Making Decisions within Monetary Unions

Here's the transcript of a talk given at the UL Debating Society, March 31st, 2011.

In this talk, I’ll briefly define my terms, talk about the costs and benefits of economic and monetary union, give a philosophical aside, then move onto monetary and fiscal policy, and finally end with a bang, talking about debt levels in the EU.

Defining Terms

Let’s start by asking: what is a monetary union? Economic and monetary union happens when two or more countries reduce their trade barriers (for example, their tariffs on imports) to zero, allow free movement of goods and services as well as capital and labour, and adopt a common regulatory regime and currency, and sometimes a common fiscal policy. One example is the European Union. Other cool examples are the Roman and Austro-Hungarian empires.
Economic and monetary union is a complex process, demanding a unified set of fiscal and monetary policies. The origin of these unions should not be forgotten however--these are economic solutions to the age old political problem of adjoining nations continually going to war.
The benefits of economic and monetary union are lower transactions costs, increased trade, and a strong central bank to maintain low inflation. Among the costs of economic and monetary union are the lack of flexibility it gives member states when dealing with crises, as well as the potential for top-down ‘policy straightjackets’ that harm regional or national interests. To date, however, the largest economic and monetary union, the European Union, has continued on a slow path of integration between member states—to the betterment of them all.

Coordination Problems Persist

Now, the key problems one encounters when we talk about monetary unions are all around coordination. How can such a diverse array of interests come to a common purpose on a set of diverse outcomes? There is a fair amount of research on this. Kenneth Arrow’s impossibility theorem says that the most efficient decision maker is a dictator. Well, the EU is more or less the opposite of that. Jason Barr and his Francesco Passarelli did a fascinating piece on who exactly has the power in the EU. They found that the change in relative power of the EU15 morphing into the EU27 was really to dilute medium-sized member states influence, rather than jeopardise the positions of France and Germany within the system.
I speak tonight as a committed Europhile, but we can easily think of several ways the EU has harmed Ireland. First, the European system is not at its heart an inclusive democracy. The purchase the average Irish or French or Belgian citizen has on the institutions of the EU is rather paltry, compared to some Irish TDs who have their clinics in pubs on a weekly basis. The EU is a Utopian experiment in trying to answer the basic questions economics is built to answer: is continual economic integration growth enhancing? Are the rich getting richer and the poor getting poorer, or will the income levels of EU member countries converge as a consequence of integration? Who benefits more from the introduction of new member states--the new member states themselves, or the ‘core’ economies? Ultimately, whose agenda is served?

Someone like Jurgen Habermas would argue that the EU really serves the EU, rather than its constituents. Habermas feels that a policy of graduated integration between member states over decades is the only possible solution to the lack of public participation in the European project, which Habermas regards as fundamentally undemocratic. In fact, Habermas believes the EU is a Utopian project, with undemocratic under- and over-tones. The only solution Habermas sees is multiple referenda by each member state, with various ‘speeds of integration’ being chosen.

Monetary and Fiscal Policy: EMU Means More Shocks, Less Insulation

Beyond the philosophical issues, looking from an economic point of view it is clear the even before the boom, the costs of entering EMU would be borne by the peripheral economies. Economies without their own monetary policy face different challenges.

For an economic theorist, one of the most significant is that monetary unions can exacerbate different patterns of business cycles across the different regions in the union. For wonks like me, this was a real concern for Ireland during the 2000s, as Ireland boomed while the Eurozone core was experiencing sluggish economic conditions.
Inappropriately low, and often negative, real interest rates for Ireland acted as a further asymmetric shock, fuelling unsustainable growth in investment and consumption. So our European friends did not put the gasoline on the fire that was Ireland’s construction boom, but they did hand us the gas can. Now, the responsibility of course lies with us, the Irish people, but clearly inappropriate monetary policy had a hand to play in Ireland’s downfall.
Indeed, as the Eurozone as a whole begins to recover and experience inflation, the European Central Bank may judge it advisable to increase interest rates to damp down that inflation, and in so doing, help the core economies while harming the peripheral nations, straining to service their debts. It is not unreasonable to assume a three quarter of a percent increase in interest rates from the ECB in the next 18 months, meaning the cost of servicing debt for a country like Ireland would skyrocket, hamstringing any chance of an economic recovery here.
As a member of the eurozone, Ireland will in the future also have to get used to greater coordination of taxation and spending between member states. Fiscal councils are the way of the future. This is all the more pertinent as Ireland’s macroeconomic position, relative to its eurozone neighbours, is precarious. For example, in relation to unemployment, which was already nearly one quarter higher than the eurozone average in 2010, it is estimated that unemployment will be more than a third higher by 2014#. The scale of macroeconomic adjustment already entered into on a European level, and planned to in the future, is onerous on the public, the government, and the civil servants who must implement government policy. So fiscal policy coordination is coming, and with it a concomittant loss of sovereignty.

Debt, debt, and more debt.

During the current crisis, the failure of Europe to deal comprehensively with the increasing fragility of some of its member states deficit positions has been revealing. I think it comes down to the nature of the EU as a decision making body that it will never, ever, see eye to eye on key issues like debt restructuring or default. The current policy with indebted member states is a stern taking to and, essentially, an urge to ‘get your house in order’ via punitive austerity measures. If you are spending more than you earn as a government, you have to cut back. And cutting back means harming citizens, in one way or another. The policy of austerity is politically dangerous, economically destructive, and socially divisive. The only thing austerity has going for it as a policy is that austerity’s costs are, most of the time anyway, less than the costs of defaulting on debt.
Really I feel we will get a mixture of hair-shirting and debt restructuring, where the core parts of the European Stabilisation Fund are blended with some bondholder burning. But remember there are costs to this. Any debt restructuring would force governments to set aside substantial sums for the bail-out of the domestic financial sector, and, eventually, of the European Central Bank. Imagine what is happening to Ireland’s banking system happening Europe-wide.
First Greece, then Ireland, and now Portugal, perhaps Spain, and even Italy may need to access European Stabilisation funds, which are not adequate to meet the competing claims of Greece, Ireland, and Portugal as they stand today. The truth is that the debt crisis will either knit the eurozone together, or blow it apart.

Thank you for your time.

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