Greece has returned to the headlines with some grim news. People of Greece are (understandably) utterly disappointed on their leaders and the leaders of the eurozone, which has led to the upsurge of the approval ratings of euro-sceptic parties. How has this crisis erupted again?
There is an economic theory that explains the problems of the euroarea and Greece: the theory of the optimal currency area (by Robert Mundell and Marcus Fleming). It states that, to function properly, currency unions should fullfill four criteria:
- Labor force should move freely within the currency area, implying that work permits, visas, and language or cultural differences should not impede the labor force mobility between the countries.
- The countries in the currency area should have close trade ties.
- The business cycles should affect the countries in the same way.
- Currency area should have some mechanisms to redistribute risks and incomes between the countries
The more of these criteria currency area satisfies, the more functional it is. As we explained in our special report in the Spring of 2012, in strict terms, the current euro zone does not satisfy any these four conditions. However, very few currency unions do. Even the United States does not satisfy all the above mentioned criteria. The United States has flourished because their cultural heritage is rather homogenous and because federal government redistributes income from strong to weak states. Many states in the USA have been more or less permanent net recipients of federal income while others are more or less permanent net contributors.
History of monetary unions is filled with examples of unsuccessful currency unions. All successful common currency mechanisms that have been in operation for any longer periods of time have been either federal states or confederacies. While some currency unions of sovereign states lasted fairly long, they exposed the members to both external and internal shocks. Additionally, currency unions have been troubled by slow economic growth. Central to the success of any currency union are political ambition and fiscal integration (see Chapter 4.1 from our book for examples and references).
Euro area relives the history of currency unions. Currently, it acts like a straitjacket holding uneven economies under the same growth regime, which is (currently) driven by Germany. What this means is that Germany sets the conditions, i.e. the level of productivity, that dictate the growth prospects of countries that operate under the fixed exchange rate. Modern Germany is highly productive and there is a minuscule change that Greece or other countries on the periphery can ever reach its level. If Germany refuses to support Greece, there is no point for Greece to stay in the eurozone.
Exit from the eurozone would not be an easy path for Greece, but it would give it a “fighting chance”. There would be bank failures, inflation would increase and it would ‘kill’ the nascent economic recovery. But, it is likely that within a year or so economy would start to improve. External devaluation would have restored competitiveness and default would have forced Greece to balance its budget, while offering relief in the form of smaller interest payments.
If ‘Grexit’ would be a success (which is likely) then there would be no reason for other peripheral countries to stay in the euro. This would force the politicians of the other, especially the richer, eurozone countries to test the will of their citizens for European integration. If there would be a will for further integration, a political transfer union would emerge. If not, euro area would be dissolved. Both of these choices would offer a permanent solution for the problems of the eurozone.