I’ve been quite perturbed that most analyses of the Eurocrisis is done by politicians and doomsayer journalists to the extent that most of the content out there centers on the least likely events and fails to capture the spirit of the intellectual debate. Nice thing about blogs is that you can make things as complicated as you like, though in this case I will restrict myself and not use formulas or graphs for the sake of clarity.
Some helpful background
Devaluation is used as a mechanism to reduce real wages. The reason devaluation works is that workers fail to notice or respond to the inflation by raising their money wage demands. If wages were all tied to inflation(also known as indexation), as many multinationals do, the process would not work, and if some did and others didn’t, the process would disproportionately affect those without this adjustment. This power of devaluation is much more prominent the more the cost of living is reliant on the outside world and hence more likely to provoke a response from the labour force. From that point of view this makes the case for much larger currency areas since devaluation is possible without provoking a response. Devaluation can occur not only through monetary means but also by decreasing the cost of doing business which includes a decrease in taxation levels;
The benefits of monetary union
These are microeconomic in nature and involve helping out small firms remain competitive as well as alleviating consumer burdens.
The first benefit is a reduced transaction cost. Though fees on large currency transactions are quite small, currency turnover is extremely high, so cumulative costs can be higher than one might imagine. Although it’s easy to say that the transaction cost of a single currency is reduced, it is possible to overestimate the magnitude by which this is so. This mistake might be enabled by ignoring the fact that not all foreign currency loans are simply hedging exchange rate risk, indeed some of these are favourable because the foreign loans have a lower interest rate. Even so the reasons for this lower financing rate could not be related to the exchange rates whatsoever, an example of which is a multinational borrowing in the domestic market because its reputational capital can be leveraged into higher credit ratings. Additionally many of the potential perceived costs of foreign trade are simply rents extracted by financial institutions exploiting their economies of scale. This allocation of resources not only has an opportunity cost in terms of human labour but also causes inequality between industries by funneling money into finance.
As an example let’s consider a bid-ask spread (buying versus selling currency) of 0.05%. To the individual this might seem insignificant, but this is a very deceptive way of analysing the situation. Given that 600 billion in currency transactions take place in London, such a spread would represent 300million in costs per day. Even so, this element is frequently ignored by politicians because the savings might be negligible from the narrow view of an individual country, especially since a great proportion of the trading is done on behalf of foreign principals, this means that although monetary union would be a considerable savings cost, the UK perceives it as a booming export sector. Even so, the savings potential from a UK resident’s perspective of an EMU would be limited to transactions within the Eurozone. Academic estimates with all this taken into account estimate that the cost savings in transaction costs would be about 1% of EU income.
Foreign flows being converted into a common currency for the consolidated balance sheet inherently introduce greater variability in forecasts of share prices and increases capital market volatility.
When evaluating risks of currency splitting we must be able to partition the arguments for what it does and doesn’t do. Any individual entrepreneur is likely to be less enthusiastic of any prospect if an additional risk of currency fluctuation is introduced. However when dealing with multinational firms this risk is not necessarily as large as it appears since a true multinational would have flows in both currencies and opportunities to finance from institutions in both currencies and so the risk is likely to be overstated if we just look at the variance of the exchange rate. If the company has accurate forecasts of these future cash flows it may even hedge, but this is a return to the previous point that this process funnels money into the financial industry. Perhaps most importantly we may overstate the cost of the currency risk because even if the foreign currency value does depreciate, this will be partially offset by the fact that the foreign production will become more competitive and in the process, increasing prospective cash flows. However these options are not present for smaller companies, which have to rely on financial institutions ability to mimic these advantages and generally are likely to reduce competitive forces within the economy since it offers more than just an economy of scale advantage to bigger firms.
Insulation from monetary disturbances and reduced political pressure
Given multiple currencies, it’s possible that the domestic prices are sticky (don’t adjust fast enough). This stickiness might lead to unnecessary and temporary fluctuations in the real exchange rate due to speculative bubbles.
Finally without the option of protectionist policies from myopic politicians, we reap the benefits from the most agreed upon economic policy of all: free trade.
Costs of monetary union
These are macroeconomic in nature (more about patterns of adjustment to disequilibrium) and would hence be up for rigorous debate. Some schools of thought, like the Austrian school of economics might even dismiss them completely and blame this thinking for the business cycle by enabling the allocating of resources to be done in a manner that does not reflect the preference of consumers, implying an inevitable crisis.
This is perhaps the main cost being referred to. Currency union makes regions less able to respond to macroeconomic imbalances through specific monetary policy. This belief is mostly credible in the monetarist sphere of thought since fiscal stabilization is a very plausible alternative to most interventionists (and perhaps the only choice when interest rates hit the zero bound, ignoring of course the more unorthodox methods being suggested).
Monetary flexibility also includes financing government spending via inflation, by reducing the burden of public debt (e.g. if your currency is worth less, government bonds are worth less and easier to pay back). Though some would question such indirect measures of taxation as not being transparent it is an important option for extreme times such as wars. However EU wide tax and transfer systems reduce the need for this. Similarly seigniorage revenue in a common currency area (the ability of new money to buy goods and services) would need to split in very equitable ways.
