The future of the Euro

There is much debate at the moment on whether Italy can or should stay in the euro, Europe’s single currency.  And not very surprisingly this leads to what would happen if Italy chose to leave the euro, and what the future of the euro might then be.

In assessing the question of the future of the euro, and of individual states’ participation in EMU, two points stand out and must be acknowledged upfront. Firstly, such questions fall squarely into the realm of politics and national interest rather than economics.  As long as the EU remains a grouping of sovereign states, member states of EMU will decide to remain a member of EMU or not entirely on the basis of what they perceive to be in their long term national interest, and this inevitably means their long term political interest.  Put simply, if the political gain of leaving is deemed to outweigh the economic upheaval and costs, then a state will choose to leave.

In this light, the fact that the Maastricht Treaty says nothing about leaving EMU is irrelevant: any sovereign state has the right to withdraw from any treaty it signs at any time, and almost no international treaty contains within it terms for its abandonment.  (And how would the other member states stop Italy if it tried?)

Secondly – and despite the way in which the EU seems to treat it as an unprecedented and ground-breaking act – EMU is not a unique experiment. There have been a very large number of currency unions in history, and a large body of experience therefore to draw on.  Indeed, history teaches us that there are basically three types of monetary union, viz:

A small country borrowing the currency (and so credibility) of a large one. Modern examples are the dollarised states such as Ecuador and Panama, or the currency board states of Bosnia, Bulgaria, Estonia, Latvia, Hong Kong et al.  We can call this a Type 1 monetary union

Monetary union as part of, or a precursor to, political union. Examples are legion, from England and Scotland in 1707 (when the English currency replaced the by then largely worthless Scottish one as part of the Act of Union), to Italy and Germany in the 19th centuries, to the imposition of the rouble on the states incorporated into the Soviet Union in the 1920s (and 1940s in the case of the Baltic states), to the extension of the Deutschemark into the DDR in 1990 (seven months before the 2 countries merged).  And many more besides.  We can call these Type 2.

Monetary union between sovereigns states which wish nevertheless to remain sovereign. Again, and perhaps more surprisingly, there are several precedents, be they the Latin Monetary Union (France, Belgium, Switzerland and occasionally Italy in the 19th century), the Scandinavian Monetary Union (Norway, Sweden, Denmark, floruit 1860s to 1920s), the East Africa shilling (Kenya, Uganda, Tanzania in the decade or so after their independence), and so on.  We will call these Type 3.

Interestingly, history also teaches us that Type 1 monetary unions survive as long as the small country is prepared to make the necessary sacrifices (the big country whose currency is being borrowed does not care and usually does not even notice), but break up as soon as the small country can construct what it considers to be a better arrangement for its monetary policy.  And Type 2 monetary unions survive as long as the political union survives, but as soon as that breaks up (eg the Soviet Union, Czechoslovakia in 1993) the monetary union usually breaks up pretty quickly too.  And finally Type 3 monetary unions never survive permanently at all.  They all break down, because eventually one of the sovereign states decides it is more in its interest to leave than to preserve the currency union.  But the costs of break up are large and so the unions can persist for some time.

What does this mean for the euro? Firstly, and to repeat, there is nothing, either in what the Maastricht Treaty says or in what it does not say, to stop a country leaving.  Secondly, unless EMU leads to political union of some sort, it is almost inevitably going to break apart eventually, and probably some time in the next 2 to 3 generations – history shows us that even the most long-lived of such Type 3 unions do not typically make it to 100 years.  Thirdly, you can break away from a monetary union without calamity and chaos inevitably following:  yes, the ending of the Soviet Rouble was chaotic, but Ireland’s break with sterling in 1979, and the “velvet divorce” between the Czech Republic and Slovakia in 1993, both went pretty smoothly.  And Malaysia has just ended its pegging of the MYR to the USD with no knock-on effects at all.

Other points from history show that a departure from a currency union benefits from being instantaneous and a surprise to the market. If people have notice of a withdrawal (say of Italy’s withdrawal), then they may well try to move assets from the Italian banking system into “hard euro”, to avoid the new lira.  One thinks of Argentina’s abandonment of the convertibility of the peso in 2002, which was well telegraphed and which was relatively disordered precisely because people could try to forestall the worst effects of pesoification.  (Though even here a sovereign state can legislate, and the Argentine government did not merely remove the convertibility from peso bank deposits, but forcibly converted dollar bank deposits into pesos as well).

My own view is that Italy is not seriously considering withdrawal from EMU.  It seems to me to be part of political infighting between an increasingly desperate (and wholly unscrupulous) Berlusconi and his main opponent Prodi as Italy approaches a general election within the next year or so.  Politically, Berlusconi has little to lose – it represents close to his last throw.  Economically, whoever wins the election will immediately declare that the economic cost is too high, not just because of the size of the debt and the likely spread that bond-holders would demand (recall that BTPs used to trade anywhere from 300 to 700 basis points over bunds), but also because the banking system might collapse as assets become devalued lire and liabilities may stay in euros (the parallel with Argentina is quite revealing).  And the political equation at the EU level is by no means straightforward, as the new political freedom that the lira would bring would come at the expense of huge disruption to the EU and so to Italy’s partners, which would not easily be forgiven.  The relationship between Rome and Brussels post an Italian departure would make that between London and Brussels, even in the worst days of Thatcher’s table-thumping in the mid 1980s and Major’s non-cooperation in the late 1990s, look like sweetness and light in comparison.  And Italy does need the EU’s help …

As to the future of the euro, I have already stated that I expect it to either to lead to political union or to fail.  Ultimately these are the only two viable end-points, though I also think it may be that we reach neither in our lifetimes.  So the strict answer is “no, I do not think it is sustainable in the long term as it stands, i.e. without being part of a political union”.  But it is more interesting to ask how it might fail.  And here I think most commentators have overlooked the incentives for a fiscally conservative country to leave.

The scenario would I think start with weaker countries having a strong incentive to pressure the ECB into running an expansionary monetary policy – “growth and jobs at the cost of minor inflation”. It is yet another way in which a weak country can freeload on the credibility of the stronger countries in EMU, and a desperate country such as Italy will certainly try it (maybe even with the threat of blackmail:  “we’ll leave and cause chaos for everyone if you don’t”).

At the moment the composition of the Council is such that the ECB can resist, but if the Council becomes “captured” by a majority of weaker member states, it may change to a less single-minded inflation-based approach

At that point a fiscally conservative member state will see the single currency as a weakness and a potential importer of inflation, and if the ECB cannot be “returned” to a straight-and-narrow focus on inflation, the temptation to leave from a position of strength will be large, with the incentives being both a stronger currency and lower interest rates (ie the opposite of what Italy faces).

To conclude, it is not impossible for EMU to survive for some time, perhaps even for several decades. But without political union, I believe it will eventually and inevitably fail.