x Abu Dhabi, UAEFriday 21 July 2017

One currency works in US but not in Europe - for some good reasons

Europe is now struggling with the inevitable adverse consequences of imposing a single currency on a very heterogeneous collection of countries.

European politicians who insisted on introducing the euro in 1999 ignored the warnings of economists who predicted a single currency for all of Europe would create serious problem. Jeff Topping / The National
European politicians who insisted on introducing the euro in 1999 ignored the warnings of economists who predicted a single currency for all of Europe would create serious problem. Jeff Topping / The National

Europe is now struggling with the inevitable adverse consequences of imposing a single currency on a very heterogeneous collection of countries.

But the budget crisis in Greece and the risk of insolvency in Italy and Spain are just part of the problem caused by the single currency.

The fragility of the major European banks, high unemployment rates, and the large, intra-European trade imbalance - Germany's US$200 billion (Dh734.62bn) current-account surplus versus the combined $300bn current-account deficit in the rest of the euro zone - also reflect the use of the euro.

European politicians who insisted on introducing the euro in 1999 ignored the warnings of economists who predicted that a single currency for all of Europe would create serious problems. The euro's advocates were focused on the goal of European political integration and saw the single currency as part of the process of creating a sense of political community in Europe.

They rallied popular support with the slogan "One Market, One Money", arguing that the free-trade area created by the EU would succeed only with a single currency.

Neither history nor economic logic supported that view. EU trade functions well, despite the fact that only 17 of the union's 27 members use the euro.

But the key argument made by European officials and other defenders of the euro has been that, because a single currency works well in the US, it should also work well in Europe. After all, both are large, continental and diverse economies. But that argument overlooks three important differences between the US and Europe.

First, the US is effectively a single labour market, with workers moving from areas of high and rising unemployment to places where jobs are more plentiful. In Europe, national labour markets are separated by barriers of language, culture, religion, union membership and social-insurance systems.

To be sure, some workers in Europe do migrate. In the absence of the high degree of mobility seen in the US, however, overall unemployment can be lowered only if high-unemployment countries can ease monetary policy, an option precluded by the single currency.

A second important difference is the US has a centralised fiscal system. Individuals and businesses pay the majority of their taxes to the federal government in Washington, rather than to their state (or local) authorities.

When a US state's economic activity slows relative to the rest of the country, the taxes its individuals and businesses pay to the federal government decline, and the funds it receives from the federal government (for unemployment benefits and other transfer programmes) increase. As a general rule, each dollar of GDP decline in states such as Massachusetts or Ohio triggers changes in taxes and transfers that offset about 40 cents of that drop, providing a substantial fiscal stimulus.

There is no comparable offset in Europe, where taxes are almost exclusively paid to, and transfers received from, national governments. The EU's Maastricht Treaty specifically reserves this tax-and-transfer authority to the member states, a reflection of Europeans' unwillingness to transfer funds to other countries' people in the way Americans are willing to do among people in different states.

The third important difference is all US states are required by their constitutions to balance their annual operating budgets. While "rainy day" funds that accumulate in boom years are used to deal with temporary revenue shortfalls, the states' "general obligation" borrowing is limited to capital projects such as roads and schools. Even a state such as California, seen by many as a poster child for fiscal profligacy, now has an annual budget deficit of just 1 per cent of its GDP and a general obligation debt of just 4 per cent.

These limits on state-level budget deficits are a logical implication of the fact that US states cannot create money to fill fiscal gaps. These constitutional rules prevent the kind of deficit and debt problems that have beset the euro zone, where capital markets ignored individual countries' lack of monetary independence.

The most likely effect of strengthening political union in the euro zone would be to give Germany the power to control the other members' budgets and prescribe changes in their taxes and spending.

But a formal transfer of sovereignty would only increase the tensions between Germany and other EU countries.

Martin Feldstein, professor of economics at Harvard, was chairman of President Ronald Reagan's Council of Economic Advisers and is former president of the National Bureau for Economic Research.

* Project Syndicate

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