Euro Vision

Mayhem in the euro zone is a major contributor to the international financial crisis. The immediate cause may be reckless policies pursued by governments and banks, but the institutional structure of the European Monetary Union is the stubborn root of the problem. First, some broad truths: Managing a large monetary union should be straightforward, so long as the right mechanisms are in place. Monetary policy requires an “all union” central bank, a custodian of the currency. Government borrowing should operate through a single unionwide bond market, with borrowing determined by coherent and decisive central authority.

Inevitably, parts of a complex union are more successful economically than others, and this can undermine the union’s monetary management. Without some way of maintaining growth in the laggards, they become a drag on the whole. Ample credit would do the trick, but this ends in growing debts, destabilizing the union’s financial system and disrupting growth. Far better would be a (stealthy) mechanism embedded in a substantial unionwide budget to transfer income from more successful parts to the less successful, sustaining their growth. Ultimately, the union should be stabilized by the safety valve of easy migration from poorer to richer parts.

This list of necessary arrangements is a description of the monetary union that is the United States of America.

The Federal Reserve manages all union monetary policy via a single bond market, with the policy on borrowing being the responsibility of federal institutions. (Of course, this can go wrong, as demonstrated by the sadomasochism of the recent debt-ceiling wrangle.) States and municipalities can borrow on their own behalf, but are ultimately constrained by their inability to monetize their debt.

As for redistribution, that is achieved by the federal tax system sustaining a substantial budget of around 20 percent of national product. It redistributes by stealth. Few taxpayers notice that richer states contribute the greater share of total taxation while poorer states benefit from a bias in federal spending. In addition, federal employment schemes have a disproportionate impact on poorer states—the U.S. military being the most important. And, of course, migration within the U.S. is easy. A third of all Americans do not live in the state in which they were born.

Apart from the European Central Bank, none of these necessary arrangements exist in the euro zone. There is no single bond market, and no central authority in charge of treasury policy. There have been attempts to substitute rules for a competent authority, notably the Growth and Stability Pact that limited government deficits in member states to 3 percent of national income. The pact resulted in neither growth nor stability. At the first whiff of recessionary pressures, the spending limits were broken, the initial transgressors being France and Germany.

Lacking a single bond market, those who wish to accumulate euro-denominated assets (pension funds, for example, with commitments to pay pensions in euros) gravitate toward the less risky assets: why hold Greek euro bonds when you can hold German euro bonds?

In addition, the euro zone has no effective mechanism for supporting poorer states. The central budget is tiny (around 1.7 percent of euro-zone income), and significant elements (the Common Agricultural Policy, for example) redistribute income in perverse directions—to France, for example. Otherwise, the nation-states are hermetically sealed fiscal units. So growth in less competitive states can be financed only by the accumulation of debt.

And despite the rhetorically ubiquitous Polish plumber, migration in Europe is, for obvious cultural and linguistic reasons, far more difficult than in the U.S.

Even given the most competent and far-sighted political leadership, the current euro-zone institutions would not work. The post-2000 boom in financial profligacy created an illusion of effective management. But the euro zone could not withstand a shock in even a tiny component, to wit, Greece. It’s as if the whole future of the dollar were threatened by fiscal problems in West Virginia. The entire national debts of Greece, Portugal, and Ireland amount to less than 5 percent of euro-zone debt.

Can the Europeans build the necessary institutions to run an effective monetary union—institutions that took 100 years, a civil war, and a Great Depression to build in the United States? Or will the euro collapse?

A collapse is unlikely, since dismantling the euro zone would be economically catastrophic. Consider a 20-euro bill. Are those German euros or Greek euros? The answer is “neither”: they are just euros. The same is true of euro bank accounts. If there were a real possibility of euro-zone disintegration, money would pour into assets with national identity (German bonds again). The money supply and economic activity would collapse.

Who is the greatest beneficiary of the existence of the euro? The answer is Germany. Not only does the rest of the euro zone absorb 40 percent of German exports, but consider the exchange rate of a reconstituted deutsche mark. The German economic model of export-led growth would crumble as the mark soared, in the same way that the prosperity of Switzerland is now threatened by the “safe haven” Swiss franc.

The beneficiary may be reluctant to pay for the benefits it enjoys, and there are still historical inhibitions to German leadership, but the remorseless logic of economic advantage will triumph in the end. After 20 excruciating months of inflammatory indecision, Germany’s Angela Merkel and France’s Nicolas Sarkozy are talking of a “real economic government” for the euro, though they have not yet defined what this means or when it will happen. Sarkozy has even declared that “euro bonds can be imagined one day,” though this would be “at the end of the integration process, not the beginning.” The euro-bond market would be as large as the dollar market, and equally irresistible.

There is a long way to go, and, along the way, many reluctant electorates to be persuaded. But in five years, with coherent political leadership and a lot of luck, the institutional framework of a passably workable monetary union will have been cobbled together. Hold your breath, however, at your peril.

Lord Eatwell is president of Queens’ College, Cambridge, and a professor at the University of Southern California.