Monetary unions have a long history in international
economics and we can trace them as far back as that between Phocaea and
Mytilene in the late fourth or early fifth centuries BC. But it was from the
late eighteenth century that formal monetary unions began to proliferate,
partly as a way to consolidate political union but also to promote the
conditions for cross-border trade to flourish. Two of the more successful to
emerge from this period were the US monetary union which came into being with
the signing of the Constitution in 1789 (which later evolved into the dollar system)
and the Zollverein of 1834 which laid the foundations for German political and
monetary union in the 1870s.
History suggests that the most successful monetary unions are those which encompass what we would now define as the nation state. Without getting too philosophical about it, a shared language raises the likelihood that smaller regions will find sufficient common ground to form a political union. It is therefore no surprise that the US and German monetary unions have tended to be more durable than those which have looser ties. But as the experience of Belgium and Switzerland indicates, a successful currency union can still emerge from regions which are neither nation states nor share a common language.
However, strong monetary unions tend to be based on regions with common interests, often based around language – and almost always where currency issuance is controlled centrally. Thus the nineteenth century gold standard – which met neither of these criteria – eventually collapsed. There are some similarities between the gold standard and European Monetary Union. Admittedly EMU members share common political aims, if not a language, and the system is underpinned by a central issuer of currency in the form of the European Central Bank. But in both cases member countries are linked together in a system of fixed exchange rates and have given up monetary sovereignty to one degree or another. Whilst in EMU the operation of monetary policy has been fully contracted out to the ECB, under the gold standard individual countries at least retained their own central monetary authority, although in neither case do members have monetary autonomy and both systems require economic deflation as a cure for imbalances.
The post-1945 Bretton Woods system suffered from many of the same flaws, and although it made provision for devaluations (a feature which the UK twice utilised in 1949 and 1967) it was designed to be a painful experience. One of the problems evident with the classical gold standard was (to quote John Maynard Keynes) that adjustment was “compulsory for the debtor and voluntary for the creditor.” Despite Keynes’ best efforts to eliminate asymmetric adjustments, the Bretton Woods system operated under the same principle.
Whilst EMU is different to previous cross-border monetary systems because it has a central bank which controls currency issuance and provides a centralised payments system which helps to smooth out capital needs, the fiscal rules which underpin the system highlight other deep flaws. The Maastricht Treaty of 1992 contained a “no bailout” clause in which one country would not be held responsible for the debt of another, and these were enshrined in targets for deficits and debt relative to GDP. Not only were debt targets ignored – after all, Italy and Belgium joined when debt ratios were around 100% versus a stipulation that it should be below 60% – but the “no bailout“ clause was deeply flawed in the first place. In an integrated economy such as the EU, one country’s debts largely represent the assets of another. Consequently, the no bailout clause was never going to hold in the long-term unless the creditor countries were prepared to take a degree of pain in the event that others experienced debt problems.
Moreover, no attention was paid to external imbalances during the EMU entry process. And we should have known better, since it was external imbalances which eventually did for Bretton Woods. An economy such as Greece, which was reliant on international inflows to cover its external deficit was always vulnerable to a sentiment shift such as occurred in 2008. EMU is thus subject to the Achilles Heel of previous systems – how to manage current account imbalances in a system of fixed exchange rates. The painful truth is that we cannot unless surplus countries are prepared to recycle liquidity to finance the debt of others.
It is for this reason that the huge surpluses being built up by the likes of Germany pose such a threat to the existence of the single currency. Whilst the EU and IMF call for Germany to expand its fiscal policy in a bid to stimulate demand, and thus help to alleviate the imbalances, we may not even have to go that far. A simple recycling of the surplus by other means will suffice – perhaps via the banking sector, which after all funded the deficit countries prior to 2008. However, the European banking system is not in sufficiently good shape to perform the same role today. So if surplus countries are not prepared to loosen their fiscal stance, the EU’s warning issued earlier this year may yet come back to haunt the single currency region: “[Germany’s] persistently high current account surplus … accounts for three quarters of the euro area surplus [and] has adverse implications for the economic performance of the euro area.” As the economist Herbert Stein once warned “if something cannot go on forever, it will stop.”
