Economics of the Euro (part 1) – Foundations

Economics of the Euro (part 1) – Foundations:


The foundations of the euro have their roots in war.  Although sovereignty, war, and currency are intertwined in ways beyond the scope of this series, the chain of causality in our story nonetheless beings following the second world war.  Following the reunification of Germany, the drumbeat of a unified Europe became a refrain that required response.  Germans, beginning with the Third Reich, developed a plan for a unified Europe that transcended the war-torn map they themselves had developed.  By the 1990’s, though, this plan had materialized as a way to prevent the future possibility of war.  If countries were intertwined in both economic and societal terms, so the thinking went, war would be an impossibility.  The first, and most significant, step was unification through trade liberalization and currency use.  Rather than separate countries, the goal of the eurozone would be create a new sovereignty on the basis of federalism.  Like the United States, the states within the eurozone would ultimately be superseded by a decision-making body that held sway over the decisions of its constituent members.  Although most every thinker will admit this goal has not been achieved, whether or not it is even possible remains largely a function of who you ask.

Optimal Currency Area (OCA), or: The Theory That Started It All

The idea underpinning the unification of the European area into a single currency union was born out of the work of Robert Mundell, who developed the theory of an Optimal Currency Area (OCA).  The OCA, roughly likened to an area like the United States (although this is a point of contention that we will return to later), is one in which certain criteria are met that allow for the frictionless adoption of a single currency.  Sovereign nations of course issue their own currencies, and this is roughly a layman’s approximation of an OCA.  More formally, areas that experience symmetric shocks in their economies should peg (fix) their currencies to one another.

Asymmetric shock of a preference change in goods between two countries – this response, common in eurozone countries, defies OCA theory

The theory of shocks and the reality of asymmetric shocks in times of crisis (like, for instance, a multi-trillion-dollar asset bubble in an ill-regulated market) is one we will return to, but these ideas have since helped to explain the problems that arise from a system of pegged currencies (see also: the Euro, Argentine peso to USD, the Tequila Crisis, Bretton Woods).  In order to qualify as an optimal currency area, four primary conditions must be satisfied:

  1. Perfect labor mobility: The first criterion for an OCA assumes that workers are interchangeable across the extent of the area.  For this assumption to hold, workers’ preferences do not vary across regions.  Language barriers must not exist, skills requirements must be satisfied by workers, and prejudice has no place in the market.  Under this scheme, no barriers to the freedom of movement have been erected and costs are negligible (think of 401K’s and switching driver’s licenses-or passports).
  2. Capital mobility and wage/price flexibility: The second criterion assumes that supply and demand dictate the flow of capital throughout the region.  This assumes that wages and prices are freely able to adjust according to the flow of workers (such as an absence of a minimum wage).  Implicit in this assumption is the notion of a non-artificially restricted labor supply, tying back to the notion of labor mobility.
  3. Risk sharing that mitigates adverse impacts of conditions (1) and (2): The third criterion states that a system of fiscal transfers takes place that reduces the economic burden brought on by shifts in the flow of wages and workers across an OCA.  In the United States, for instance, redistribution of wealth takes place at the federal level and the state level, where certain states are net beneficiaries of federal dollars and others are net payers.
  4. Similarity of business cycles: The fourth criterion assumes that areas within the OCA have similar business cycles.  When the cycle trends upward in one area, that effect is similarly felt in all other parts of the optimal currency area.  This is also true in the reverse, whereby all areas affected by an adverse economic shock are affected equally.  This is closely related to the notion of asymmetric shocks, which we will later see disqualify certain areas from being truly optimal currency areas.

The list above constitutes the main four conditions that must be satisfied in order to be considered an OCA as originally set forth by Mundell.  Other potential criteria include product diversification, homogenous preferences, and solidarity.  If the list above sounds to you more like textbook theory than the eurozone, you aren’t alone.  However, the reasoning was sufficient to give proper context to the Maastricht Treaty, which started the domino effect of unification.

