By Michel Dévoluy | 

This article seeks to make a contribution to the discussions surrounding the future of the Eurozone. The objective is to synthesize the issues and challenges of the single currency, in order to justify the need to rapidly progress towards a real federal state and, until then, to better understand the current debate.

                                                                 Summary

In order to not upset national sovereignties too much, the current treaties largely avoid to mention the integrating role of the euro and in fact make its future more fragile. This perilous over cautiousness is identified and discussed here through two themes: the devolved role of the single currency and the conditional requirements to successfully create a new monetary zone. The format of the official documents reduce the mission of the euro to simply achieve a single market and neglect its capacity to become one of the founding vehicles of a social and political contract between Europeans. The treaties are equally reluctant to impose on members the convergence required for the irreversible success of the Eurozone. This paper demonstrates that the refusal of political integration causes the Eurozone to submit to a tutelary federalism embodied through rules and multilateral surveillance. This tutelary federalism has indeed allowed for the creation of the euro, but it also generates economic inefficiencies, a lack of democracy and, finally, perplexity and disengagement of the Europeans. The solution is known, but the path towards a political federation is embed with national egos. It is high time to open these discussions to citizens debates.

I. The  general context to remember with the help of five comments providing context of the difficulties of the Eurozone.

1. The EU is a construct always torn between intergovernmental and federal, from which arise sovereignty conflicts. The result is a lack of democracy, a blurred identity and an administrative supervision of the currency and the economy (what I call a tutelary federalism).
2. The EU remains a space far too heterogeneous. European states exhibit strong differences in their economic, social and political structures; their economic specifications; the political orientation of their governments; their expectations towards the EU. It is thus very difficult to set up policies that convey ambitious common goals. Such policies must indeed meet the expectations of all states with a majority share of the vote. This leads to low interventionism policies and a preference of regulations through the market.
3. The EU applies a minimum solidarity policy. National selfishness still prevail. This translates in a minimal common budget, the absence of european taxes and a fiscal and social competition between the state members.
4. Incomplete and sometimes violent answers to the 2008 crisis. Among the positive advances: non conventional measures from the BCE, aiming at supplying the banks with more cash flow; a new financial supervision; a conditional solidarity mechanism (the European Stability Mechanism) and an intensification of the macroeconomic surveillance. Negative sides: a violence that was a response to the excessive austerity programs imposed in particular on Greece.
5. The report on “Completing Economic and Monetary Union” published in June 2015, also known as the “Five Presidents’ Report” (European Council, European Parliament, European Commission, ECB, Eurogroup) gives interesting prospects. They have been validated by the heads of states and governments. However, looking more closely, all the considered changes are still submitted to the intergovernmental system, the regulations tutelary and the reign of experts. The idea of modifying the treaties seems to still petrify the minds.

In Summary: Due to the lack of political integration, the EU has focused on the construction of a tutelary federalism which is not very democratic and insufficiently protective of the citizens. The hold of economic liberalism in Europe is evidence of the ideological victory of this doctrine in the world. But not only. Liberalism offers an “optimum” answer to the management of a space with a single currency but unable to democratically choose its economic policies. Regarding this, the ordoliberal doctrine of Germany is an excellent candidate. It supports: the free and undistorted competition, the respect of strict budgetary rules and the rigorous maintenance of monetary stability. In short, everything which is already found explicitly in the current treaties.

II.  Which roles for the single currency?

A) Two different stakes

The euro answers two concerns. One is about the single currency as, above all else, a tool for economic efficiency which finalises the building of the single market. The other insists on the role of the euro as a driving force for political integration. These two views correspond to different analyses of what a currency is. The first focuses on its role (its functions in economy), the second on its nature (its essence).

The functional approach is the most familiar to economists. It studies what a currency does, in other words the services it provides to economic agents and to the economy in general. It is admitted that a currency has three functions: a unit for amounts (one counts and communicates using the currency unit); a medium for exchanges (a currency solves the disadvantages of barter); a stock for value (money is saved and one delays economic decisions by withholding money).

The promotional campaign for the euro that came before the choice of the single currency through the Maastricht Treaty has largely relied on the economic efficiency of the euro. It was in particular supposed to:

• Decrease the costs of trade and financial exchanges between states;
• Present to economic agents prices prices in the same currency and therefore favor competition;
• Eliminate currency crises;
• Promote the euro as the rival of dollar.

The idea that the euro was automatically going to lead to some form of political union was also there. But this logic got immediately jammed. Indeed, many economic and political leaders are content with a euro as a medium of the good functioning of the single market.

