As you might have guessed, I have been following the Brexit vote very closely over these past few days. One of the central grievances driving voters to the Leave camp is the dysfunctional E.U. I certainly understand this. After all, while I’m not exactly a Euro-skeptic, I find the E.U. to be a deeply flawed, inefficient, and undemocratic organization. Its institutions are complex beyond belief and its economic linkages are insufficient. That being said, I don’t buy the argument that Europe is inherently incapable of existing in a currency union.
There has recently been much discussion and debate over the economic underpinnings of the E.U. From 2008 post mortems to Brits weighing the costs and benefits of dropping the Pound, the Euro question has been analyzed ad nauseam. Currency unions are an interesting economic idea, and they are certainly not without controversy. One argument many people make against the single currency is that it fails to allow countries to set interest rates and inflation levels individually, preventing fine-grained economic tuning. These analysts argue that Germany and Spain, for example, possess very different markets with different business cycles, and it therefore makes very little sense for them to utilize the same monetary policy.
This argument is certainly logical, but it is ultimately unpersuasive. First, no economy or financial system is perfectly efficient. While granting individual countries their own currencies would certainly allow for better monetary stimulus measures during times of economic downturn, it would also massively increase transaction costs. Just consider every European country possessing its own currency; it would be an absolute nightmare. Cross-border trade would be complicated due to ever-changing currencies, and constantly fluctuating exchange rates would make investments more challenging. Moreover, if advocates of disbanding the Euro are correct about Europe being a non-optimum currency area, they should be equally skeptical of national currencies. As Waltraud Schelkle points out, “Large countries should have internal exchange rates: for instance the UK between Southern and Northern England or the US between California and Texas as their economies are so different that they are hit by different shocks and are on different business cycles.” In other words, complaining about currency unions is infinitely regressive, and the problems impacting supra-national currency areas apply just as much to national currencies. There is also very little evidence to suggest that membership in the Euro currency union meaningfully impacted countries’ ability to respond to the economic downturn in 2008. Thus, the argument that the Euro acted as a straight jacket preventing effective government responses is largely without merit.
It’s also important to realize that exchange rates and monetary policy aren’t the only tools available to policy makers. Stimulus spending, tax breaks, and regulatory policy are other powerful instruments with which governments can influence their economies. Furthermore, as Schelkle goes on to point out, it’s far from clear that exchange rates are even effective tools at combating economic malaise.
Exchange rates have proven to be completely unreliable adjustment mechanisms for the real economy. They are determined by markets for financial assets, not the needs of labour markets or the trade balance. Or else the US dollar should have devalued much more than it did against the euro so as to correct the stubborn current account deficit. Instead, at the height of the financial crisis in 2008 that had started in the US, capital flows streamed into US Treasury bonds as a safe haven. Optimal currency area theory ignores financial markets completely, along with monetary policy and central banks. Quite curious for a theory about monetary integration. Maybe this a clue to why the Euro-architects did not find the theory all that helpful?
The E.U. absolutely must improve its economic system. For instance, there needs to be a much more integrated fiscal system in which wealthy states give economic transfers to more economically stagnant ones (much like the U.S. model). Moreover, the E.C.B. needs to be reformed so as to act as a lender of last resort, and there must be better cooperation and coordination over economic activities. That being said, it’s important to recognize that the Euro is not the problem. Instead, it is the lack of effective institutions that is currently retarding European economic growth. Instead of throwing out the entire system, Europe simply needs to reform it.