Sunday, June 21, 2015

Greece needs to leave the euro: Part IV

This is my response to a great article by Wolfgang Munchau in the FT on 21st June, 2015 which you can access here.
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As usual, a great article from Wolfgang Munchau.

In one sense Munchau is over-reacting to the prospect of Grexit, and in another sense I think his reaction is perhaps understated.  So let me explain.

First, Munchau states that "The pretence of irreversibility is what distinguishes a monetary union from a fixed exchange rate system with a shared currency."  This is not accurate, as irreversibility was completely absent from the Latin Monetary Union of 1865, which Greece actually joined in 1867, and then was ejected from in 1908 (as were the Papal States at an earlier date). While the intent of a monetary union is not reversibility, there is nothing to stop some reverse actions occurring while maintaining the rest of the monetary union. Grexit need not threaten the rest of the euro area.

Second, economists have always claimed that the euro area requires a fiscal union if it is to become more sustainable and less susceptible to asymmetric shocks or the development of non-synchronous growth in a particular member state.  That is clearly stated in the optimal currency area theory which should be the economic foundation which forms the basis for any monetary union.

What Munchau does not state, but I think will be the result of this week's events is the realization among EU policymakers that they now have to deal with the reality of a "two (or even three) speed" EU.  There has always been the hope among European federalists that one day the EU will have the euro as it's currency, but this is now unlikely to be the reality unless further action (such as fiscal union) is taken.

To me, as an economist, the lesson is that although monetary union in the EU has been conceived in a political space and embodies the political ambitions of the EU elite, it will not succeed unless its economic foundations are solid.  As economists such as Willem Buiter stated years ago, there was both "sense and nonsense" in the Maastricht Treaty, and now we are about to pay the price for ignoring international economics in favor of establishing grand European political projects.

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