Trying to understand the problems of the euro has sent me back to my undergraduate economic textbooks and Robert Mundell’s work on optimum currency areas. As Spectator readers (many of whom are bankers) will know, the US economist theorised that a group of countries will benefit from a common currency like the euro if three conditions are satisfied.
1). The countries should not be hit by shocks that are too asymmetric: i.e. one country should not be substantially worse off while the other regions are booming.
2). There is a high degree of labour mobility and/or wage flexibility within the group of countries.
3). There is a centralized fiscal policy in place that will transfer money or other resources from countries that are doing well to countries that are doing poorly
The economic crisis has put paid to the first condition. Even though travel within Europe has been greatly facilitated by the creation of a single Europe, there are substantial barriers to the mobility of labour. Language and other barriers make it difficult for an Irish worker to move to Portugal and find a job with anywhere near the same ease that a displaced worker from Virginia can move to California and find a job. Furthermore, wage flexibility is hardly the word one would use to describe the state of the highly regulated, structural problems plaguing European economies. The powerful roles played by unions and the generally high level of wage regulations mean that European workers have some of the highest wages in the world.
Finally, there is no centralised fiscal policy for the redistribution of income and what was meant to substitute it – the Stability and Growth Pact – is irrelevant. It would be difficult to see how it would be politically feasible for the French government to raise taxes on its citizens and redistribute them to assist displaced Portuguese fishermen. As we have seen with the German reaction to the Greek crisis, transferring taxes inside the eurozone poses significant problems. In short, there were always serious doubts, according to economic theory, as to how successful the euro could ever be.
That said I don’t think there is any chance the euro will be abandoned. Nor that the Franco-German initiative for “strong co-ordination of economic policies" across the EU will happen. The two governments will struggle to agree on what this actually means or get the required treaty changed. Finally, a well-organised Euro-bond market is also unrealistic.
So what will happen to solve what economists call “indeterminacy”, the fact that the markets know that there are problems with the euro but European leaders have not presented them with a credible solution? One way out of the problem may be the implementation of a two-currency EMU, with both currencies run by the Frankfurt-based ECB. The Euro is so great, Europe may be lucky enough to get two for the price of one….