Monday, February 23, 2015

Financial crisis, the Euro and the need for political union.

In today's Financial Times, Gideon Rachman discusses the flaws of the Euro and the possibility of failure. He admits that from the beginning he believed that the Euro project would eventually collapsed because

"First, a currency union cannot ultimately survive unless it is backed by a political union. Second, there will be no political union in Europe because there is no common political identity to underpin it. And so, third — the euro will collapse."

I have always been very skeptical about statements arguing that a currency union needs a political union. The political consequences of sharing a currency (the Euro area) are in many ways much smaller than the political consequences of being part of the European Union, why don't we make the same argument about the European Union? (just to be clear, some make the same argument but clearly it is much less common, as can be seen in the article by Rachman).

There are plenty of example where the European Union (EU) requires some serious political consensus: the EU requires partial transfers of sovereignty to a supranational authority when it comes to legislation, the EU has economic mechanisms that imply a significant transfer of income across countries (via its budget, the structural and cohesion funds). Then why is it that the EU does not require to be backed by a political union in the same way the Euro project does?

My view is that the request for more political union in the Euro area is not so much the result of sharing monetary policy and a currency, I think that the answer comes much more from the power and size of financial flows and how these flows create a risk that is centralized and needs to be managed through the ECB.

The current debate between Greece and others in the Euro area is not about monetary policy. While there have been disagreements about the best course for monetary policy during the crisis, the fact is that the ECB has not been "too far" from what other central banks have done, interest rates have been close to zero for years and while QE has been different from that of other central banks, it is unlikely that a US-style QE would have made that much of a difference (we are still debating how effective QE was in the US or the UK).

The real debate in the Euro area today is about dealing with a debt crisis. The real issue is that the financial flows in the period 2000-2007 established links between countries and spread a risk across all Euro members, in a way that other countries (including EU members) not part of the Euro did not see. And the creation of the Euro was instrumental for this.

The role of the Euro was twofold. First it facilitated flows across countries as exchange rate risks had disappeared and provided the illusion of no risk. Second, once the flows had taken place it created financial links between banks and governments across countries that made them exposed to the same risk. In addition, the ECB because its connections with banks became a central repository of that risk and a solution for some of the countries facing a credit crunch -- the ECB acted like the IMF in many ways.

None of this is exactly about monetary policy, even if the ECB is involved. This is about financial risk and how financial crises have painful economic consequences. When sharing a currency the risk of financial crisis and its potential solutions bring countries and governments together in a way that a political consensus seems to be necessary because transfers might be involved and because common political solutions need to be found. And while these transfers might be smaller than the ones agreed as part of the Social and Cohesion Funds of the European Union, they come as a surprise and they are uncertain (we cannot agree ex-ante on their final size). This is what makes the Euro project a much more difficult one to manage without a sense that we all belong to the same group and are willing to work on this together.

For many, the Euro was one of the projects within the much bigger ambition behind the European Union (which came with the idea of a partial political union). But the recent financial crisis has shown that the risks associated to sharing a currency when financial and sovereign crises are possible, are a lot larger than what we thought. And these risks are much larger than the risks associated to simply sharing the same currency and the same monetary policy (yes, one interest rate does not fit all but this is not the real issue this time).

If there was a way to avoid the next financial crisis I would go back to my original idea that a currency union can survive without a political union. But as long as financial flows (and sovereign debt) can potentially generate the same type of risk as in this crisis, then the Euro might not survive the next one without stronger political ties between all its members.

Antonio Fatás