings that have been used to buy other countries’ government debt would therefore return to Greece. This would push Greek government bond yields down to the levels observed in the U.S. and the U.K., thereby helping the Greek government implement the fiscal stimulus required during a balance sheet recession.
    The Maastricht Treaty with its rigid 3 percent GDP limit on budget deficits made no provision for balance sheet recessions which last quite a few years. This is understandable given that the concept of balance sheet recessions did not exist when the Treaty was being negotiated in the 1990s. In contrast, the proposed new rule would allow individual governments to pursue autonomous fiscal policies within its constraint. In effect, governments could run larger deficits as long as they could persuade citizens to hold their debt. This would both instill discipline and provide flexibility to individual governments. German banks should still be allowed to buy Greek private sector debt, and Spanish banks should still be allowed to buy Dutch shares.
    http://www.paecon.net/PAEReview/issue58/Koo58.pdf”
    Koo uses Spain instead of Greece in his text but that should make no difference to the concept. Relaxing the stringent balance requirement would allow Koo's suggestion to work.
    Please comment on this suggestion.

Featured