The Euro – the Beginning, the Middle … and the End?

Abstract

The UK decided not to join the euro on economic grounds. This was a decision which met with approval from the vast majority of UK liberal economists and which has been proved right by the course of events. Indeed, even the major supposed benefit of the euro – reduced currency volatility – is questionable when the volatility of sterling and the euro against other world currencies is considered.The euro zone – even without the UK – was not an optimal currency area. Many proponents of the euro thought that it would evolve into an optimal currency area through structural reform and economic convergence. This has not happened in practice.Differences in financial systems between euro zone members meant that their economies responded very differently to global economic shocks and to the ECB’s monetary policy operations. This helped to create the financial imbalances that became unsustainable.With the possible exception of Ireland, product and labour markets in euro zone members are too rigid to respond adequately to economic shocks. The result has been high unemployment and low or negative economic growth in a number of euro zone countries.In general, floating exchange rates are likely to deal with economic shocks at lower cost than fixed exchange rates or single currency arrangements. This was not the major consideration, however, when countries decided to join the euro. Many of the countries that joined the single currency did so because it was thought that external discipline on domestic governments would have beneficial long-term effects.Historical evidence suggests that monetary unions that have not been followed by political unions have tended to fail. This does not mean that such unions are impossible. In this respect, however, the euro was an experiment. It might be possible to proceed from the current position to a euro zone made up of a smaller number of countries. Any countries participating in a single currency should, however, examine carefully their long-term fiscal balance sheets if the strong are not to become responsible for the debts of the weak. This process should include careful analysis of pension and other long-term liabilities. Indeed, if the euro survives the current crisis, it could be brought down by government indebtedness caused by pension liabilities.It is very difficult for countries to leave the euro although members could be suspended. Suspension should happen in the case of Greece, at least. This could be followed by the adoption of parallel currency systems whereby the euro can be used alongside new domestic currencies in those member states that are suspended. Currency competition would complement a more general agenda for decentralisation in the EU.If there is a break-up of the euro, it is extremely important that it happens in an orderly way. This will be difficult to achieve because the EU elite are unwilling to countenance the possibility that the euro might break up and will therefore not plan for such an eventuality. A break-up of the euro must go hand in hand with vigorous promotion of free trade in the difficult political environment that will exist.An alternative solution to the euro crisis would be to return the euro to its founding principles. There could be very strict enforceable ex ante rules that all member countries had to meet. Countries that did not abide by the rules would take no part in the economic and monetary policy decisions of the EU or would be suspended from membership.EU states could also decide that monetary policy should be decoupled from government altogether. The euro has not succeeded as a single currency with its current institutional mechanisms, and state currencies have often proved to be inflationary. On the other hand, free banking systems create the right incentives for bankers to act prudently and to not inflate the money supply.