It is sometimes suggested that one or more countries will voluntarily decide to leave the European Monetary Union (EMU), sometimes referred to as the Eurozone, just as the UK has decided to leave the European Union (EU). To understand whether this is likely, and what are the economic arguments for and against such a decision, it is necessary to understand some basic facts about the EMU.
The EMU, has brought substantial benefits to the EMU’s citizens. It has made travelling across the EMU much easier (since it is no longer necessary to change money as one goes from one member of the Union to another). It has made ordering goods or services from another member country simpler and cheaper as the same money is used in both. It has also eliminated intra-EMU exchange rate crises [1], and reduced inflation and interest rates in traditionally high-inflation & high-interest-rate countries. For businesses it provides a large area with a common currency, low inflation, and low interest rates in which to operate. However, it also has costs. The most important of these are that it eliminates the possibility of member states pursuing active counter-cyclical policies, enforces pro-cyclical policies, and reduces the possibilities for member states to pursue active growth policies.
The member states can not stimulate net exports by devaluation since they no longer have national currencies. This is a serious matter since real devaluations (that is devaluations that are not cancelled out by subsequent domestic price increases) can be an important means of increasing domestic economic activity and employment. In addition, member states are severely constrained in using fiscal policy for counter-cyclical or growth purposes in view of the EMU fiscal rules. Moreover, EMU rules make it more difficult for member states to support their own banks. Furthermore, in the absence of a national central bank which is prepared to buy their own bonds, they may be unable to finance budget deficits at reasonable interest rates and face a crisis in the bond market and high interest rates. Also, the EMU has no effective mechanism to force persistent current account surplus countries to reduce their surpluses (e.g. by raising wages) so ensuring that some members have persistent current account deficits and a worsening debt situation. (One country’s surplus is another country’s deficit.)
The Great Recession (2009-2013) sharply divided the EMU members. They split into two groups – creditors and debtors. The creditors, mainly Germany but also some small countries such as the Netherlands, ran large current account surpluses which would have resulted in currency appreciation and hence a check on their exports if they still had national currencies. This was a big gain to them from the euro. They experienced recessions but not depressions. The debtors, such as Greece, Ireland, Portugal, Spain, and Cyprus, were unable on their own to finance their banks and governments, and turned to the creditors for assistance. This assistance (in some cases more in the nature of assistance to private sector financial institutions in the creditor countries than to the countries concerned) came with harsh fiscal conditions. This meant a pro-cyclical reduction in government expenditure. As a result economic activity fell, unemployment in several debtor countries rose to very high levels, and social benefits such as pensions were reduced.
This outcome displayed a fundamental flaw in the construction of the EMU. The EMU resulted from a decades-long political process in which the two main players were France and Germany. [2] France wished to increase its monetary power, first relative to the dollar and later relative to the DM (Deutsche Mark). Prior to monetary union, European monetary policy was dominated by the DM, a situation with which the French political elite was dissatisfied. Germany aimed at political union, to integrate Germany firmly within Europe, and regarded monetary union as a step towards it.
However, it insisted that if Germany gave up its beloved DM, the new European Central Bank should be modelled on the self-image of the Bundesbank (the German Central Bank), that is, independent and with the sole goal of keeping inflation low. [3] The result was a compromise. France got rid of the DM and obtained a voice in European monetary policy, and Germany achieved the kind of central bank it had insisted on. The warning of those economists who had long argued that monetary union required also fiscal transfers was ignored.[4] So were the arguments of those economists who argued that the creation of a monetary system based on a sharp distinction between money and state power was based on an erroneous theory of money. [5]
The dominant economic ideas at the time the EMU was designed were that the central bank should be independent of governments and primarily aim at low inflation, and that the market economy had adequate inbuilt stabilising features. Governments it was thought, should concentrate on providing the physical and knowledge infrastructure for the economy to grow, and on removing barriers to growth, such as laws restricting the dismissal of workers, too high wages, unnecessarily high transfer payments, too-early pension ages, and tax systems which stimulated the rapid accumulation of household (mortgage) debt (these were known as structural reforms). Keynesian counter-cyclical policies were considered unnecessary and undesirable, and industrial policy considered an unwelcome remnant of socialist thinking.
Some of the debtor countries accepted their medicine and are now recovering. For example, Ireland went through a deep depression but its GDP has grown every year since 2013 and its unemployment rate in June 2017 was only 6.3% whereas in 2011 & 2012 it had been 14.7%. Similarly, Spain has been growing since 2014 and its unemployment rate, thought still very high (17.1% in June 2017) has fallen sharply from the 2013 peak of 26.1%. Other debtor countries remain in deep trouble. For example, although Greece is expected to have a positive growth rate this year, in June 2017 it still had an unemployment rate of 21.7% and its GDP is currently well below the 2007 level. Similarly, Italy (which has managed without a Troika assistance program [6] ) in June 2017 had an unemployment rate of 11.1% and its GDP has been stagnant for a decade. The poor economic performance of Greece and Italy within the EMU has naturally created political support in them for leaving it.
