When Greece was bailed out by a joint eurozone-IMF rescue package back in May, it was clear that the deal had bought only a temporary respite. Now the other shoe has dropped. With Ireland’s troubles threatening to spill over to Portugal, Spain and even Italy, it is time to rethink the viability of Europe’s currency union.
These words do not come easily, as I am no euro-skeptic. Unlike others, such as my Harvard colleague Martin Feldstein, who argue that Europe is not a natural monetary area, I believed that monetary union made perfect sense in the context of a broader European project that emphasized — as it still does — political institution-building alongside economic integration.
Europe’s bad luck was to be hit with the worst financial crisis since the 1930s while still only halfway through its integration process. The eurozone was too integrated for cross-border spillovers not to cause mayhem in national economies, but not integrated enough to have the institutional capacity needed to manage the crisis.
Consider what happens when banks in Texas, Florida or California make bad lending decisions that threaten their survival. If the banks are merely illiquid, the Federal Reserve in Washington is ready to act as a lender of the last resort. If they are judged to be insolvent, they are allowed to fail or are taken over by federal authorities, while depositors are reimbursed by the Federal Deposit Insurance Corp.
Similarly, in case of bankruptcy, federal laws and courts readily adjudicate claims among creditors and do so without regard to state borders. Regardless of the outcome, private debt is not socialized by state governments, (but by the federal government, if at all) and does not threaten public finances at the state level.
State governments in turn have no legal power to abrogate debt contracts vis-a-vis out-of-state creditors and no incentive to do so (given the help they get from the federal government). So, even in the throes of a financial crisis, banks and non-financial firms can continue to borrow if their balance sheets are sound, uncontaminated by the “sovereign risk” of their state government.
Meanwhile, the federal government makes up for a good chunk of the drop in state incomes by transfers or reduced taxes. Workers, who nonetheless have it bad, can move easily to better-performing states without worries about language differences or culture shock. Almost all of this happens automatically, without long, contentious negotiations among state governors and federal officials, assistance from the IMF or calling into question the existence of the US as a unified political-economic entity.
So the real problem in Europe is not that Spain or Ireland has borrowed a lot, or that too much Spanish and Irish debt sits on banks balance sheets elsewhere in Europe. After all, who cares about Florida’s current-account deficit — or even knows what it amounts to?
No, the real problem is that Europe has not created the union-wide institutions that an integrated financial market requires.
This reflects the absence of adequate political institutions at the center. The EU has taught us valuable lessons over the last few decades: first, that financial integration requires eliminating volatility among national currencies; next, that eradicating exchange-rate risk requires doing away with national currencies altogether; and now, that monetary union is impossible, among democracies, without political union.