When the European Monetary Union was set up, member-states adopted what was essentially a foreign currency (the euro) but were left in charge of their own fiscal policy. Dimitri Papadimitriou and Randall Wray explain in a new Policy Note (“Euroland’s Original Sin“) why this basic structural defect was always bound to tear the eurozone apart. The solvency crises and the bank runs afflicting Spain, Greece, and Italy were entirely foreseeable (and as Papadimitriou and Wray point out, entirely foreseen). Unless something is done to remedy this design flaw, the EMU will continue to crumble.
The banking crises laid bare what happens when you try to separate fiscal policy from a sovereign currency: “banks were freed to run up massive debts that would ultimately need to be carried by governments that, because they had abandoned currency sovereignty, were in no position to bear the burden,” say Papadimitriou and Wray. Inasmuch as they are users rather than issuers of a currency, EMU nations are essentially in the same position as US states—but the difference is that US states can rely on the currency-issuing firepower of the federal government (when Texas was hit with the S&L crisis in the 1980s, the federal government picked up the tab; a tab that was about one quarter the size of Texas’ entire GDP). And the problem is not just the size of the debts member-states took on, but that they took them on without the benefit of controlling their own currency—which makes all the difference in the world. The US and Japan can borrow at very low rates while countries like Spain (whose debt ratios are much, much smaller than those of Japan) are caught in a vicious cycle of rising borrowing costs.
Papadimitriou and Wray explain how all of this was compounded by the TARGET system, which made possible the massive bank runs in Spain, Greece, and Italy. They argue that EMU-wide deposit insurance backed by the creation of a strong EU-level treasury is necessary. There was some initial enthusiasm (as there always is, initially) when the latest “solution” emerged from the June 29 summit. But it is becoming clear that the EMU is not moving towards a true banking union* anytime soon.
Read the whole Policy Note here.
* The term “banking union” is being thrown around a lot, but there’s a difference between giving the ECB extra supervisory powers over the banking system and moving to unlimited deposit insurance, which, as of yet, does not appear to be on the horizon. A similar confusion can arise with the term “fiscal union”: rather than the creation of a strong European federal treasury, the term is commonly used to refer merely to the new fiscal accord in which member-states will face stiffer penalties when they violate the Maastricht criteria limits on deficits and debt. The only “union” that will remedy the structural error built into the EMU is one that addresses the doomed separation between fiscal policy and currency sovereignty.