Monday, March 8, 2010

The Nature of the Euro: A Public Choice Perspective

Confronted to the mounting evidence showing that the Eurozone is not an “optimal currency area” (OCA) some economists have been arguing that the very existence of the euro is powerful enough to force the zone into becoming one. A single currency, they claim, would compel heterogeneous economies to converge toward a similar rate of inflation and would synchronize national business cycles. This is a very strong assumption about the power of money on the real economy. If true, it would mean for instance that all the nations of the world could be transformed into a single economy with a single synchronized business cycle and a single inflation rate, after deciding to share a same currency. It seems a bit farfetched to say the least. If true, the design of a currency union would then be purely a matter of unconstrained political choice. But is it the case?

In an thought provoking paper, Real Exchange Rate Movements and Endogenous OCA Analysis: Lessons from the Euro Area for Asia, prepared for the EUSA International Conference, April 24, 2009, Clas Wihlborg, Thomas D. Willett, and Nan Zhang write:

“While international monetary economists seldom reach complete agreement about the application of OCA criteria to particular countries, it is rather widely agreed among them that many euro entrants did not meet the major OCA criteria”.

And they add:
“… many economists have expressed concerns that mounting disparities in national wage and price movements are foreshadowing a day of reckoning.”

The two charts below (from Nouriel Roubini, Elisa Parisi-Capone, and Christian Menegatti, “Growth Differentials in the EMU: Facts and Considerations”, RGE Monitor, June 2007) provide a clear illustration of that conclusion: the internal adjustment mechanisms within the euro area are not operating powerfully enough to prevent inflation levels (and thus real intra-zone exchange rates)from diverging ,and they show no sign of reverting toward the group average.

It was indeed relatively easy to forecast such an evolution from the start, before the introduction of the euro (see my 1998 book L’erreur européenne), but politicians and bureaucrats did not pay heed. One can wonder why. Paul Krugman diagnoses a severe case of political hubris in The Making of a Euromess.

He concludes: … "it's important to understand the nature of Europe's fatal flaw. Yes, some governments were irresponsible; but the fundamental problem was hubris, the arrogant belief that Europe could make a single currency work despite strong reasons to believe that it wasn't ready."

I almost completely agree with him, having warned of the costly consequences of a move to a single currency for the last fifteen years or so (see my papers in Le Figaro from the mid 1990s), except that I do not think that pure hubris is the only -- and irrational -- motive. I believe instead that Big Government and Big Business found some strong interests in centralizing monetary policy at the continental level rather than keeping decisions and regulations at the national level. That’s what I wrote in my 2005 paper (in French) “Arithmétique de la démocratie” (The Arithmetic of Democracy), downloadable on my homepage.

At a time when it proves more and more difficult to raises tax rates in increasingly open economies, due to the mobility of some of the taxable matter (mostly capital), regulation is a good substitute for taxes, as explained long ago by Posner and Stigler: regulations increase the cost of a good or a service borne by some agents, for instance the producers, while simultaneously decreasing the costs for other ones, for instance the buyers (but it could be the other way around). Just like tax-cum-subsidy, they are a means for redistributing wealth.

Substituting one centralized regulation for 12, 15 or 25 national ones tremendously decreases the cost of these regulations for public bureaucracies – by a factor of 10 or more – and increases their effectiveness since is suppresses the regulatory competition between various states.

For the big business lobbies it is a bargain since the cost of lobbying is also decreased by a factor of 12, 15 or 20, while cartelization is made much more efficient when all trading corporations in various national economies are constrained by a single rule. In that case, producers get rid of the regulatory competition between states to select the one most favorable to consumers. And their collusive agreements are much easier to establish and to enforce, when not disrupted by the uncertainties of multiple exchange rates fluctuations.

This is precisely why the EU regulations have been proliferating at such a mindboggling rate during the recent decades, the single currency being only the most visible and the most important one, among many others.

The gains of such a regulatory bargain can then be shared between governments, bureaucrats and big cartelized corporations. With more powerful regulatory power at their hands, politicians and bureaucrats can satisfy both their taste for power – hubris – and their ordinary preference for income. And since the centralized regulation is much more powerful than national ones (the ratio of rents to costs being much higher), it opens a new and more rewarding echelon in the careers of bureaucrats.

Of course, the post WWII momentum towards a political integration of Western European states has many other causes such as the Cold War, and the general “first twentieth century” trend towards centralization of all hierarchical organizations (including states), or the belief in the peace guarantee that a merger of previously competing nations could provide.

But the main reason for the relentless pursuit of the political centralization of the continent, by big businesses as well as by national politicians, cannot be explained in these terms after the mid-1970s, when the previous centralizing trend was reversed by the information revolution and big hierarchies tended to break down, while markets expanded worldwide. Indeed, the very expansion of markets (the globalization phenomenon) resulted in an increase of worldwide competition, and thus a decrease of the market power of national cartels, as well as of the taxing power of states over capital. It thus became urgent for firms to reconstitute cartels on a broader geographical base, and for states to impose tax-replacing regulations upon firms and consumers, also on a broader geographical area. It is interesting to note that the 1970s were the years of disintegration of the Bretton Woods system of fixed exchange rates: floating exchange rates also contributed to dismantle national cartels.

As a consequence, big businesses and states tried to recover their market power and power to tax by the means of regulations, in a centralizing enterprise encompassing the whole continent. A move exactly contrary to the increasingly dominant trend of the “second twentieth century”.

This strategy, in my view, could meet some success in the short term, but is inevitably doomed in the end. Unable to reach a complete political unification in such an adversary context, the promoters of the Euro tried, as a first step, to establish a technical-economic, more modest, monetary union. Recent events have shown that such an instrument is too weak in itself to shield a centralizing experience from the fundamental decentralizing forces of the current era.

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