The Euro and the EU: A Complicated Relationship

The European Union, started as a free trade zone for Europe, is moving toward a comprehensive European government — a United States of Europe — in small steps.  Europeans rejected a European Constitution in 2005, indicating their reluctance to give up their national sovereignty to the EU, but little by little, that is what is happening.

Currently, the Euro zone is providing the big push toward the increased power of the EU over its member nations.  On the surface, there appears to be no reason why the common currency should result in a push toward a common government.  Beneath the surface, the problem is that a common currency means a common monetary policy for all Eurozone members, and different countries often would like different monetary policies.  If they are going to stick with the common currency, the current direction for resolving this tension resulting from different countries wanting different monetary policies is to move toward making Europe a single nation.

One reason different countries might want different monetary policies is that economic conditions can vary among countries.  Countries with localized conditions causing economic slowdowns might want looser monetary policies than countries experiencing booms.  At the moment, though, countries like Greece would desperately like easier monetary policy as a way of inflating away their debt obligations.  With Euro-denominated debt, there is no way they can meet their present obligations, but if they still had the Drachma they could inflate away those obligations.  Inflation is not the ideal solution to heavy government debt, but now that Greece is in the Euro zone, inflating it away is not an option.

Commentators often say that the Greek bailout is a move to maintain the strength of the Euro, but in reality, the opposite is true.  If Greece defaulted, the Euro as a currency would not be compromised, even if Greece’s borrowing ability would.  Greece might decide to leave the Euro zone, and a Greek default might hasten the financial decline in other Eurozone countries, but the value of the Euro would not be compromised by the default of Euro-demominated debt.

Ironically, bailing out Greece and supporting other Eurozone countries’ debt will weaken the Euro, because the bailouts make it more likely that the Eurozone will have to resort to inflation to manage the burden of their fiscally irresponsible neighbors.

Everyone can see that the EU policy of bailing out Greece sets up bad incentives for Eurozone countries.  It says that if you are fiscally irresponsible, rather than having to bear the costs of that irresponsibility yourself, the more fiscally responsible members of the EU will bail you out.  That makes it less costly for EU governments to engage in fiscally responsible behavior, and it also means that rather than having to actually reform and change their ways, they can continue their fiscally irresponsible policies with the financial strength of the EU behind them.

The incentive problem I’ve outlined in the previous paragraph is obvious, and the reason why French President Nicolas Sarkozy and German Chancellor Angela Merkel are proposing more EU oversight over the fiscal policies of their members.  The bailout policy they are currently pursuing is ultimately not compatible with fiscal independence of the EU member nations.

The best policy for the citizens of Europe would have been to let Greece deal with its fiscal problems on its own.  In the short run, that would have been harder on the Greeks, but in the long run it would have forced them toward fiscal responsibility.  And, as I explained earlier, this would have been better for the Euro, and obviously better for the citizens of the other EU countries who are paying for Greece’s fiscal irresponsibility.  If this had happened, the crisis would already have been over, albeit with some people — Greek bondholders and those who depend on the government of Greece for their incomes — immediately worse off.  The EU bailout policy will just prolong and deepen the crisis as it spreads to other countries.

If that is the best policy, why didn’t it happen?  One reason is that Germany suffers a lingering guilt over World War II — something that happened well before most Germans were even born.  If Germany had not acted in response to the problems of an EU member, it would not be acting “European,” and one role of the EU is to unite Europe so that the World Wars of the twentieth century (and frequent hostilities before that) do not reoccur.

A second reason is that despite the fact that EU citizens — in fiscally strong countries, anyway — do not want to give up their national sovereignty to the EU, their political leaders feel differently.  They like the idea of a more centralized government, because it allows bigger government.  More centralized government makes it harder for economic activity to escape oppressive government policies and move to countries that extract less from productive activity.

While the Euro and the EU can exist independently, and there is no reason why a Eurozone has to lead to a more centralized and powerful EU government, the response of the EU to the Greek crisis is intimately connected to Greece’s membership in the Eurozone.  The common currency does not have to imply a central government for Europe, but because of the EU’s policies, the Euro is the major factor in the present push toward centralization.  Looking ahead, this is not a good development for Europe.