VIDEO
The European Monetary Union and the Financial Crisis: Lessons for Economic Policy
Federal Ministry of Finance – German Government
First consideration
The possibility that an incumbent member of the euro area might reintroduce its national currency cannot be excluded. The European Union is still an entity whose residents identify themselves as citizens of nation states.
Differences in national history and identity imply differences in preferences over monetary policy. Monetary union by its nature entails compromises and trade-offs. Member states must agree on a common monetary policy that in some cases is not any nation’s optimum. By choosing to remain members, countries trade off the costs of a suboptimal monetary policy against other benefits.
Where there are compromises and trade-offs, it is possible that changes in circumstances may lead to a change in commitments. A country that experiences an asymmetric shock may find the costs of following policies determined by the majority of participating member states, while tolerable previously, to now be prohibitive.
A country that sees its monetary union partners appointing less inflation- adverse central bankers to the ECB board may similarly decide that the costs of accepting the common policy, while previously tolerable, are now prohibitively high.
How formidable are the obstacles to withdrawing? Economically, it is not clear which way the arguments cut. A country contemplating exit in order to obtain the kind of real depreciation needed to address problems of chronic slow growth and high unemployment would be deterred if it thought that its efforts to engineer a real depreciation would be frustrated by the inflationary response of domestic wages and prices, or if it thought that leaving the monetary union would significantly raise its debt- servicing costs. But if the defector strengthens the independence of its central bank and the efficiency of its fiscal institutions, then it is at least conceivable that these negative economic effects would not obtain.
In contrast to some other authors, I have argued that the technical and legal difficulties of reintroducing the national currency, while surmountable, should not be underestimated. But the political domain is where the most serious obstacles to withdrawing reside.
A country that withdraws from Europe’s monetary union would be seen as disregarding its commitments to other euro area members. Such a country would not be welcomed in the meetings where the future architecture of the European Union is discussed and where policy priorities are decided. Insofar as member states value their participation in these political discussions, they would incur significant costs.
The “insofar” in the preceding sentence is of course an important caveat. Be that as it may, my own assessment is that the high value that member states attach to the larger European project would prevent them from exiting from the monetary union, except under the most extreme circumstances.62 would defection by one country cause the general disintegration of the euro area?
As with many things economic, the answer is, “it depends.” For other countries experiencing the same economic problem, there might be a strengthened incentive to follow. If Italy left, owing to inadequate competitiveness and slow growth, and depreciated its national currency against the euro, other euro area members suffering from inadequate competitiveness and slow growth would feel greater discomfort and a greater temptation to follow. If Germany left, owing to high inflation, and allowed its national currency to appreciate against the euro, then other euro area members that were similarly uncomfortable with the rate of inflation would experience still higher import prices and again would be more tempted to follow suit.
But if economic problems in the defecting country were the converse of those of its partners in the monetary union, then the opposite conclusion might obtain: the rump union could be rendered more cohesive. Similarly, if the country exiting the union had different preferences, independent of differences in national economic circumstances, its departure might make it easier for the remaining members to agree on a policy more to their liking and render the residual union more cohesive.
The first set of effects is likely to be of negligible importance if the departing country is small but of greater significance if it is large. The second set of effects would be independent of country size insofar as ECB policy is decided on the basis of one country, one vote.
The analysis here has focused on scenarios for the next ten years. What about longer horizons? The longer the euro survives, the less likely it would seem that a participating country would see reintroducing its national currency as a logical treatment for its economic ills. Markets adapt to the single currency, rendering attempts to tamper with it correspondingly more costly.
Expectations adapt to its existence: having no first-hand experience with alternatives, residents take the existence of a European currency as the normal state of affairs and come to regard the reintroduction of a national currency as beyond the pale. Notwithstanding the fact that it experienced a very severe asymmetric shock in the form of Hurricane Katrina and was disappointed by the assistance it then received from its partners in the U.S. currency union, the state of Louisiana did not contemplate abandoning the dollar and introducing its own currency, even though a sharp depreciation might have been appropriate for addressing some of its economic problems.63
At the same time, other developments could make the breakup of the euro area more likely. There could be a diplomatic and political falling out, say, over foreign policy. In a world of dirty bombs and terrorist cells, a member state could experience an asymmetric shock of sufficient magnitude that a dramatic real depreciation was seen as essential and the costs of abandoning the euro were trivial in comparison. The possibilities are endless.
62. This is a specific application of the general conclusion drawn by Cohen (2000) that monetary unions have tended to be stable when they are interwoven into a fabric of related ties.
63. One can object that high labor mobility between Louisiana and neighboring states obviated the need for such a response, but one can also argue that after nearly two centuries of currency union, leaving the dollar area was inconceivable in any case.
