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.