History suggests that the most successful monetary unions are those which encompass what we would now define as the nation state. Without getting too philosophical about it, a shared language raises the likelihood that smaller regions will find sufficient common ground to form a political union. It is therefore no surprise that the US and German monetary unions have tended to be more durable than those which have looser ties. But as the experience of Belgium and Switzerland indicates, a successful currency union can still emerge from regions which are neither nation states nor share a common language.
However, strong monetary unions tend to be based on regions with common interests, often based around language – and almost always where currency issuance is controlled centrally. Thus the nineteenth century gold standard – which met neither of these criteria – eventually collapsed. There are some similarities between the gold standard and European Monetary Union. Admittedly EMU members share common political aims, if not a language, and the system is underpinned by a central issuer of currency in the form of the European Central Bank. But in both cases member countries are linked together in a system of fixed exchange rates and have given up monetary sovereignty to one degree or another. Whilst in EMU the operation of monetary policy has been fully contracted out to the ECB, under the gold standard individual countries at least retained their own central monetary authority, although in neither case do members have monetary autonomy and both systems require economic deflation as a cure for imbalances.
The post-1945 Bretton Woods system suffered from many of the same flaws, and although it made provision for devaluations (a feature which the UK twice utilised in 1949 and 1967) it was designed to be a painful experience. One of the problems evident with the classical gold standard was (to quote John Maynard Keynes) that adjustment was “compulsory for the debtor and voluntary for the creditor.” Despite Keynes’ best efforts to eliminate asymmetric adjustments, the Bretton Woods system operated under the same principle.
Whilst EMU is different to previous cross-border monetary systems because it has a central bank which controls currency issuance and provides a centralised payments system which helps to smooth out capital needs, the fiscal rules which underpin the system highlight other deep flaws. The Maastricht Treaty of 1992 contained a “no bailout” clause in which one country would not be held responsible for the debt of another, and these were enshrined in targets for deficits and debt relative to GDP. Not only were debt targets ignored – after all, Italy and Belgium joined when debt ratios were around 100% versus a stipulation that it should be below 60% – but the “no bailout“ clause was deeply flawed in the first place. In an integrated economy such as the EU, one country’s debts largely represent the assets of another. Consequently, the no bailout clause was never going to hold in the long-term unless the creditor countries were prepared to take a degree of pain in the event that others experienced debt problems.
Moreover, no attention was paid to external imbalances during the EMU entry process. And we should have known better, since it was external imbalances which eventually did for Bretton Woods. An economy such as Greece, which was reliant on international inflows to cover its external deficit was always vulnerable to a sentiment shift such as occurred in 2008. EMU is thus subject to the Achilles Heel of previous systems – how to manage current account imbalances in a system of fixed exchange rates. The painful truth is that we cannot unless surplus countries are prepared to recycle liquidity to finance the debt of others.
It is for this reason that the huge surpluses being built up by the likes of Germany pose such a threat to the existence of the single currency. Whilst the EU and IMF call for Germany to expand its fiscal policy in a bid to stimulate demand, and thus help to alleviate the imbalances, we may not even have to go that far. A simple recycling of the surplus by other means will suffice – perhaps via the banking sector, which after all funded the deficit countries prior to 2008. However, the European banking system is not in sufficiently good shape to perform the same role today. So if surplus countries are not prepared to loosen their fiscal stance, the EU’s warning issued earlier this year may yet come back to haunt the single currency region: “[Germany’s] persistently high current account surplus … accounts for three quarters of the euro area surplus [and] has adverse implications for the economic performance of the euro area.” As the economist Herbert Stein once warned “if something cannot go on forever, it will stop.”