In view of the obvious defects of the EMU as it now exists, various proposal have been made to reform it so as to overcome them. Prominent among them have been a bank union, common bond issues, and a fiscal union. All of them meet a common barrier – they require the creditor countries to agree to transfers to the debtors. Such a mechanism already exists within the EU, which has structural funds which redistribute income from prosperous to less prosperous countries. It also exists within the European Central Bank (ECB) as can be seen from its TARGET 2 balances. [7] However, the creditor countries do not want to provide additional transfers and their electorates would be very reluctant to accept them. Furthermore, there is a widespread popular feeling throughout the EMU that giving more power to its central bodies reduces the democratic rights of citizens to determine the policies that affect them. Democratic voting determines the governments of the EMU countries (and hence policies in such crucial areas as social spending and taxation), but the ECB is, and the EMU’s potential central budget would be, beyond the control of the citizens of the EMU countries. However, although fiscal transfers on the MacDougall scale (5-7% of GDP) are not politically feasible now, fiscal transfers of a lesser amount might be feasible as a compromise after a long process of negotiation about fiscal union, if France initiates such a process. The obvious policy of requiring current-account-surplus countries to reduce their surpluses, unfortunately seems to those countries like punishing householders who lock their doors at night.
Naturally the question arises as to whether one or more of the countries which have done badly out of the EMU should leave it. There is nothing strange about this. Previous monetary unions (the Latin Monetary Union of 1865-1914, and the Scandinavian Monetary Union of 1873-1914) have broken up in the past. The two obvious candidates to leave are Greece and Italy. In both cases the argument for leaving is that it would enable the country concerned to pursue active exchange rate, fiscal, and monetary policies (possibly including debt default) to reduce the burdens of EMU membership and stimulate economic growth. However, there are two short-run and two long-run argument against leaving. The first short-run argument is that it would be impossible to keep the preparation of such a major step secret (even the USSR under Stalin was unable to keep the 1947 monetary reform secret in advance of implementation). Since everyone will assume that the new national currency will depreciate against the euro, rumours of such a decision will immediately lead to mass withdrawals from domestic banks and the flight of money to euro deposits in the remaining EMU countries. This would undermine domestic banks, domestic investment and domestic economic activity in general, and hence generate an immediate economic crisis. For this reason, Varoufakis, the former Greek Finance Minister, argued when he was in office against Greece leaving the EMU. The second short-run argument concerns current ECB policies. The quantitative easing program of the ECB makes it easy to finance Italy’s budget deficit (the ECB makes large purchases of Italian government bonds). At the same time the ECB’s TARGET 2 settlement system enables Italy to obtain easy credit. The loss of this ECB help would generate fiscal and payments problems. Exit from the EMU might well also result in a request for Italy to repay its TARGET 2 deficit (currently a little over 400 billion euro).The first long-run argument against such a policy is that the new domestic currency would probably depreciate against the euro, but the depreciation might well be cancelled out by price and wage increases, so that instead of achieving a real devaluation, exit from the EMU would simply turn the country into a high-inflation high-interest rate country without improving its net export position. The second long-run argument against leaving the EMU is that the governments concerned are incapable of pursuing a successful growth strategy. The Greek government even has trouble with such basic tasks as publishing accurate economic statistics and collecting taxes, and the Italian government, despite decades of attempts, has been unable to bring the south of the country up to the economic level of the north.
Whether any country, most likely Italy but possibly Greece, will actually leave the EMU depends on the strength and duration of the current economic upswing in the EMU, future EMU institutions and policies, and future political events, all of which are uncertain. The UK leaving the EU was not generally anticipated but is now being negotiated, and an Italian &/or Greek exit from the EMU could happen in the future. A shrunken EMU would most probably continue because of the benefits it brings to many (but not all) of its citizens and businesses, and the influence it gives member states on EMU monetary policy. Although leaving the EMU but remaining in the EU is supposed not to be possible, if a major country such as Italy left the EMU but wished to stay in the EU that would probably be tolerated, although this is uncertain and this uncertainty is an additional reason not to leave the EMU. However, several existing members of the EU which are non-members of the EMU, such as Sweden and Poland, show no signs of wanting to enter the EMU but are not expelled from the EU for that reason.
Michael Ellman is Emeritus Professor, University of Amsterdam
[1] Before the EMU was created there were frequent exchange rate crises between the currencies of the countries which subsequently joined the EMU.
[2] See for example A.Szasz, The road to monetary union (Basingstoke: Macmillan, 1999).
[3] For an analysis of the Bundesbank’s views on economic policy and their implications for the EMU, see J.Bibow, At the crossroads: the Euro and its central bank guardian (and saviour?), Cambridge Journal of Economics 37(3): 609-626.
[4] The 1977 MacDougall Report estimated that monetary union would require central expenditures of about 5 ̶ 7% of GDP. See Report of the Study Group on the Role of Public Finance in European Integration Volume 1: General Report (Brussels 1977): 17-18.
[5] C.Goodhart, The two concepts of money: implications for the analysis of optimal currency areas, European Journal of Political Economy 14: 407-432.
[6] The Troika is the term for the combination of the European Commission, the ECB and the IMF.
[7] TARGET 2 is the system for settling payments between the central banks of the EMU members. Data on the balances in it of the member states can be found on the ECB’s website. For a discussion of TARGET 2, and the causes of the very large imbalances within it, see J.Bibow, The euroland crisis and Germany’s trilemma, International Review of Applied Economics 27(3): 376-377.
