Pandemic could save ‘half-baked’ European monetary union

January 15, 2021

The pandemic might save the euro. (Unsplash/Marek Studzinski)

The first two decades of a single European currency have been marred by economic disparities, instability and crisis, but the coronavirus pandemic's economic fallout provides an opportunity for the European Union to strengthen its monetary union with more robust fiscal policies, a former Greek finance minister and his co-author claim in a new paper.

The biggest issue, the researchers said in a new paper published in the Journal of Applied Corporate Finance, is that the "politically motivated launch of the euro" in 1999 never met the requirements of an "optimal currency area," a term used by economists to determine whether a group of geographically contiguous countries or regions should adopt a single currency. 

Typical requirements of an optimal currency area include economies with similar economic structures that are closely intertwined through trade and have "significant mobility" of capital and labor, the economists wrote. The regions also should be linked though "a significant federal budget" that can act as a shock absorber if significant economic disparities occur.

"To me, the single currency, it's a great idea, but it came in early and it was half-baked," said Laurent Jacque, professor at Tufts University and a co-author of the research. "Because we did the monetary union, but we never did the fiscal union. And until we do a fiscal union, the monetary union is going to be very hard to keep afloat."

The United States is the longest-surviving, and most successful, example of a well-functioning currency area because of its fiscal union, the researchers wrote. At its core, fiscal policy has three parts: the ability to spend money, the ability to tax and the ability to finance gaps between expenditures and revenues. 

The European Union, by contrast, has very limited taxing power, does not have the power to make fiscal transfers that could smooth out national economic shocks and has little control over European budgets.

"Until we do a fiscal union, the monetary union is going to be very hard to keep afloat, because we have disparities" Jacque said. "One country runs a budget deficit of 5% of GDP and has unemployment or inflation of X percent, and those countries move in different directions."

Though the euro was established in 1999, these faults were baked in even before the Maastricht treaty, the 1992 agreement that set the European Union on the path toward a monetary union, according to Jacque and his co-author George Alogoskoufis, professor at the Athens University of Economics and Business and Greek finance minister between 2004 and 2009. 

In 1979, the European Economic Community, a predecessor to the European Union, established the European Money System, in the hopes of reducing exchange rate variability, limiting macroeconomic asymmetries and fostering monetary stability, but higher than anticipated exchange rate volatility, national interest rates and inflation rates caused the system to fall apart.

When the euro was launched in 1999, though, economic gaps between the "core" countries, including Germany and France, and "periphery" countries, such as Spain, Greece and Italy, had only been partly reduced, and lessons learned from the European Monetary System were ignored.

"The disparities, what we call the asymmetries, were never corrected," Jacque said. "They've been there all along. We knew that they will not disappear with a single currency because we don't have mobility of labor … and these are the ways in an optimal currency area, as we describe in the paper, that those things are corrected."

Building a fiscal union, Jacque said, is potentially doable but comes with great political risk, as European countries are unlikely to cede their discretion over taxes and spending easily. 

"That's the challenge of a fiscal union, is that you have to give up your right to collect taxes and spend it to the best possible use in the context of the European Union, which is big," Jacque said.

With the onset COVID-19, however, the European Union created a €750 billion economic recovery package backed by the credit of its member states, with the majority of the funds — €390 billion — distributed as grants to the most impacted countries.

"For the first time, there was a European agreement to say, 'We've got to do something,' which from the fiscal point of view, we've never seen before," Jacque said.

Though much more work is left to be done — potential steps include mutualizing national sovereign debts, establishing a central electoral calendar and harmonizing tax rates — Jacque said the pandemic relief package is a step in the right direction.

Without a common fiscal policy for the eurozone, Jacque and Alogoskoufis wrote, "Creeping pauperization will increasingly fuel Europhobia and could unleash political mayhem." Jacque told The Academic Times he's concerned that the economic toll of the single currency is building up a fringe of the population that increasingly feels left out and is vehemently opposed to the European Union.

"And the sad news is the European Union is actually something very good," Jacque said. "It has done a lot of wonderful things. And in fact, until 2000 — until we launched the euro — the European Union was doing fine."

Even after the Great Recession and the European debt crisis, no countries left the eurozone, even those most damaged by the single currency who may have benefited from readopting their own currency.

"And the bad news is that those countries have actually never quite recovered from the crisis," Jacque said. "Even today, you go to Greece, you have in the class of young people … a rate of unemployment above 35-40%. Spain is almost as bad. So we've basically, for the benefit of a single currency, we've sacrificed a generation."

The study "The Euro @ 20: How Economic and Financial 'Asymmetries' Marred the Promise of the Single Currency," published Dec. 9, 2020, in the Journal of Applied Corporate Finance, was authored by George Alogoskoufis, Athens University of Economics and Business; and Laurent Jacque, Tufts University. 

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