(Toward Philippine economic and social progress)
Philippine Star, 30 November 2011

A fundamental understanding of the euro debt crisis can be appreciated better if its historical background is told. Then, the euro is examined as an economic experiment in institution-building.

Euro currency is a stage of the European economic integration process. As the European economic market progressed towards greater integration, the desirability of a single, stable currency among the European countries became a much desired objective. The fixed exchange rate system as the world’s monetary system ended in 1971 when the floating exchange rates displaced it. For almost three decades after 1945, the system of fixed exchange rates worked well. But in the face of large trade and fiscal deficits that had accumulated before it, the US, in order to adjust its own economy better, had to abandon the system in favor of floating the dollar against all currencies.

The European Common Market by that time had enlarged from the original six to nine member countries that included the industrially advanced economies of that continent. As tariff barriers were dismantled and the economic market widened, the member countries began to move towards stabilizing the exchange rates that existed among themselves, and in consequence, against all other currencies. The member countries wanted to move toward some form of unified exchange rate system.

In 1979, they created the European Monetary System  (EMS). This arrangement involved the tight coordination of the respective central banks with the help of a reference currency that was crafted out of a basket of their currencies. They called this reference currency the ecu.

The EMS countries wanted a narrow band of allowed variations of the national currencies at 2.5 percent plus or minus against the ecu. The system functioned, but during periods of economic shocks to the world economy, that band was difficult to keep. Nevertheless, it kept the EMS very busy as it sought a more stable currency arrangement.

Expanding European integration seeks a single currency, the euro. By 1994, the already expanded nine countries of the European Common Market became even larger with the accession of more countries that used to be in the European Free Trade  Association (EFTA), the rival European trading bloc that accepted the common market strategy as a far better approach to integration. With this development, the grouping renamed itself the European Union.

Among the immediate moves toward integration was the creation of a single currency to eliminate exchange rate fluctuations among themselves. In essence, the European system wanted to move toward a fixed exchange rate system  that they managed.

The euro was adopted as the currency in 1999 and the national currencies of the members disappeared. For reasons of their own, some countries in the European Union , significantly the United Kingdom, did not join the euro. But 15 of the countries are members of the euro, the currency of what came to be known as the European Monetary Union (EMU).

In a customs union, which is what the European Union is, the member gives up its sovereign right to determine its own tariffs on traded goods imported from other countries. Likewise, in a monetary union, the member country also gives up its right to adjust the own exchange rate of its currency to meet any national economic contingency. Thus, each country gives up a sovereign right for the benefits that it expects from union.

Because money is used to value a lot of goods and assets in an economy, this surrender of sovereignty to a supra-national body is a major decision. The result of this monetary union is the creation of a single central bank for all the countries, the European Central Bank (ECB).

How to make a successful currency union. Robert Mundell was the economist who in the 1960s analyzed the conditions that will make a currency union successful. For that seminal work, he was awarded a Nobel Prize in Economics.

Three conditions are needed to make a currency union successful.

First, no members of the union are to be hit by economic shocks that are too severe while other members do well. In short, economic shocks cannot be asymmetric among the members.

Second, the members of the currency union have flexible labor markets: that is, labor is mobile across countries and, what is almost equivalent, wages are allowed to adjust downward when conditions are bad in order to keep labor fully employed.

Third, there is a centralized fiscal authority that transfers money and other resources from countries doing well to those doing poorly. The presence of fiscal authority provides stability to the currency. In short, for monetary union success, there ought to be some measure of fiscal union too.

The reality is that all three conditions are not fully met! At its beginning, the EMU was formed with these conditions not fully present. There were however expectations that eventually these conditions could be met. There was hope that the system would approach these conditions.

In fact, in the Maastricht Treaty that led to the creation of the euro, “convergence conditions” were introduced that member countries were required to adopt. Countries that could not yet meet the convergence conditions would be required eventually to adopt the policies in due time.

In practice, however, it was not been easy to achieve these conditions easily and fully. Difficulties abound in the efforts of the countries to make their social welfare system conform to the requirements of fiscal discipline. One of the convergence conditions was to keep the fiscal deficit to within three percent of gross domestic product, but many countries could hardly keep it.

Even the countries like France and Germany with strong fiscal positions sometimes had difficulty keeping in line. The situation was even worse for those with more fragile fiscal frameworks.

Lack of fiscal authority across the EMU was demonstrated when Greece faced its debt crisis. It took the Economic Union a long time to device what turned out to be an inadequate fiscal and monetary support system to avert the impending Greek debt problem from escalating.

Also, the labor markets of individual countries need major reforms, but there is resistance to make the social welfare system conform to the requirements of greater labor market flexibility. So, the social support system remains expensive and unaffordable for many countries.

To break or not to break. The euro monetary union is under threat of breaking up with the weight of the combined Italian, Spanish, and the Greek problems pressing for support. The European Union could solve this problem by creating a fiscal union to match the monetary union.

Barring that, the euro could unravel. That would be a great disappointment to those who dream of more stable monetary union. But it could help make the affected countries adjust and solve their problems by regaining their monetary sovereignty. In which case a crack in the system results.