FT: Intolerable choices for the eurozone

31 May 2011

Martin Wolf writes that the eurozone - based on a set of principles that have proved unworkable at the first contact with a financial and fiscal crisis - has failed, and that it has only two options: to go forwards towards a closer union, or backwards towards at least partial dissolution.

The eurozone was supposed to be an updated version of the classical gold standard. Countries in external deficit receive private financing from abroad. If such financing dries up, economic activity shrinks. Unemployment then drives down wages and prices, causing an “internal devaluation”. In the eurozone, however, much of this borrowing flows via banks. When the crisis comes, liquidity-starved banking sectors start to collapse. Credit-constrained governments can do little, or nothing, to prevent that from happening.

Almost all of the money in a contemporary economy consists of the liabilities of financial institutions. If this is a true currency union, a deposit in any eurozone bank must be the equivalent of a deposit in any other bank. But if the banks in a given country are on the verge of collapse, this presumption of equal value no longer holds. In this situation, there is not only the risk of a run on a bank but also the risk of a run on a national banking system.

The eurozone confronts a choice between two intolerable options: either default and partial dissolution or open-ended official support. The existence of this choice proves that an enduring union will at the very least need deeper financial integration and greater fiscal support than was originally envisaged.

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