Among the many unfortunate features of capitalist history that tend to repeat themselves with depressing regularity is the conversion of crises of private activity in financial markets into fiscal crises of the state. This is already happening once again, as the very expansion of public expenditure that was necessitated by the financial crisis (which itself resulted from the irresponsibility of private financial players) is being attacked by those who argue that excessive fiscal deficits are unsustainable and must be controlled as soon as possible.

The focus of financial market attention in the past week has been on the fiscal problems in some developed countries, in particular the countries that are now rudely designated as PIIGS (Portugal, Ireland, Iceland, Greece, and Spain) within the European Union. The fiscal problems in Greece are currently the most pronounced, not least because the previous government apparently fudged the books so massively that the newly elected government is faced with an unexpectedly large deficit even as it needs to increase fiscal stimulus in the midst of economic downswing.

Bond markets have already declared their displeasure by requiring huge spreads on Greek government debt, and a liquidity crisis looms for the country. In a dose of the monetarist medicine familiar to many developing countries, Greece is now being asked by the European Union to make wrenching cuts in public spending, which are not only difficult to implement for the new Socialist government but unlikely to be accepted by the restive public. The IMF waits in the wings.

But the problem posed by the sovereign debt issues of Greece is deeper and potentially more significant, since it calls into question the stability and viability of the eurozone itself. Without currency union, devaluation of the currency would have been one of the most obvious easy ways to ensure adjustment in Greece and similar economies. With that option closed, adjustment based entirely on domestic economy measures will require such severe cutbacks on public spending and private consumption that they are unlikely to be accepted in a democratic set up. The only other option is bailout by Brussels, but the European Charter did not provide any bailout clause, and this depends crucially on the ability and willingness of countries like Germany and France to set such a precedent.

The euro has always been an unlikely major currency, based as it is on monetary union between countries who do not share political union. Its creation was remarkable, a tribute to idealism and a reflection of the triumph of political will over economic barriers. To outsiders, it is a fascinating experiment, since its apparent stability thus far calls into question a belief that was axiomatically held by many economists: that monetary union is difficult if not impossible without fiscal federalism underpinned by more comprehensive political union.

Of course the eurozone is not the first attempt at monetary union in history, nor is it likely to be the last. But thus far it has been the most successful by far. It is the culmination of the century-long drive in Europe towards greater integration, punctuated by wars, other conflicts and instabilities, but proceeding regardless of those hurdles.

The driving force of such a union may well have been political, but there are also clear economic benefits. These stem mostly from the reduced transaction costs of all cross-border economic activities, including trade in goods and services. In addition, the stability provided by a single currency serves to reduce risk in a world of very volatile currency movements driven by mobile capital flows, and this is seen to be an additional inducement to invest in productive activities.

But there are also significant costs of such union, which are becoming especially evident now. The most obvious is the loss of two major macroeconomic policy instruments: the exchange rate and monetary policy, which can otherwise be used to prevent an economy from falling into a slump. For example, Greece could have tried to use a combination of exchange rate devaluation and lower interest rates to stimulate demand, increase income and reduce unemployment, as well as prevent the external deficit from deteriorating. Of course this is not foolproof, as many countries know, but trying to adjust without such instruments is that much harder.

The other way to resolve this would be for workers in Greece to move to other parts of the eurozone, and so reduce the pressure on the domestic economy. This obviously requires free flow of factors across borders, which is often seen as a basic economic condition for currency union, and this was sought to be created by the Single Market in 1994. Even till date labour does not really move freely across European borders despite the removal of official restrictions.

Finally then, the option would be to have fiscal transfers (implicit bailouts) to Greece from stronger segments of the eurozone economy. This fiscal federalism is quite important in the US, which is another large area that is a currency union (in this case backed by political union). But so far, such fiscal federalism is less developed in the European Union, and there is already a backlash in several countries against ceding more powers to Brussels. In this context, temptations on the part of some members to free ride on the strength of others, and equally strong attempts to resist such pressures by the stronger members, can even make the union unviable.

This is what makes some commentators question the medium-term future of the euro. It is not just the current problem of Greece or any other country, but the larger structural issue of whether the currency union can survive without more explicit fiscal federalism. This requires political commitment to European unification which goes far beyond anything we have yet seen, but it may still occur. If not, we may be witnessing a 21st century Greek tragedy unfolding on a grander European scale.

February 9, 2010.