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Can the Euro Survive?

di - 20 Dicembre 2010
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Now, as McCallum goes on to remark, although stating the optimisation problem is certainly the first step to solving it, it is not the same thing as solving it. Indeed, he points out that a long list of distinguished scholars has had no success in making the theory operational. The theory produces a list of factors which are possibly relevant to the optimality (or otherwise) of any proposed currency area, but many of these factors are not quantifiable and none of the tradeoffs between them can be specified, other than (at best) as to sign. The same goes for a less often mentioned benefit of a common currency – increased capital market integration, and its associated increased capital mobility.

This body of theory’s failure to be operational has  much in common with another, and older, body of work – that on the optimal size of firm. This was neglected completely at the time the Euro was created, but in fact has much to say on the matter.

The Optimal Size of Firm
Work on the optimal size of firm was always inconclusive, whatever industrial sector was being investigated. George Stigler, writing in 1958, observed that “the theory of economies of scale has never achieved scientific prosperity”.  (1958, p4) In the same paper he went on as follows: “A large cause of its poverty is that the central concept of the theory – the firm of optimum size – has eluded confident measurement.” (1958, p14)   He then argued that we should judge the optimum size by whether firms survive or not. To quote Stigler again, “The basic definition of a firm of optimum size is that it can maintain itself indefinitely in competition with firms of other sizes.” (Stigler, 1987)

We see the same when we look at currency areas which are free of exchange controls. Many different sizes of area survive. What can we do with this observation? We can borrow from Stigler again, and look at various factors popularly said to contribute to currency area size, as he did when considering firm size. We could look at labour mobility; at price stability; at composition of output, and so forth. And, when considering the Euro, we could look for a long- lasting currency area of similar size, and ask if the Eurozone has all or most of the same attributes.

The obvious comparator is the USA. The Euro area does not have the same amount of labour mobility. In principle labour is free to move anywhere in the EU, but of course lack of a common language greatly restricts such movement. The Euro area does not have a central fiscal authority which can help smooth shocks which hit one area but not others. There is not the ready mobility of firms to take up the advantages that one area offers over another in terms of unemployed labour. And of course, it does not have the political cohesion which comes from having been a nation state, and one still proud to have fought for its independence, for over two hundred years.

What if anything can compensate for these missing characteristics? If there are no such compensating factors, we must be driven to conclude that there are design flaws in the Euro, and the latest problems are a symptom of these flaws.

Looking at the recent, and very grave, problems of Ireland reveals whether there are compensating factors, or whether a Euro redesign is needed.

Ireland’s Difficulties
Back around the time when Britain’s Northern Rock and then Iceland’s banks got into severe difficulties, a run started on the Irish banking system. The Irish government stopped this by guaranteeing all funds deposited with Irish banks. Not just retail deposits, but everything. Not surprisingly, the run stopped. But recently fresh problems appeared. The problems in Ireland’s banks were much greater than had been thought. The already considerable fiscal tightening needed to repay the borrowings the Irish government had made to prop up their banks seemed likely not to be enough.

But more fiscal tightening was perhaps not politically feasible, and indeed, it seemed possible that the Irish economy, however hard it was willing to try, might actually not be able to repay the debts. A further run on the banks developed. This run has triggered a loan from the EU and the IMF to the Irish government.

Now, if the problem was too much debt, how can taking on more debt help? There is only one answer – the loan must be on terms so generous that the new, bigger, loan is much easier to pay than the old one, and must also initially be used to repay the earlier debts. So if, for example, the earlier debts needed to be repaid over five years, if the new loan is bigger than the old ones (so as not just to repay them but also capitalise the Irish banks more securely), needs to be repaid over a much longer period, and bears a lower rate of interest, then the new loan will bail out Ireland.

But what will that mean for Ireland, for those who have lent the money, and for the Euro?

For Ireland it will mean years, maybe decades, of high taxes. Even if the most obvious source of damage, a higher corporation tax rate, is avoided, there will be problems. Ireland has a well educated work force, and one which if not accustomed itself to going abroad at times of economic difficulty has certainly, and recently, seen earlier generations do so. Will any skilled workers be left in Ireland after the bail out? Who will pay these higher taxes? Ireland’s problems have not been solved. They have simply been changed to a different kind of problem.

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