Angela Merkel's Eurodenial?

Any country is, among other things, also a currency union. But a currency union can succeed only when complemented with some other factors. Consider this.

Imagine if the city of Bombay (or the state of Maharashtra), which contributes an over-sized share to India's gross tax revenues, refuses to share the taxes collected within its territorial jurisdiction. Or the central government at New Delhi refuses help to beleaguered wheat farmers of Punjab devastated by floods. Or Tamil Nadu restrains Telugu speaking people from Andhra Pradesh working in Chennai and elsewhere in the state.

Any currency union immediately takes currency and monetary policy autonomy out of the equation. You sink or swim along with all others within the union. The problem arises when different areas within the union are at different stages of the business cycle.

Denied off the freedom to lower interest rates (and thereby stoke inflation and lower the real domestic debt burden) or devalue the currency (and thereby increase competitiveness and lower the real external debt burden), the struggling areas need help from outside. They need fiscal transfers from elsewhere to cushion the impact of reduced output and lower tax revenues and there should also be freedom for labor migration that would take the load off the local job market.

The first requires fiscal integration and the second political union. This does raise questions about the difficulty of sustaining a currency union without greater political and financial integration. Bombay or Tamil Nadu cannot have the benefits of a national economy without the costs imposed by fiscal transfers and labor mobility. Similarly, Eurozone economies cannot enjoy the benefits of a currency union without greater political and economic integration.

Fiscal federalism and (less so) labor mobility are the fundamental attributes of any national economy or any successful optimal currency area (OCA). The critical component of fiscal federalism is the transfer of resources across areas - from the well-off (or resource-rich or economically vibrant) to the poorer areas - and to those experiencing output declines and job losses during downturns.

In the circumstances, the intransigence of Angela Merkel on any efforts towards stronger fiscal integration of Europe is baffling. A case of Eurodenial?

Update 1 (25/1/2011)

French finance mininster Christine Lagarde too is not too keen and sure about closer fiscal integration within Eurozone.