The essentialist approach sees currency as a fundamental social and political institution. The existence of currency is not only intrinsic to trade, but it also sets a space for political sovereignty and collective acknowledgement through a symbol. Sharing a currency asserts the existence of a social consensus and a common identity. The currency and the central bank are thus interpreted as common goods, which found a social and political contract. History of Antiquity teaches us indeed that the presence of a currency was first the expression of a political power, before being a tool for economic efficiency. Recent history shows the agreement between political integration and adoption of a single currency through three examples: the creation of the Deutsch Mark in 1875, of the italian Lira in 1926 and the adoption of the Mark on the entire german territory after the reunification in 1990. Creating a single currency without a political union is therefore in principle a challenge.

B) Currency and monetary policy

It is known, especially since Keynes, that currency is not neutral. More precisely, monetary policy and currency policy are two major tools for political authorities in order to take action on the economy. However, a single currency implies a single monetary policy and a single currency policy across the entire space where this currency has legal tender. In principle, the presence of a single political power is sufficient for this issue to be resolved. But the Eurozone is not a unified political space. The problem is therefore to make a single currency shared by several sovereign state to work.

The solution to this is written in the treaties in two key measures:

1. the creation of a central bank (the ECB) completely independent from national and european political powers, which is de facto a loss of monetary sovereignty;
2. The obligation for the ECB to focus on a single objective, stability of prices. This objective, largely consensual, avoids the trick question of political arbitration between potential targets (for example should one support the economic situation of fight inflation?) A tool of macroeconomic policy is therefore no longer available.

In short, with the current treaties, monetary policy does not fall within the attributes of national governments and does not either fall within the authority of the Union. Let us remind here that the american Federal Reserve System (the Fed), although independent, monitors both inflation and growth. It thus deals with politics.

The treaties’ approach implicitly reveals a lack of interest for an essentialist analysis of currency. The euro is indeed only used for consolidating the functioning of the single market. It is not there to openly contribute to the building of a european society. Its unifying role in the social and political body is de facto forgotten. Unless we would agree to gather around the sole objective of price stability, which would constitute a pretty disappointing collective goal compared to the hopes put in the construction of the EU.

Consistently with the previous elements, the ECB’s mission is not to lead a currency policy in the name of the Eurozone, unless the evolution of the exchange rate would increase the risk of inflation.

Let us note that to the question, “what to do with national budget policies when states share a currency and one wishes to preserve its sovereignty over national finances?”, the treaties give some answers in line with the previous analyses: a multilateral surveillance of the economic policies of state members with, in particular, a control of national finances through the Stability and Growth Pact (the totem numbers of 3% deficit and 60% debt).

To sum up, a single currency accepted by states which refuse a single political administration implies, at least, agreeing to a strict surveillance. Here lies a paradox: by pushing for the preservation of their sovereignties, the state members lose in fact a crucial part of their economic powers, without however transferring them to the Union. These states prefer imposing on themselves rules through treaties. That is what we call tutelary federalism.

III. The requirements for a single currency: a demanding initiative.

Was it rational and reasonable to embark upon a single currency? The answer goes through some technical considerations. First, what is an exchange rate used for. Then, what are the conditions to fulfill to justify the existence of a single currency within a given space. We will see that in the end, it is the role of politics to overshadow these debates.

A) What is an exchange rate used for?

The transition to a single currency implies the loss of one essential and tunable feature of an economy: the exchange rate. Let us be more precise. Aside from its daily fluctuations, related to the trading and financial exchanges of the moment, an exchange rate reflects the fundamental gaps (or differences) between two economies. It is accepted that if two economies A and B (with currencies A and B) have different interest or inflation rates, then the exchange rate between A and B will adapt and tend to compensate the gap.

It is however important to notice that in reality inflation and interest rates in A and B depend on their own economies, that is to say: price fixing mechanisms, tax and social security systems, work productivity, firms-employees relations, dependence from the outside, properties of the banking and financial systems, level of unemployment, influence of the state, growth, state of public finances, trust in the economy both short and long-term wise. All these structural and temporary features are responsible for the characteristics of economies A and B. By reminding and insisting on the fact that they are numerous and of many different natures, we wish to point out how hard it is to get truly homogeneous economies. This said, we are now facing the following issue: different economies give rise to diverging evolutions of prices and interest rates. That is where the exchange rate is needed to make adjustments: as long as economies are heterogeneous, one would need to be able to use exchange rates.

Let us add that exchange rate is also useful when an economy goes through a shock which devalues its international competitiveness (what is called an asymmetric shock). In this case, “manipulating” the exchange rate (devaluation) may help counter the negative effects of the shock.

In short, by strictly following the previous analysis, only two perfectly similar economies (homogeneous) should agree to a single currency. This is however only a necessary but not sufficient condition. To be complete, one must also make sure that both states have similar political preferences and economical goals. Fulfilling all these conditions to the letter would make the creation of a single currency theoretically impossible, and at best a very risky initiative.