Labour mobility is king
These arguments are all rendered irrelevant by one thing, a sufficiently high labour mobility (people willing to move across the currency zone).
To give an example lets imagine the price level dropped in a country by 10% and that foreign goods are responsible for 50% of the cost of living, so real wages have increased by 50*10%=5%(since you can now afford your previous lifestyle with less money). However given that the people can now buy more but their productivity has not changed this will make firms less competitive and apply downward pressure on the economy which will increase unemployment, bankruptcies and so forth. With sufficient labour mobility, employment will be restored without transitional unemployment because people will fleet to the new high wage country until the supply of people brings wages back to equilibrium.
The question as to how the existence of labour mobility comes about is of course a different one. Although Economists usually perceive it as a requirement for an optimal currency area, it is likely that action must first be taken to increase the labour mobility. Indeed since the Euro was introduced an increase of labour mobility has occurred within the Eurozone and the crisis has further fuelled this trend.
However it is obviously still insufficient and more could be done to encourage this trend, reforms to this end would include: a single language being used in business, transferable pensions, lower transportation costs(from country to country), standardized unemployment benefits, common legal systems…etc; This encouragement is not only important for Europe but also for the US where empirical estimates show that about six years are required for labour mobility to substitute the failure of wage levels to fall. From this point of view you could argue that even the US should be a candidate for monetary disintegration. I would also add that policies that encourage home ownership, which are taken by most governments are likely to reduce labour mobility.
Of course there is also the matter that entering a common currency usually leaves countries open to speculative attacks by investors. Though this has already been experienced by the EU in the early 1990s and paying any attention to this now is merely a sunk cost fallacy.
Expectations and Politics
Fixed exchange rates could theoretically offer many of the benefits of union without the costs. Though the assumption here is that the countries can keep this indefinitely, and if it would have been done indefinitely they would have just joined the monetary union. So in practice fixed exchange rates have a problem of credibility, how long will they keep doing this? In some cases the market will use immense capital to attack these fixed exchange rates and break down the regime.
Although this analysis is economic, it is impossible to ignore the effects of political framing on the markets. From the very outset the framing of North versus South has had an enormous influence on the markets and has greatly impeded the ability of governments to take action. When it was presented that the crisis is a result of Greek fraudulence and profligacy, it becomes difficult to aid them from a political point of view. If the crisis was framed in terms of economic interdependence and not of morality aka, helping the lazy Greek (some economists disagree with that stereotype) it is likely that bond spreads within the EU would not be as high as they are now and more credibility could have been given to weaker governments, as it is now stronger governments are able to retain market confidence. The more these benefits are spread out, the more consumers of these advantaged countries will lose out in terms of an increase in cost of living.
The idea that monetary union requires fiscal union has been spouted enough but it doesn’t go far enough. In addition to the measures that would encourage labour mobility, common deposit insurance, financial regulation, true lender of last resort abilities from the ECB and a federal constitution that overrides state power would all go a long way to unifying Europe.
Of course in ordinary times it is true that countries are able to borrow more than they would have otherwise due to the credibility of their neighbours, creating an incentive for governments to be unsustainable. In turn this increased spending creates inflation and boosts real wages (and hence, standard of living) to levels that don’t reflect the competitiveness of the country.
However, in another light all this talk about restricting countries from defaulting and requiring German taxpayers to bail out other sovereigns is nonsense. US states and local governments have defaulted in the past as John H. Cochrane’s puts it: “A currency is simply a unit of value, as meters are units of length. If the Greeks had skimped on the olive oil in a litter bottle, that wouldn’t threaten the metric system.” Too much is done to enable bailouts either in more direct manners (ECB buying government bonds in the secondary markets) or indirectly (ECB lending to banks that lend money to the governments), which is not helping sustainability and will require hoards of EU taxes to fix or the Euro will be inflated away.
Governments and the ECB have been pressuring banks to keep buying their debts, the ECB is more of culprit since it gives conditional liquidity injections. These banks become more and more dangerous as this effect continues, Cyprus’s recent bank troubles are but a demonstration of this instability.
We could possibly kick the can down the road with just more bailouts but eventually wishful thinking will end and the true choices will emerge.
One of these is fiscal and monetary union, federal government issuing controls on government budgets and allowing for some of the above frictions for labour mobility to be eliminated.
The other is monetary union only, this would mean governments need to be able to default like companies, and banks would be allowed to treat sovereign debt like any other debt (something BASEL 3 doesn’t help with).
And the most costly option is the breakup, probably after a crisis and inflation. This would be seriously debilitating to all contracts that would have to be converted to a currency that doesn’t exist and would lead to immense capital flight and economic damage. Once again in the words of Cochrane: “The euro, like the meter, is a great idea. Throwing it away would be a real and needless tragedy.”