FOR a long time it was taboo to suggest the Eurozone would collapse – now people write and talk of little else. Currency break-up is inevitable, but despite the twists and turns a workable solution isn’t in sight. Although it’s impossible to predict the precise outcome, previous monetary unions offer insights into what went wrong and how things could develop once the dust settles.
As an enthusiast for closer economic relations within Europe, I helped prepare the way for European monetary union (EMU). The disappointing 1995 Green Paper led to the euro being introduced without a bailout rule, but no provision for exit; a Stability and Growth Pact, but no means of enforcing it; a legal structure, which blocks any solution; and no provision whatsoever for dealing with asymmetric shocks. I did not know when and in what form the crisis would come – but it was certain.
It came sooner than I expected, precipitated by the more general crisis, but caused by the convergence of interest rates. The apparent benefit of cheap credit to the weaker countries proved to be a dangerous trap, leading to over-borrowing in Greece and an unsustainable property bubble in Ireland.
There have since been a series of botched initiatives. The European Financial Stability Fund aimed to package lower grade (sub prime) debt into tranches to achieve AAA status. Financial markets have short memories, but not that short. Eurobonds collectively guaranteed by member states would also fail to have the rating assumed: indeed, several countries have since been downgraded. The idea of a fiscal union is half-baked: falling short politically, but going beyond economically, a true federal union. Fiscal discipline will mean in practice cutting expenditure and the only real alternative to devaluation is deflation, which is working fairly well in Ireland, but would cause a massive recession in the whole of the EU.
As such, we are heading for a two-speed Europe. Some countries, under the leadership of Germany will form a closer union, with others opting out of the euro, defaulting, reconstructing their debt and or devaluing.
Learning from unions
Most of the interesting previous monetary unions – the Soviet Union, Austria Hungary, the former Yugoslavia – collapsed at a time of hyper-inflation. But there are useful lessons from two other unions: Bretton Woods and the Sterling area.
The Bretton Woods approach involved initially fixed exchange rates bolstered by international transfers negotiated by the International Monetary Fund (IMF), but with the right – and indeed the obligation – to change the rate when there was a fundamental disequilibrium. There were many examples of this – often in Latin America. The original design of EMU should have included such a workable proposal for exit. The question is: can we revert to this? The essential first step is to make it absolutely clear that each member state is responsible for its own debts. They could then make their own arrangements, on the classic gold standard procedures, for maintaining external balance, and there could be a “living will” procedure for dealing with the inevitable occasional default in a less damaging way. Convergence would cease to be an intelligent tactic for investors – if it ever was – and interest rates on each country’s debt would reflect investor perception of its government actions, giving early warning of trouble.
The Sterling area, being informal, worked well for many years, but because of that, quietly fell apart when it became less relevant. The only monetary authority was the Bank of England. Others had neither any say in UK monetary policy, nor – after they ceased to be colonies – any obligation to follow it. But they had, in the area’s heyday, strong incentives to remain in the club, which had substantial benefits, including freedom from exchange control.
The early leavers, such as New Zealand, introduced its own currency without any immediate or expected change in parity. This arrangement had some similarities to the Currency Boards used in the old colonies, which could be an alternative for smaller EU members.
The same result could have been achieved economically – but certainly not politically – by countries accepting Germany’s Bundesbank as the monetary authority, voluntarily adopting their currency. This is what Estonia did very successfully. Note issues and the monetary base would be the responsibility of the Central Bank or Currency Board of the country concerned.
Countries which leave the Eurozone and others – even outside the EU – might well find that the new euro becomes widely used as a secondary currency, creating the partial advantages of our old 1989 proposal to introduce a “basket European currency unit” as a secondary currency. It may even become the currency of choice for internal contracts; a role the US dollar once had. This might reach the stage when they would accept “euroisation” and partly or wholly abandon their own currencies.
John Chown is principal in Chown Dewhurst and a co-founder of the Institute for Fiscal Studies. He discusses the themes of this article in more detail in a paper released today by the Adam Smith Institute: The Future of European Monetary Union.