No good blaming US for woes of euro zone

As its workers flee to former colonies, Europe¿s single-currency area may not survive the next few years without more economic and political integration.

The Nobel Prize winner Robert Mundell famously said in 1961 that national and currency borders need not significantly overlap, providing there was sufficient mobility. Akos Stiller / Bloomberg News
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With youth unemployment touching 50 per cent in euro-zone countries such as Spain and Greece, is a generation being sacrificed for the sake of a single currency that encompasses too diverse a group of countries to be sustainable? If so, does enlarging the euro's membership really serve Europe's apparent goal of maximising economic integration without necessarily achieving full political union?

The good news is that economic research does have a few things to say about whether Europe should have a single currency.

The bad news is that it has become clear that, at least for large countries, currency areas will be highly unstable unless they follow national borders. At a minimum, currency unions require a confederation with far more centralised power over taxation and other policies than European leaders envision for the euro zone.

What of the Nobel Prize winner Robert Mundell's famous 1961 conjecture that national and currency borders need not significantly overlap? In his provocative American Economic Review paper A Theory of Optimum Currency Areas,he argued that as long as workers could move within a currency region to where the jobs were, the region could afford to forgo the equilibrating mechanism of exchange-rate adjustment.

He credited another (future) Nobel Prize winner, James Meade, with having recognised the importance of labour mobility in earlier work, but criticised him as interpreting the idea too stringently, especially in the context of Europe's nascent integration. Mr Mundell did not emphasise financial crises, but presumably labour mobility is more important today than ever.

Not surprisingly, workers are leaving the euro zone's crisis countries, but not necessarily for its stronger northern region. Instead, Portuguese workers are fleeing to booming former colonies such as Brazil and Macau. Irish workers are leaving in droves to Canada, Australia, and the United States. Spanish workers are streaming into Romania, which until recently had been a major source of agricultural labour for Spain.

Still, if intra-euro-zone mobility were anything like Mr Mundell's ideal, today we would not be seeing 25 per cent unemployment in Spain while Germany's unemployment rate is below 7 per cent.

Later writers came to recognise that there are other essential criteria for a successful currency union, which are difficult to achieve without deep political integration. Peter Kenen argued in the late 1960s that without exchange-rate movements as a shock absorber, a currency union requires fiscal transfers as a way to share risk.

For a normal country, the national income-tax system constitutes a huge automatic stabiliser across regions. In the US, when oil prices go up, incomes in Texas and Montana rise, which means that these states then contribute more tax revenue to the federal budget, thereby helping out the rest of the country.

Europe, of course, has no significant centralised tax authority, so this key automatic stabiliser is essentially absent.

Some European academics tried to argue that there was no need for US-like fiscal transfers, because any desired degree of risk sharing could, in theory, be achieved through financial markets. This claim was hugely misguided. Financial markets can be fragile, and they provide little capacity for sharing risk related to labour income, which constitutes the largest part of income in any advanced economy.

Mr Kenen was mainly concerned with short-term transfers to smooth out cyclical bumpiness.

But, in a currency union with huge differences in income and development levels, the short term can stretch out for a very long time. Many Germans rightly feel that any system of fiscal transfers will morph into a permanent feeding tube, much the way that northern Italy has been propping up southern Italy for the past century.

Indeed, more than 20 years on, western Germans still see no end in sight for the bills from German unification.

Later, Maurice Obstfeld pointed out that in addition to fiscal transfers, a currency union needs clearly defined rules for the lender of last resort. Otherwise, bank runs and debt panics will be rampant.

He had in mind a bailout mechanism for banks, but it is now clear that one also needs a lender of last resort and a bankruptcy mechanism for states and municipalities.

A logical corollary of the criteria set forth Mr Kenen and Mr Obstfeld, and even of Mr Mundell's labour-mobility criterion, is that currency unions cannot survive without political legitimacy, most likely involving region-wide popular elections.

Europe's leaders cannot carry out large transfers across countries indefinitely without a coherent European political framework.

European policymakers today often complain that were it not for the US financial crisis, the euro zone would be doing just fine. Perhaps they are right. But any financial system must be able to withstand shocks, including big ones.

Europe may never be an "optimum" currency area by any standard. But, without further profound political and economic integration - which may not end up including all current euro-zone members - the euro may not make it even to the end of this decade.

Kenneth Rogoff is a professor of economics and public policy at Harvard University, and was a chief economist at the IMF

* Project Syndicate