history lessons for the eurozone

Rutgers University economist Michael Bordo thinks that the eurozone can learn from the history of successful monetary unions.

Federal nations like the United States, Canada, Australia, Germany and Switzerland are examples of monetary unions combined with fiscal unions that have been successful for long periods. However not all monetary unions with fiscal unions have been successful. Two obvious cases of failure are Argentina and Brazil (until quite recently).

There are a number of factors explaining the success of national monetary unions with fiscal unions. These monetary/fiscal unions are in federal states based on common goals and a commitment to political unity. The elements of success include: a) a unified currency area (single currency) … [with] aggregate price level stability; b) free trade and free factor mobility among the members; c) a common federal fiscal policy …; d) … fiscal discipline enforced by market forces and above all a” no bail-out “rule on state debts by the federal government; and e) the presence of mechanisms to deal with asymmetric shocks. These include automatic stabilizers like unemployment insurance, a progressive income tax, transfers from states less hard hit by shocks to other states more hard hit, and equalization payments.

The fiscal history of the U.S. (and Canada) illustrates the evolution of these factors. …. Threatened debt defaults in 1840 by a number of states which had financed unsustainable public projects (canals) by foreign debt were not prevented by the Federal government assuming the debt. The subsequent defaults led to a cessation of British capital inflows for decades. This experience eventually led all the states to henceforth follow balanced budgets and effectively established the “no bailout rule”.

The hardship of the Great Depression in the 1930s … led to the institution of fiscal transfers to the [US] states [and equalization payments to Canadian provinces]. ….

Argentina and Brazil … were established as federal nations on the US model but the states had considerable power relative to the federal government. In their fiscal histories the “no bailout rule” was not followed. In the late twentieth century the state governments ran large fiscal deficits and when faced with default was bailed out by the federal government. In addition the fiscal deficits of the federal government were often monetized by the central bank. As a consequence, on a number of occasions these countries suffered massive currency and debt crises. ….

[U]nless the eurozone moves much more in the direction of the fiscal transfers of successful fiscal federal nations, … the next global crisis may lead to its break up. Moreover if the member states are unwilling to give up fiscal authority to the central EU government and to accept … adherence to credible eurozone wide fiscal rules such as no bailouts and budget balance over the business cycle, then the euro experiment is doomed to failure.

Michael D. Bordo, “The Euro needs a Fiscal Union: Some Lessons from History“, Shadow Open Market Committee, New York, NY, 12 October 2010.

Michael Bordo is a member of the Shadow Open Market Committee (SOMC), which was founded in 1973 by Professors Karl Brunner (University of Rochester) and Allan Meltzer (Carnegie Mellon University) to evaluate actions of the US Federal Reserve’s Open Market Committee (FOMC). Over the years the SOMC has added a broad range of macroeconomic issues to its original focus on monetary policy.

I would place more emphasis than Prof Bordo does on the “no bailout rule”. In fact, a fiscal union, while helpful, may not be necessary if a strong “no bailout rule” is in place. Consider Panama, for example. That country has enjoyed a unilateral currency union with the United States since it broke away from Colombia in 1904. Panama calls its unit of account a “Balboa”, equal to one US dollar. But it does not print Balboas, so cannot devalue its currency. US dollars circulate as the only paper money in Panama. The US does not – and will not – bail out the government of Panama if it cannot pay its debts. Panamanian bonds have no more backing from the US federal government than do the bonds of neighbouring Colombia and Costa Rica, which have their own currencies. More recently, El Salvador and Ecuador joined the US currency area, on the same terms as Panama, i.e. with no fiscal transfers and no possibility of a bailout.

For more on this subject, see my TdJ of July 20th 2011 on monetary union in Europe and the US.

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