Wednesday, July 4, 2012

A sustainable currency union has to embrace some form of political union

The debate surrounding the future of Eurozone, especially how it should redesign its institutions to prevent the recurrence of such crises, is essentially one about what are the pre-requisites for a currency union.

In the context of the ongoing crisis in Eurozone, I have blogged about optimal currency areas and how countries like India manage a single currency zone. In both cases, it is amply clear that some form of fiscal transfers are critical to manage asymmetric shocks faced by members. Such shocks are inevitable when members start out from different economic backgrounds and exhibit considerable heterogenity in their social and political systems. In simple terms, the loss of flexibility with monetary and exchange rate policies that accompanies any currency union will have to be traded off with a mixture of free labour market mobility and fiscal integration. See this brilliant description by Paul Krugman.

The Economist has an excellent graphic of federal fiscal transfers among the 50 American states that puts this in perspective. Would be interesting to have a similar graphic for India!

Derek Thompson in The Atlantic contrasts the difference between US and the Eurozone,
The poorest states like Mississippi, New Mexico, and West Virginia rely on enormous transfers of federal taxes in the form of unemployment benefits and Medicaid. Like the United States, the euro zone is all on one currency. Unlike the United States, the euro zone collects a teensy share of total taxes at the EU level and has no legacy of permanent fiscal transfers from the richer countries, like Germany, to the poorer countries, like Greece.
As Krugman writes, in addition to fiscal transfers and labor mobility, a currency union should also embrace banking union (a single banking regulator and area-wide deposit insurance) and monetary union (mitigate liquidity risk by the creation of a single currency-zone wide lender of last resort). His assessment of Eurozone as a currency union is spot on,
Members of a currency area, it turns out, should have high integration of bank guarantees and a system of lender of last resort provisions for governments as well as the traditional Mundell criterion of high labor mobility and the Kenen criterion of fiscal integration. The euro area has none of these.
Whatever its denouement, as the Eurozone lurches from one crisis to another, there is increasing realization that some form of banking, monetary and fiscal union is inevitable. The latest Eurozone leaders summit saw the first step in a banking union with agreement to replace the 17 national banking regulators with a Eurozone-wide single banking supervisor under the control of the ECB.

This first step to a banking union will be followed by the EU bailout funds being injected directly into Spanish banks (to recapitalize them) instead of the current practice of being routed through the Spanish government's balance sheet. This means Spain can remove the burden of bailouts off its sovereign books. Further, instead of being subjected to Greek-style austerity programmes, these countries will have to maintain their EU debt and deficit commitments, though EU authorities could mandate tighter deadlines and timetables. The bailout funds will also be able to directly buy sovereign bonds in the market and loans from rescue funds would not be senior to existing loans. All this is likely to be followed by the slow introduction of the other elements of a banking union like a Eurozone wide deposit insurance.

If the Eurozone comes out of the current crisis in one piece, or at worst minus Greece, then we can say with some certainty that it would have advanced more down the path of a political union than would have been possible through negotiations and deal-making during the normal times. Historians of European integration will then take the name of Angela Merkel in the same breath as that of Robert Schuman and Jean Monnet. But that's going far ahead in time!

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