Reflections from Europe | MAY 2, 2011
Our Cherished Optimum Currency Area: Its Trials and Tribulations
When its adoption was decided, Milton Friedman gave it but a couple of years before it would collapse. His razor-sharp mind was convinced that a system of sovereign states with independent fiscal regimes, different legislation and imperfectly integrated factor and product markets cannot operate a common currency without getting into an unholy mess that will bring about the breakup of the common currency area.
It is now an accepted fact of history that many of the early advocates of a common currency largely agreed with Friedman's prognosis. They were mostly Christian Democrats or right-leaning Social Democrats, meliorist, mildly corporatist, (as Friedrich Hayek would put it, "constructivist"), no fervent believers in the nation-state and also more than a little jealous of the USA whose power overshadowed the European mosaic of disunited countries. The French contingent of these centrist politicians and intellectuals in addition believed that if there was to be a united Europe, only the French could and would lead it, while the Germans, having lost two cataclysmic world wars and covered with shame for the Holocaust perpetrated in the second, sought forgetfulness and a fresh, non-national start in a united Europe. All had an overt objective: to enhance prosperity, to stimulate economic growth, to have the somewhat laggard Europe catch up with American performance. Joining together in a common currency area would help to achieve this.
Besides the overt purpose, however, the shrewdest among them also had a covert one. Like Friedman, they thought that a currency area without a high degree of economic integration was dysfunctional. Unlike Friedman, however, they did not expect this to lead to an early breakup. Instead, they believed the member countries would almost sub-consciously and step by reluctant step move toward greater economic integration which, in turn, would almost imperceptibly bring about the political integration that was their real goal. As power drifted from national capitals to Brussels (and more recently also to the expensively feathered nest of demagogy at the European Assembly in Strasbourg), a federal but tightly united Europe would emerge.
The cack-handed attempt to accelerate this process by foisting on the member states a singularly inept and verbose European Constitution, a monument to mindless verbosity with the Social Charter apt to undermine the economic advantages of greater unity, was sunk by its defeat in the Dutch and French referendums, that produced the right result for wrong reasons. Five years later the Lisbon Treaty, only a little less damaging, took its place and is causing only a manageable amount of pointless inconvenience. Meanwhile, economic integration is advancing, but the trials and tribulations of a common currency area, lacking anything like the optimum conditions, are outpacing them at what looks like menacing speed.
The exact conditions that warrant two or more (not necessarily contiguous) countries abandoning their separate currencies and adopting a common one have to do with the costs of alternative means of remedial adjustment when the economy of one country gets, so to speak, out of kilter with the other(s). The adjustment may take place automatically or administered by government policy or, of course, a dose of each.
An underlying assumption of the optimum area theory is that the mere fact that two regions are using different currencies reduces trade between them to some significant amount below what it would be if they were in the same currency zone. This effect is due solely to transaction costs being higher if foreign exchange is involved. (It is reasonable to accept this assumption, but very difficult to assess it quantitatively. Some estimates have put the reduction of trade between two contiguous regions of the US and Canada due solely to the two using two different currencies at 30 per cent or more, a number that looks implausibly high). If the region gets into balance of payments trouble, having a separate currency of its own can serve as a means of remedial adjustment either by an automatic decline in the exchange rate if it floats freely, or by devaluation if it is fixed. In either case, the region pays for the luxury of having its separate currency and the means of adjustment the currency provides, by incurring the loss of potentially higher trade—a permanent opportunity cost of currency independence.
The theory postulates that there are other means of adjustment, such as the level of output and employment, downward price and wage flexibility, mobility of capital and labour both geographically and between sectors producing tradable and non-tradable goods and services, as well as shifts in taxes and transfers between regions subject to the same fiscal system. They may be subsumed under the heading of economic integration.
Broadly speaking, if remedial adjustment can be obtained by greater integration at a lower cost than by having a separate currency a region can gain by giving up its own currency, joining a multi-country currency area and strive for ever greater integration with the rest of the area using the same common currency.
Summarily, this was the promise held out by the creation of the euro-zone, starting with 12 countries, expanded to 17 at present and due further to expand as a few more candidate countries manage to satisfy some fairly easy conditions of entry. A good deal of integration was achieved by way of creating a single market in goods though not in services, and in mobility of capital though not of labour. Certain areas of integration, notably the establishment of a high-tax cartel politely called "fiscal harmonisation", are still being fought over.
At its establishment, the euro area was promised durably to raise economic growth by 1 per cent or more, a staggering acceleration destined to change the course of European history. Disappointingly, there is no evidence whatever that this has happened or is due to happen. As may note, with bittersweet irony, that instead of Europe becoming economically more like America, it is America that is straining to become more like Europe, piling on gigantic new welfare entitlements that, like Europe, it cannot or will not pay for and that, like Europe, it cannot stop from pre-empting an ever larger share of the national product.
Why is the optimum currency area failing to deliver the great good that seems implicit in the flawless logic of its theory? The reason, I suggest, is that the theory tacitly assumes that economic policy pursues the same objectives of maximising an area's material wellbeing throughout. Plainly, however, a typical modern government depending for its continuing tenure on the favour of an electorate does not operate under the same constraints in a multi-country currency zone as under its own particular money that it shares with no other country (nor, we may add with a side glance at the USA, when its own money is also the world's foremost common reserve currency).
When Mr. Mitterrand was elected President of France in 1981 and turned the country towards "the morrows that sing", socialism proved its generosity by showering new "social rights" and entitlements all round, raising public spending at a dizzying pace. The balance of payments duly weakened, the markets fled from the franc and the government in 1983 was forced into a spectacular U-turn, moderating its generous financial largesse. (It also blamed France's deficit on Germany's surplus and insisted that it is not the franc that must be devalued, but the deutschmark that must be revalued).
No U-turn of sobriety and discipline is imposed by any one member government of the 17-nation "optimum currency area". The area is a characteristic public choice problem, offering to each of its members a free rider option. Each member government has a strong electoral interest to take the option and ride free in the sense of letting rip both its budget and its balance of payments deficit in order to win the next election. As the effect of one country's free riding is diluted over 16 others, the offending country is not punished by the markets as France was after 1981, and is under no constraint to behave responsibly. The sanctions periodically thought up and brandished by Brussels have so far been simply been ignored and continue to look naive and unenforceable.
The rest, as the saying goes, is history. It is punctuated by "crises", such as the Greek rescue, the Irish rescue and the Portuguese rescue. Whether more are to come, and whether rescuing to gain time before real decisions must at last be taken, is anybody's guess. The zone for now seems to be rearranging itself into two halves, the Latin and Catholic Club Med half and the Teutonic and Protestant-ethic Northern half, the latter carrying the former. Both halves cherish the "optimum currency area," the Club Med half for the protection from market forces and the free rider option it offers, the less happy-go-lucky Northern part, one suspects, mostly because it fears the unknown scenario of a breakup of the area and would rather muddle through than face that. If history teaches us something about the future, it is that it will not bring any clean-cut outcome, but a long succession of trials and tribulations, muddles and fudges.