Crisis in the Eurozone: Many of the Most Serious Errors in EU Economic Policy Stem from a Basic Failure to Understand How Market Economies Function

By Grahl, John | Soundings, January 2011 | Go to article overview
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Crisis in the Eurozone: Many of the Most Serious Errors in EU Economic Policy Stem from a Basic Failure to Understand How Market Economies Function


Grahl, John, Soundings


Well before the Maastricht Treaty and the introduction to the euro, the economic analysis of monetary unions had reached widely accepted conclusions. The advantages of using one money instead of two or more always have the same character - a reduction in many transactions costs. (1) The importance of these advantages depends then on the actual and potential transactions among the territories in question: where there is little trade between two countries and few financial interactions, there won't be many benefits from the use of a single currency; if, on the other hand, economic interrelations are many and intense, the gains will be much larger.

What are the costs and problems in moving to a single currency? The key issue concerns monetary policy: what are the costs to a country of giving up its own monetary policy? There are two key policy variables that it loses control of. Firstly, the exchange rate can no longer be altered - that of the monetary union has to be accepted. This means that when a country encounters problems of competitiveness, it can no longer devalue its currency (if the exchange rate was fixed) or allow it to depreciate (in the case of a floating currency). Such exchange rate changes are a very effective and relatively painless way of dealing with competitiveness problems and unsustainable trade deficits. In the recent crises it has been a big advantage for Britain that it was not in the Eurozone and was therefore able to let the pound fall against the euro and other currencies.

Secondly, to join a monetary union is to give up domestic control of interest rates. These are used to influence the costs of financing investment and consumption expenditures and thus the level of expenditure and the consequent levels of economic activity and employment. If the economies in the monetary union as a whole move closely together this may not be a problem - a common monetary policy can be appropriate for them all. On the other hand, if the economies diverge - some tending to overheating and inflation while others are in recession, then the loss of the interest rate instrument could prove to be very costly. (2)

Thus divergence in competitiveness or in the general rate of production and employment across the member economies is a central challenge to monetary unions. How can that challenge be met? Standard theory pointed to two mechanisms, one based on markets, the other on government. Divergent rates of unemployment could be tempered through the market mechanism of out-migration from depressed countries or regions; and if the monetary union had a common public budgetary policy, a government could intervene through raising taxes in the more successful economies to support expenditure in those in difficulty.

Both mechanisms can be found in the United States: if one state has higher unemployment than the others a lot of people will leave; while the working of the federal income tax and social security systems redistributes income to the states with weaker economic performance.

Neither mechanism exists in the Eurozone. There has been some labour migration from central and eastern European members of the EU, but several of them, including Poland, the largest, do not yet use the euro. There has not been much migration among the main countries using the euro since the 1970s. And, since the central budget of the EU is very small, there is no possibility of fiscal transfers.

The Eurozone - with built-in dogma

How then was the monetary union supposed to work, without any way of coping with divergence? There were two views. One, which it is reasonable to associate with the French, relied on further institutional development or 'creative imbalance'. Experience with the monetary union would show that it needed a stronger institutional framework, including more centralised taxes and public expenditures. At that point the EU would give rise to the necessary institutions.

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Crisis in the Eurozone: Many of the Most Serious Errors in EU Economic Policy Stem from a Basic Failure to Understand How Market Economies Function
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