24 February 2013

Simon Wren-Lewis: Is a monetary union without fiscal/political union doomed?

If eurozone failure due to bad design leads to a fiscal and monetary union imposed from above on an unwilling electorate, we may go on to discover that a badly-conceived political union could be even more disastrous than a badly-designed monetary union.

It may be worth reminding ourselves about why the eurozone has not been a fair test of monetary union without fiscal union:

1) The crisis of competitiveness was partly a result of a mistaken belief in the market that default risk on everyone’s debt was similar to German debt, a mistake that is unlikely to occur again in decades. In the years before the recession, no attempt was made to use fiscal policy to offset overheating in periphery countries.

2) In probably only one case, Greece, was there a clear problem of underlying fiscal excess. Yet instead of recognising the need for default early on, the union made a futile attempt to avoid it by replacing private debt with intergovernmental lending, which had disastrous consequences. This major and avoidable error produced the worst moment of the crisis, when Greece was threatened with exit. It continues to impose a disastrous degree of austerity on Greece.

3) The fiscal position of other eurozone economies became critical because the ECB refused to act as a lender of last resort. If the ECB had introduced its OMT programme two years earlier than it did, the crisis might well have dissipated very quickly. This is hardly wisdom from hindsight, as anyone reading Paul De Grauwe (or indeed this blog) will know. Market reaction always had much more to do with the ECB than the fiscal position of the countries involved, an observation that inspired my first blog post and which research confirms.

4) The current double dip recession in the eurozone is largely about a collective failure of fiscal and monetary policy. The position of the eurozone would look significantly better if the ECB acted more like the US Fed, and if Germany and other fiscally untroubled economies were less obsessed with austerity. Neither has much to do with the absence of fiscal union.

To use evidence from one very badly-designed test case to condemn the whole concept of  monetary union without political union is far too hasty. It is also potentially very dangerous. We should not forget that monetary union itself was encouraged by a belief that the fixed exchange rate regime that preceded EMU was untenable because of market pressure. The lesson of eurozone failure so far is mainly about bad design, rather than disproof of concept. If this failure leads to a fiscal and monetary union imposed from above on an unwilling electorate, by an elite that played such a big part in creating the current failure, we may go on to find out that a badly-conceived political union could be even more disastrous than a badly-designed monetary union.

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© Karl Whelan