B) Minimalist choices for the access to the eurozone.

The european treaties (starting from the Maastricht Treaty signed in 1992) have not taken all the theoretical precautions. They chose to measure the minimum homogeneity level of economies according to four convergence criteria: inflation rates, interest rates, stability of the exchange rate during the two years before the creation of the euro and the state of public finances with the famous 3% and 60%. Let us add that the treaties also planned to coordinate economic policies through a multilateral surveillance. However, in the end the mechanisms that are set only embody a feeble collective ownership regulation of the single currency. They are clearly not sufficient to firmly lead to a true convergence of the economies.

Despite all our critical observations, history seems to have ruled in the treaties’ favor. The euro has been here since 1999 and the crisis which has shaken the eurozone has not made it collapse. Duly noted! This said, the five opening remarks tell us a lot about the limits and weaknesses of the european monetary construction.

C) A necessary reminder: the criteria for an optimum currency area.

The need for an exchange rate tends to disappear when economies come together. So be it. Another issue, related to the previous one, must however be pointed out: are there mechanisms which could take over exchange rates? If such mechanisms exist, one could get rid of exchange rates and adopt a single currency. The different approaches in terms of optimum currency area (OCA) shed light on the matter. A currency area is an optimum if using a single currency within it is rationally valid. This is ensured through specific conditions, which are called OCA criteria. They are the main tools that can be used to replace exchange rates:

• workers mobility (unemployed individuals are able to go where jobs are);
• flexibility of prices and salaries (to have economies competing in a fair manner);
• convergence of tax and social policies (to avoid competition on tax and social policies, and more importantly to establish transfer mechanisms between economies performing differently);
• financial convergence (debts must circulate freely between economies in excess and in deficit);
• firmly open economies (by infiltrating each other, economies tend to have similar inflation rates and specifications);
• diverse economies (they are thus more likely to be similar than very specialised economies);
• shared goals in terms of economic policy (diverging policies maintain the heterogeneity of economies);
• presence of structures so that a single economic policy will have the same effect on the whole area (if not then a policy could lead to opposite effects within the economic space, which would perpetuate the heterogeneity).

Listing these criteria leads to two concluding remarks:

1. Some of the previously listed criteria will pose serious problems as long as a supranational sovereignty of the eurozone is denied. For example, forcing a state to regain competitiveness through a forced lowering of salaries and social security benefits has harmful consequences. One should only look at the policies that Greece was ordered in order to stay within the eurozone (in technical terms, an internal devaluation replaces an external one of the national currency). On the other hand, the problem of an internal devaluation disappears in a unified economy. Similarly, the reluctance to establish clear mechanisms of financial solidarity between sovereign states is well known and constitutes an impediment to the progress of integration. These transfers are however well accepted when they operate automatically through the finances and social systems of a political union.
2. All these criteria reveal the intrinsic links between the building of a sovereign state, the creation of an optimum currency area and the process of homogenising the related economy.

To Summarise: Fulfilling all the criteria of an OCA in a space where states hold onto their national sovereignties is a delicate challenge that will most surely fail. Convinced of the benefits of the euro, the measures written in the current treaties have avoided these difficulties. Identifying them accurately helps to understand the economic and political weaknesses of the current currency system. In the end, the treaties have set a currency area which is “sub-optimum”, so to speak. However, building a political federation for the eurozone amounts to recognise the necessity for homogeneity, and as a consequence to establish a true OCA.

IV.  Conclusion: from economy to politics

The two main themes that were addressed in this note, namely the role of currency and the conditions necessary for a single currency, naturally call for theoretical thinking. But the point of view of economists is not enough. Before applying this approach one should consider the essentialist approach. It points out the social and integrative role of currency. Similarly, the criteria that must be fulfilled to create an optimum currency area are equivalent to the main founding elements of a political union. This leads to a logical conclusion. The future of the euro goes through consenting to a multi-tiered Europe (or with several circles). More precisely, holding to a lopsided system, which persists in refusing the transfers of sovereignty that are necessary to a proper functioning of the eurozone, produces economic inefficiency, social frustration and a lack of democracy. European citizens can rightfully expect better, and soon. It is about time they get called to debate these issues.

To go further, let me suggest reading my short work called “Comprendre le débat européen” (Understanding the european debate), edited by Points, 2014 (157 pages). One can also look into the collective and a bit more technical work of “Les politiques économiques européennes” (The european economic policies) directed by Michel Dévoluy and Gilbert Koenig, edited by Points, 2015 (429 pages).

Translated into English by Mathieu Génois, Matthew Farnham.

Michel Dévoluy – Professor emeritus, University of Strasbourg October 2017