Toward Two European Monetary Unions

The crisis of the European Monetary Union (EMU) came as a surprise to most decision-makers. Most politicians had thought that putting a large group of countries together under one monetary regime would be an easy matter, requiring only the political will to do so.

By comparison, differences in political governance (a preference for markets versus state intervention) and value systems (rule-bound versus a proclivity to cheat), as well as matters of economic development, economic structure and performance, seemed of secondary importance. These differences were expected to be ironed out over time via a permanent flow of transfers in the form of regional aid.

One of the main lessons to be drawn from Europe's current crisis is that it is a serious matter to admit a country to the European Union. The country becomes part of the political decision-making body of the EU. Just imagine a union consisting of 20 Romanias, Bulgarias and Greeces, and only ten Netherlands, Denmarks and Swedens. What kind of political body and value system would emerge for the EU?

And for the EMU, it obviously is not an easy matter to refuse an EU member. Witness the membership of Belgium, Italy, Greece and Portugal. One clear lesson should be — and must be — to weigh again the pros and cons of the admission of the Balkan countries. The much-used argument that "what matters most is political stability for the continent" has used up its mileage when it comes to economic and monetary integration.

While it is unthinkable, and would surely be costly, for Greece to opt out or be kicked out of the EMU, let's imagine we were back in the 1990s and preparing the EMU. We should be ready not to admit just any country eager to become a member, even if such countries believe it would be in their interest to join. Greece today would be happy not having joined.

I would, however, go a step further. It is quite clear that for countries of the southeastern part of the EU, the EMU is far from an ideal framework and that, pure (and irrelevant) prestige considerations aside, they would not necessarily gain from joining.

Therefore, it would be beneficial to contemplate the creation of a second monetary union, perhaps called SEMU, or South EMU. Based on their own common economic traditions, such a grouping of countries may aim at an inflation target above 2%, or it may find it more convenient not to have an inflation target, but an exchange rate target with respect to the North EMU.

They may also choose to create a political body overseeing their joint central bank, thus not insisting on central bank independence. The SEMU may tolerate some controls on capital movements.

Once such a South EMU were created, certain members of the North EMU would have a choice of changing camp. Which countries would benefit from doing so? This question should not be settled by looking only at fiscal deficits, the public debt or current account deficits. They are important indicators, but are insufficient. The table below summarizes the arguments:

Click on the image for a larger version of this figure.

Chart based on the author’s research.

Note that the criteria for classification into the various categories are based on performance since the introduction of the euro. Concerning fiscal discipline, Spain and Ireland have run a surplus before the crisis and had a low public debt. Hence they are in the North. Italy has not substantially reduced its outstanding debt, although currently it is containing its deficit. It is thus part of the South. Belgium has a lower current account deficit than Italy and has reduced its public debt by more, so it is in an intermediate situation.

The current account deficits of Greece, Ireland, Portugal and Spain were very large even before the crisis. Hence they are part of the South. The financial systems in these countries have of course shown their weakness since the onset of the crisis, but their foreign indebtedness goes back to the years before.

Spain is in an intermediate situation. The cajas (small savings banks) suffer from the real estate bust, but the major banks are solid.

Cost flexibility results from domestic labor market practices and institutions. The Germans have demonstrated through years of wage moderation during the early years of the EMU how to adjust to an overvaluation. Labor unit costs in Greece, Italy, Portugal and Spain have substantially increased since the creation of the EMU, and no substantial correction has been implemented so far.

In a dynamic economy, product innovation is a key requirement for maintaining competitiveness. Innovation also requires a highly educated labor force. According to OECD data, the quality of education and extent of tertiary education is ranked much lower in the Southern countries. The number of patents obtained per capita on a yearly basis is also much lower.

Finally, the average of a country's performance may mask serious and sometimes insurmountable regional differences. Italy's mezzogiorno, or southern half, is a case in point, dragging substantial resources into regional transfers with little visible catching up.

This then suggests a future picture. Portugal and Greece do not fit into the Northern EMU. Ireland, despite the extent of the crisis, is a much better fit. Italy and Spain also have their weaknesses, but they may be accommodated in the Northern EMU, although they eventually may choose to be more at ease in a Southern EMU.

What the current euro crisis has taught us is that to have that choice is what really matters for countries. Rather than being straight-jacketed, they ought to be able to choose their own destiny.