Can Europe Make It?

Is the eurozone a sustainable currency area?

It’s turned out that the can policymakers have been kicking down the road over the years is, in fact, a grenade. Read more from our You Tell Us bloggers.

Marcus How
10 March 2014

Is the Eurozone a sustainable currency area? Most critics of the currency area would very likely agree that it isn’t. Institutional weaknesses – along with the intergovernmental nature of policymaking – prevent the necessary measures that might guarantee the Eurozone’s sustainability.

The most recent example of this is the banking union, which was maligned by most economists. The union is two-pronged, proposing, first, that all Eurozone banks be regulated by a single supervisor (the ECB); and second, that commercially viable banks requiring a bailout receive automatic fiscal transfers from a rescue fund. The idea is that banking sector risk should be decoupled from sovereign risk – which would prevent budget deficits from rising, given that national governments will no longer have to step in to rescue struggling banks.

Policymakers settled on half measures. The costs of bank bailouts will not be shared by member states immediately; rather, they will be mutualised gradually over ten years. In the meantime, the costs will remain the responsibility of national governments. Were the Eurozone in boom, this delay would be annoying and risky but just about acceptable. But in a depressed economic climate, where banks are withholding crucial investments for fear that national governments will not be able to prop them up, this is madness; all motivated by short-sighted politicking by the ‘creditor’ states.

So that’s that then – the Eurozone is screwed. It’s turned out that the can policymakers have been kicking down the road over the years is, in fact, a grenade. No one knows whether it’s on a timer or will detonate on impact; but at some point, the currency area’s foot will be blown off. Or, to change metaphors, it’s a house with shaky foundations, some of whose tenants are reluctant to invest in fixing them – because they have mouths to feed and what not. But if they don’t invest now, who’s to say they will be able to feed said mouths in the future, when the house collapses? Either way, it’s set in stone. Good night.

What’s that? I haven’t turned the light off? It’s because I wasn’t being serious. Clearly, there are numerous question marks hovering over the future of the Eurozone. The whole project could end in disaster. But if there’s one thing I’ve learned, just because sums add up, doesn’t mean that reality follows. When it comes to the crunch, irrationality can often prevail – but that doesn’t equal doom.

An obvious but underused point of comparison lies across the Atlantic. No, sceptics croon, the United States aren’t a valid point of comparison. This was a union that was consolidated from the start. The Constitution – ratified in 1789 – provided oven-ready political apparatus that would foster interstate convergence: an executive, headed by a president; a judiciary, represented by the Supreme Court; a bicameral legislature; and a central bank. And in any event, the states were essentially blank slates anyway.

The sceptics would be wrong. The political economy of the US was defined by its regionalisation well into the twentieth century. Culture played a part in this regionalisation, given that the thirteen colonies, although governed by the British Empire, had developed independently of one another in many respects. These cultural differences, which were reinforced by geography to a large extent, manifested themselves in the economies and political outlooks of the respective states, and vice versa.

The largely agrarian regions of the South and Midwest, for example, were very suspicious of the Eastern seaboard regions, which were oriented far more towards mercantilism, commerce and finance. Elsewhere, D.C. couldn’t compensate for regionalisation, as its institutions were weak, its spending power insipid, and its agents a product of the regional squabbling that concentrated itself in the party political landscape. 

Regional squabbling manifested itself in many different forms over the years. At some points it was ideological, concerning what the United States should look like. At other points, it was practical, regarding management. Sometimes it was simply out-and-out regional. I don’t have the room to explore the extent of regional differences. However, it’s notable that regional and state interests were what shaped the integration process, particularly on the issue of the management and valuation of the currency, and on the regulation of state banking sectors.

Regional differences over these issues illustrated the trial-and-error nature of US integration. For the most part, integration was a case of muddling through, with the regions settling on half-baked compromises. Backward step taking was commonplace. In some ways, the regional politicking was worse than in the Eurozone, with ideologically motivated institutional sabotage taking place.

The Bank of the United States was the biggest victim of this sort of sabotage. Since being established in 1789 – and re-established in 1813 – the bank had excelled at bringing inflation under control. It did this by demanding that state banks – who were able to issue their own bills of credit until after the civil war – be able to settle their debts in specie. As state banking proliferated in the nineteenth century, the bank made enemies. Ideologically, some saw it as a front for foreign and financial interests. In 1836, Andrew Jackson’s Democrat administration abolished the bank’s charter. The age of free banking ensued, and would last for thirty-five years, although a central bank wasn’t re-established until 1911, in the form of the Federal Reserve.

Banking panics were a regular occurrence until 1911. They were particularly common during the age of free banking, since state banks were effectively unregulated. Credit bubbles would build and burst; and the regions and states, with their different economies, would be hit with varying severity. Contagion was inevitable, since the movement of capital was relatively free. Bank runs would quickly spread to the nationwide level, since deposits were uninsured; so a bank hammered by such a run in New York would be unable to maintain investments in, say, the agrarian regions, leaving farms and industry debt-addled. No federal institution had the power to make fiscal transfers to compensate for rising unemployment, or to prop up failing banks. From the point of view of economic stability, the age of free banking was chaotic. It arguably reinforced regional divides and contributed indirectly to the motivations for civil war.

The 1907 panic led to the establishment of the Federal Reserve. Private banks had pooled their resources to collectively act as a lender of last resort, and realised thereafter that a formal institution performing that function – and regulating the banking sector generally – was required. A second realisation came as a result of the 1929 crash. Franklin Roosevelt’s New Deal programme established the Federal Deposit Insurance Corporation (FDIC), which would protect consumer deposits regardless of whether their bank failed or not – mitigating the risks of contagious panics.

It was only at this point that the US can be said to have become a sustainable currency union. The key to this metamorphosis was the construction of federal apparatus that would ‘nationalise’ the regional economies, uniting them under a mutually beneficial common framework that compensated for regional differences. Granted, the states would have to pay to maintain such a framework, and relinquish autonomy; but the alternative had been repeatedly been proven to be more costly.

This conclusion was only arrived at after 150 years of trial-and-error, underscored by cynical political wrangling. At many points, the future of the US seemed far from secure; indeed, it was defined by uncertainty more often than not. But in defiance of logic and reason, it somehow survived and strengthened, with the crucial steps forward being taken in response to crises. I suspect that the future of the Eurozone generally may follow a similar path.

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