I read a pre-print of this book last October. Now that it has been published, here are my notes.
Crisis, Cycle, Challenges: The Evolution and Future of the Euro – Amazon link
The Euro’s Origin
By and large, in the Eurozone – and in the EU – countries manage their own taxes and budgets. The Euro was not meant to change that. When setting interest rates, the European Central Bank (ECB) was supposed to focus on managing inflation. There was no remit for the European Central Bank to buy the bonds of struggling Eurozone countries.
That changed with the crises of 2010 and afterwards. With countries like Ireland and Greece in trouble, the ECB bought up government bonds – and continues to hold the bonds of many countries today. Today, the practical role of the ECB is not just to manage inflation, but to subsidise the borrowing of countries that have run large deficits.
This makes the Euro unstable, for at least two reasons:
a) some countries are subsidising others – which is politically unstable, and
b) there is an incentive for countries to run deficits (as highlighted in the book), and, some day the ECB won’t be able to bail them out without very significantly inflating the Euro (my personal extrapolation).
Why can’t we just go back?
An obvious question is why the Eurozone doesn’t just go back to the original premise and commit to stop bailing countries out? Once the market knows the ECB has stepped in before, it’s hard to put that genie back in the bottle.
Putting the genie back in the bottle
The proposal in this book is somewhat of a mid-way solution, and includes plans to:
a. Create a new bail-out authority with clearly defined limits on what it will do, and when it will impose costs (default) on countries.
b. Impose penalties banks holding too much of their own country’s bonds. Today, many of a given country’s banks (e.g. Italian) own a very large chunk of their own country’s bonds. This means that if Italy were to default as a country, that would also take down the Italian banking system too. By contrast, if Italian banks had diversified bonds, the Italian government could default and the banks might be ok.
c. Unify deposit guarantee schemes across Europe. Today, the Irish government provides deposit guarantees for Irish banks. If the Irish government defaults, then the deposit guarantee is gone. The change would be for deposit guarantees to be done at a European level, so the Irish government could default and depositors are still protected.
d. Put rules in place limiting the ECB from stepping in and doing bailouts. Even given a-c, there is still the risk that markets feel the ECB will step in anyways in a crises. So it’s not entirely credible, especially given the history.
One question is why might the dollar work in the US but is riskier in the EU?
The biggest difference in the US and Eurozone is that US states are in a fiscal/tax union while the Eurozone is (was) only a currency union not a tax union. The problem with a currency-only union is that – if you don’t allow individual countries to default – then individual country debts become shared debt. Effectively, the currency union becomes a fiscal/tax union (without people having voted on a tax union).
But, there is more. One benefit of having your own currency is that the currency can devalue relative to other countries. This is a useful tool because wages are sticky downwards, i.e. wages tend only to go up in fixed currency terms.
If there is a recession – wages generally don’t move downwards easily in currency terms. This is more true in Europe than in the US because a) labour laws are stricter and b) there is less labour mobility between countries owing to language and norms. If wages can’t numerically move downwards (e.g. a wage is fixed at X Euro per hour), one practical way the market can adjust is by devaluing that country’s currency. This would make wages – denominated in any other currency – go down.
If you have a shared currency, you lose this flexibility. If wages get overheated and there is a recession, you lose this pressure relief valve to reset wages.
Partial reserve banking accentuates the need for bailouts
This isn’t a topic of the book, but it’s relevant here overall to banking, and puts pressure on the currency union.
Bailing out governments in a currency union is already a problem because it makes that union a fiscal union. But, the need for bailouts is accentuated because banking is done on a partial reserve basis (i.e. banks are allowed to lend out more than they have on deposit). This puts pressure on governments to bail out banks if they lend poorly – to protect depositors. This puts big pressure on government finances and ultimately on the currency. The pressure can only be released via a bailout or inflation. This is an issue in the Eurozone and in the US.
A solution to this – and it’s not new – is narrow banking, where banks must hold deposits to match lending. In this kind of economy, most lending and financing is done by the private sector and not by banks. The argument against narrow-banking is that subsidising banks allows an important source of lending that drives the economy. I don’t say this confidently – because narrow banking would be quite a different system (perhaps it might mean less home ownership?) – but my gut feel is that we would avoid larger crises by going back to narrow banking in the EU, and US.
A Simpler EU without the Euro
These questions are difficult, and I say all of what I say below with low confidence. Dropping the Euro could particularly be a bad thing for higher deficit countries such as Greece and Italy. Namely, it would reduce the leverage of the EU and ECB over those countries’ governments. You could argue this leverage keeps those countries in check – a somewhat paternalistic argument.
Side note: Technology has made it easier to handle multiple currencies than before. It’s very easy for me to earn and spend and convert in Euro, dollars or pounds with Wise or Revolut. That said, maybe I still underestimate the costs and frictions in having different currencies – for example, even Stripe charges a 3.97% foreign exchange spread on Euro to Bulgarian currency, for example.
My current view is that the EU and Eurozone would perhaps do best to drop the Euro and re-focus on a simpler European Union, one that focuses on:
a. freedom of movement of people, including for work
b. freedom of movement of goods, services and capital
There remain big barriers around the freedom of movement (article by Luis Garicano, a co-author of the above book). EU countries are not respecting (and the EU is not enforcing) the reciprocity that is supposed to be in place, i.e. if a profession is considered qualified in one EU country, that license should apply in others (I know that’s a strong statement, but think this would close a big gap in unifying the EU market in the same way that the US has one big market). In the current system, differing national rules co-exist with some EU-wide rules. Rather than adding further rules, it may be simpler to focus on enforcing reciprocity.
I don’t think the Euro is under any immediate threat, but it may well be under threat in the next big crisis. A relevant vignette is perhaps the Latin Monetary Union from 19th century Europe and how it went out of use after countries started devaluing the currency to finance spending. I also don’t think the Euro will initially abandoned, it’s more likely certain countries would leave – whether voluntarily or involuntarily (betting markets are illiquid; Metaculus prediction markets have the odds just below 10%; perhaps Italian or Greek bond yields are the best indicator).
There are some big questions here as to whether we should return to narrow banking, and, the matter of whether the EU will ultimately become a fiscal/tax union. The answers are uncertain, and these questions tend to take decades, if not centuries, to resolve.