In part one of our story, we touched upon some of the theoretic foundations underlying the Eurozone. Optimal Currency Area Theory and the notion that currency areas lead to positive political ties that prevent war combined to create the winds of change driving the sails that swept along European intellectuals in the latest great experiment in post-nationalism. Although the discussion of a unified Europe predated the eurozone by decades, the main drivers behind the change were public intellectuals like Delors and Mundell, who saw a way to bridge the divides of nationhood and overcome some inherent functions of psychology (ex. in-groups and out-groups) and economics (ex. bond spreads between Eurozone countries).
“Europe exemplifies a situation unfavorable to a common currency. It is composed of separate nations, speaking different languages, with different customs, and having citizens feeling far greater loyalty and attachment to their own country than to a common market or to the idea of Europe.”
-Milton Friedman, 1997
The theory underpinning the creation of the Eurozone was built on the belief that nations could come together as could the various united states within the American Union. Of course, at the root, members of the United States see themselves as Americans, while Europeans rarely identify as such. This lack of a supra-national identity has distinct ramifications for the Eurozone, as well as all areas that try to overcome the limits of banking. Even the United States, which uses a common currency courtesy of the 1913 Federal Reserve Act, is hardly a bastion of unity. In fact, Michael Kouparitsas of the Chicago Fed argues that the United States is not one OCA but rather eight. This analysis comes courtesy of a 2001 paper on the topic, which highlights the economic differences between various regions of the United States.
The main flaw, of course, need not even be thought of as the failures of assumption in creating the framework, but the active forces pulling at the Eurozone today.
Economists agree that two primary forces are at work in the macroeconomy – monetary policy and fiscal policy. Generally, monetary policy is the application of controls to various aspects of the financial system, such as regulating bond prices or controlling the amount of money in circulation (who does this, as with many aspects of economics, varies according to who you ask). The ability to regulate monetary policy has generally come under the purview of central banks in the last 100 years. Markets keep a close watch on what central banks plan on doing with regards to monetary policy, and as such there has been a general push to separate central banks (the Federal Reserve, for example) from government (Congress, for example), in hopes of avoiding a political business cycle driven by partisan economics.
On the flip side of this coin is fiscal policy, which in the simplest terms is the way about which government chooses to tax and spend. But for a brief period during the Clinton administration, but United States has nearly continuously run budget deficits for the last century. Of course, the United States can do this primarily because of its ownership of a central bank that can print money to bail out any loans that might have accrued over time. Contrary to the alarmism present in the popular press, the United States is not “in debt to China” and cannot default on its debt unless congress willfully defaults on its own.
In the Eurozone, however, such a case is not so cut and dry. Imagine, for a moment, that the Eurozone is simply the United States. Kansas is France, and le Gouverneur Sam Brownback has decided to spend significantly more euros than the French state brings in through taxation. This is a problem for La République. In order to cover the cost incurred by the state, bonds must be sold in order to pay off the current debt brought about by this year’s shortfall. This can happen for a few years without suspicion, but eventually financial markets begin to question the solvency of the French state. This of course, is precisely what happens in the eurozone, where some states post significantly greater default risk than their counterparts.
This point can clearly be seen in bond spreads, where certain countries in the Eurozone have significantly higher yields in order to compensate for the added default risk. The United States, unlike the Eurozone, can bail itself out by printing its own money. If creditors come calling, bills can be printed and debts paid off. In the Eurozone, however, individual countries do not have the option to print their own euros. Rather, the European Central Bank (ECB) prints euros that are then distributed. This creates adverse incentives for individual member states, however. States that overspend might expect to be bailed out by the ECB in the event of default, as the Germans accused Greece and Cyprus of expecting during the turbulence of the post-Great Recession crisis. This tension between fiscal policy and monetary policy is a recurring theme in macroeconomics today and one that we will regularly revisit as this series continues. The graph above on bond spreads warrants a discussion all its own, and misaligned incentives will make a reprising role in future parts. Stay tuned.