Dismantling the Eurozone

by George Hatjoullis

The National Bank of Poland has produced and published a working paper entitled:

Controlled dismantlement of the Eurozone:
A proposal for a New European Monetary System
and a new role for the European Central Bank


The content of the paper is less remarkable than the fact that it has been produced. Poland is a member of the EU but not the eurozone. One must conclude from this paper that Poland will not be joining the eurozone in its present incarnation. This is interesting of itself. The logic behind the proposal is not novel. Indeed this part of the paper reads a little like my first undergraduate paper written in 1971 at UCL. The topic was ‘is the EEC an optimal currency area?’. The answer was, of course, it depends on which countries make up the EEC. In 1971 nobody but the ‘elite’ envisaged a EU of 28 members and growing, let alone a common currency area of 17 countries and growing.

The present composition of the EU and eurozone does not constitute an optimal currency area. This is self-evident. Moreover, the constitution of EMU (the Maastricht Treaty) precludes the possibility of EMU ever metamorphosing into an optimal currency area. This would require fiscal transfers across nation states. This would require a federal fiscal structure and joint and several liability for federally issued national debt. The crisis has brought into being arrangements that emphasise that such arrangements, and hence a metamorphosis, will never take place. Member states that have low absolute productivity, and thus ceteris paribus lower living standards, have no mechanism for altering this situation. Capital and Labour will move out of these member states in search of a better life and greater profits. However as these states are national sovereign entities, the consequences are socially and politically catastrophic. It should also be noted that even with a fully federal structure regional problems would persist. Just review the success of regional policies in the UK.

The main argument against the common currency was that, given the large differences in productivity across the region, large movements in population and capital would be necessary and much larger than would be socially and politically acceptable. The result would bring ethnic tensions and leave some sovereign states in perpetually depressed state. The abuse of credit allowed many member states to circumvent the problem for a while and the result was the eurozone crisis. The response to the crisis is not a solution to the underlying problems. The eurozone now consists of a group of countries that are running fiscal policies dictated by Berlin. There is some transitional credit available but only on condition that the member states put in place mechanisms that ensure that in future they ‘live within their means’. Each member state must now boost its productivity internally. There will be some limited fiscal transfer through EU ‘development funds’ but no fiscal integration.

The NBP is arguing that this is an unstable and unsustainable situation and it is correct. As long as the eurozone consists of sovereign states, the present structure will not last. It presents a proposal to dismantle the existing structure and reform the EU as a number of common currency areas. The main point is that since the system will eventually fall apart it would be best to take it apart and start again. Easier said than done. However, there is merit in the spirit of this paper. The crisis response has shored up the eurozone but not resolved the basic architectural frailties. Moreover, it highlights the obvious structural flaw, namely that a common currency amongst sovereign states requires strong fiscal integration and collective liability. In other words, it is not possible because the strong fiscal integration and collective liability means the states are no longer sovereign.

The NBP paper needs wider discussion because the strains of the crisis in some sovereign member states have reached breaking point or soon will. Greece is a case in point. In my professional capacity, I noted the risks to Greek democracy of the resolution mechanism proposed in 2010. No one was interested. Today I can say, with regret, I told you so. However, I suspect the architects of the resolution mechanism, Berlin, do not much care. Greece is a fragile democracy and the strains of austerity have fanned internal political divisions that were ever-present. Political positions are prone to polarize in some countries. What Berlin has failed to grasp is that Greece is not unique and the same predisposition to political polarisation is evident in Cyprus, Italy, Spain, Portugal and of course Germany itself. The EU and EMU projects have always been political projects with economic costs. The cost is proving higher than forecast and this political project is experiencing some predictable political stress. It is not going to be possible to have free movement of capital and labour in a region if the differences in  standard of living become too wide and the regions are sovereign states with separate ethnic and cultural histories. The NBP fear that the common currency area threatens the EU and the single market. They are correct.