Humble Beginnings

The Maastricht Treaty provided the backbone of what would eventually become the EU.  In order to consolidate the various forces pushing for union, the Maastricht Treaty (along with the Delors Commission) created the three pillars of what would become the European Union:

  1. The European Communities (such as the ECSC)
  2. The Common Foreign and Security Policy
  3. The Police and Judicial Co-operation in Criminal Matters


three pillars dos.jpg
‘Three Pillars’ of the Maastricht Treaty, which eventually spawned the EU of today

The three pillars can still be seen today, in some ways in greater detail.  The ECSC in many ways acted as the precursor to the eurozone, while the third pillar foreshadowed Interpol.  Despite these beginnings, Europe remains somewhat distant from the ideals laid out by the three pillars.  For instance, many scholars have waxed poetic about the failure of Europe to enact a comprehensive foreign policy in the face of the global winds of change (despite the second pillar).

The Ghost of Maastricht

In order for states to enter the eurozone, however, price stability was needed.  Achieving it, according to the Maastricht treaty, required five criteria to be met.  The convergence criteria, or Maastricht criteria, were thought to constitute the necessary conditions for an optimal currency area’s creation.  The five criteria were:

  1. HICP inflation: Inflation levels for the countries entering the eurozone were supposed to stay within an ill-defined range which was counted as the unweighted arithmetic average of the similar HICP inflation rates in the 3 EU member states with the lowest HICP inflation plus 1.5 percentage points.  If, however, states had significantly lower interest rates than the average, they were not to be included in the measure of the lowest three.  How this was determined was through a test as to whether they had suffered from “exceptional factors.”  What seems more exceptional was that this rule was implemented at all.
  2. Government budget deficit: The ratio of the domestic government deficit was not to exceed 3% of GDP of the previous fiscal year.  This rule, although used as convergence criteria, was supposed to have been a strict, binding rule, although as we will see this has largely been violated by virtually every eurozone country at any given point in time.
  3. Government debt-to-GDP ratio: The government debt to GDP ratio was not to exceed 60% of the GDP at any time.  While the budget deficit is a flow, the debt ratio was a stock that, again, was supposed to be inviolable.  As time has progressed, however, most eurozone countries have gone well beyond the 60% mark, calling into question the ECB’s commitment to honoring the ground rules and the extent to which it seems willing to stamp out “moral hazard.”
  4. Exchange rate stability: Devaluation of the applying country’s currency was not to have happened in the prior two years to convergence.  Unlike the previous two rules, this rule (for obvious reasons) does not carry forward to the present day.  However, the inability of countries like Cyprus and Greece to devalue their currencies while Germany amasses a large trade surplus features centrally in the problems of the eurozone at the present time.
  5. Long-term interest rates: Long term interest rates were not to exceed 2% greater than the average of applicant countries, with wording similar to the first criterion.  The foundational notion behind both the first and fifth criteria was that post-convergence, inflation and interest rates for all eurozone countries would be exactly equal, as the market would view these countries’ bonds as perfect substitutes. As we will see, this erroneous line of thinking nearly caused Grexit and the eventual collapse of the EU.  Although that problem was staved off temporarily, the chief lesson from the 2008 financial crisis was that without fiscal controls available to the member nations, the assumptions behind the first and fifth criteria are fallacious enough to potentially end the eurozone experiment.
maastricht comic
Live look-in at current EU talks – c.21st century

The EU, founded upon the notion that unification would prevent war, has struggled since its inception to build a stable economic policy framework.  Between the assumptions made in equating the eurozone to an optimal currency area (four) and the assumptions implicitly behind the convergence criteria (five), the great unification experiment was founded upon a set of notions that have been in want of a solution in the decades since.  In the coming parts of the series we will examine these assumptions, the tensions behind solving them, and the outcomes if they go unsolved.  The experiment to end war through economics may ultimately rest on these very outcomes.

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