The European Central Bank Changes Its Spots

The intention was to make the euro a special kind of currency, a sort of European Deutschemark with no need for a government to back it. Monetary sovereignty would reside in a fully independent European Central Bank. Its remit according to the Maastricht Treaty (1992) was strictly reduced to issuing the euro, to managing an area-wide interest rate, and contributing as far as possible to the financial stability of the Eurozone. The ECB was to be a rule-bound institution. Its only obligation was to maintain the purchasing power of its currency. Knowing that repeated budget deficits and continuous accumulation of sovereign debt sooner or later lead the issuer of the currency to print excessive amounts of money, a parallel document, the Stability and Growth Pact (1997) put a limit to member states’ deficits and debt. This transfer of monetary sovereignty to the ECB and the limiting rules accompanying it meant that neither member states nor the European Union could use the euro as an instrument of discretionary economic management. In practice, no devaluation and no inflation imposed a harsh discipline on the Ministers of Finance of the Euro area—a welcome brake on democratic profligacy.

This well-meaning project had its failings, as experience has shown. Some small instrumental changes, especially regarding the over-lenient interest rate policy, would have given the new currency greater stability. But nobody made clear from the start its possible costs in terms of budgetary discipline, structural reform and reduction of entitlements. A pampered electorate should have been told the price to be paid for the great advantage of a stable currency. In sum, the euro could have been a sort of pale replica of the gold standard, aspiring to the solidity of gold but free of gold’s automatic rigidity. Better that than nothing.

An ‘American’ euro

The current crisis has led the European authorities and the Bank to throw away the monetary ideal of rule-bound action, independence from politics and attention to the long run. The ECB is now a lender of last resort not only to the commercial banks in its club but to governments in its area. Far from being independent of politics, it is in continuous consultation and collaboration with European and national authorities. The current president of the ECB has gone so far as to says that the Bank will “do whatever it takes” to save the euro, which markets have understood as creating all the liquidity necessary to stop speculators. Thus, the ECB is now turning itself into a traditional government banker, ready to aid and abet in counter-cyclical monetary management, protectionist exchange rate policy, and ‘controlled’ inflationism.

Euro-enthusiasts would like the euro to be another dollar, not only for the privilege of cashing in the seignorage income of a world currency but also because it would help Europe on the way to becoming a federal country. Whenever the Eurozone authorities show lack of decision in facing some euro crisis, as in the case of Cyprus, the cry goes up that “We need more Europe!”, meaning ‘we need a more federal Europe’. Why not issue Eurobonds along the lines of the American Treasury to replace of so many different euro-denominated national bonds? Many would like the ECB to be turned into another Fed with full capacity for indefinite Quantitative Easing. They sigh for the likes of the United States President, Federal Reserve Chair, and Treasury Secretary to appear together before the media to issue a common policy statement when a crisis arises.

Mundell, the sorcerer’s apprentice

Robert Mundell (1961) is the main author of the theory of monetary unions, on which the blueprint of the euro was based. He made two points: He criticized the reliance on flexible exchange rates to solve a country’s balance of payments difficulties, and he outlined the conditions for successful monetary unions, an arrangement he much preferred to dispersed monetary sovereignties.

His first point is well taken if one wants a world of stable currencies and solid forward contracts. The classical gold standard of the second half of the 19th century was precisely an arrangement of this kind. This was not Mundell’s idea. For him, a single currency was an instrument of political power.

His list of conditions for a well functioning monetary union is really a list of impossibilities in the case of the euro. A single currency could only function optimally in single market, where workers would be ready and able to relocate. If this was not so, it was enough if in places of low productivity, wages and prices were fully flexible downwards. If the EU had made real progress towards becoming a single market, the euro would not find itself in such straits as now.

In a recent lecture, Mundell (2011)1 wants Europe to imitate the beginnings of the monetary and financial union in America after independence. The creation of the dollar as a legal tender currency posed no problems of its own; the states’ debt was the problem. For Mundell, the crisis of the euro is one of fiscal insolvency, to be remedied by a measure of fiscal consolidation, but mainly by merging all European sovereign debt into a single Eurodebt and placing it on the world’s capital markets. This was Alexander Hamilton’s idea in 1792, to issue federal debt for all the states of the Union. The result, notes Mundell, is that the United States has over $5 trillion in debt outstanding around the world today. EU bonds would permit Europe to place perhaps €4 trillion worth of debt and so attend to the needs of Greece, Ireland, Portugal, Spain, Italy and even Cyprus without turning a hair. But Mundell undermines his own argument by quoting Thomas Jefferson in 1810, who said, thinking of Hamilton, “And we were told that the public debt would be a blessing”. Just ask the Americans of 2013.

John Major and the ‘men of system’

The political aim of “an ever closer union” led the framers of the euro to impose a single currency. John Major, then Chancellor of the Exchequer in Lady Thatcher’s Government, proposed launching a common currency to run in competition with national currencies. He called it the “hard ecu”, offering people a choice currency they could freely adopt. It was to be an electronic money to be used in business and tourism. Its value would initially have been equal to a basket of European currencies, but would not depreciate subsequently relative to any member currency, even if one of them lost value. This would have made the ecu as hard as the hardest currency in the basket. Jacques Delors, then President of the Commission, rejected Major’s plan out of hand because he was more interested in the politics of union than in the economics of competition. (Schwartz 2013) The euro would have fared much better as a choice rather than as an imposition.

The euro is the product of men of system, whom Adam Smith so memorably portrayed in his Theory of Moral Sentiments (1759): “The man of system […] seems to imagine that he can arrange the different members of a great society with as much ease as the hand arranges the different pieces upon a chess-board. […] In the great chess-board of human society, every single piece has a principle of its own, altogether different from that which the legislature might chuse to impose upon it.”2

Mundell, Robert A. (1961): “A Theory of Optimum Currency Areas”, American Economic Review, vol. 51, pgs. 657-665.

Mundell, Robert A. (2012): “Making Europe Work”, Lecture at Columbia University, May 24th, 2012. Forthcoming in the Proceedings of the “Global Conference on European Economic Governance in a Global Context”.

Schwartz, Pedro (2013): “Why the Euro Failed and How it Will Survive”. Forthcoming, Cato Journal.

Smith, Adam. The Theory of Moral Sentiments. Indianapolis (Liberty Fund, Inc.), 1984.