This article is by Mazen A. Skaf, a partner and managing director with Strategic Decisions Group, a consultancy in strategic decision-making, risk management, and shareholder value creation.
Headquarters of the European Central Bank, in Frankfurt, Germany.
Time is fast running out on the euro. With record high unemployment in the euro zone, failing austerity measures, and restive populations in southern Europe, the E.U. may soon have to consider a far more radical long-term solution to the crisis: the introduction of dual currencies.
This solution of last resort would allow member countries such as Greece or Spain to introduce a new local currency—the new drachma or the new peseta, for instance. This national currency would be used for domestic transactions, pension benefits, and the salaries of public sector employees. All external debts denominated in euros would continue to be honored in euros. Similarly, all existing bank deposits in euros would be maintained in euros, preventing bank runs.
The local currency could be devalued based on an agreed upon schedule or allowed to float within a specified range in order to restore competitiveness and economic growth in the local market. The European Central Bank would provide loans to support the member countries through the transition but would not extend any support for a member country’s primary expenses. Those expenses would be financed with the member country’s new local currency and be subject to the country’s budgetary policy.
This dual-currency system would help circumvent the structural weaknesses that will remain—and that will cause more zone-wide economic crises in the future even if the ECB somehow manages to alleviate the debt crisis in the short term.
Under current arrangements, member countries simply lack the ability to stimulate their economies, as monetary policy resides solely in the hands of the ECB. Economic shocks affect different countries differently and require different responses, yet the only tool they have for influencing their economies is fiscal policy—their budgets. And that tool is severely limited by the E.U.’s stability and growth pact, essentially an E.U. rule requiring members to keep their budget deficits below 3% of gross domestic product. So the flexibility usually enjoyed by a sovereign country to run budget deficits in a recession to counterbalance the business cycle is virtually nonexistent.
The current situation is like trying to control the temperature of a 16-story building with a single thermostat, and then telling the tenants that they can’t use a space heater or a portable air-conditioning unit when the temperature leaves the comfortable range. Under a dual-currency system, member countries would continue to enjoy the benefits of the euro while increasing their maneuvering space to drive monetary and fiscal policy on a local basis.
Other remedies to these structural weaknesses have been proposed. One is greater fiscal integration, including a joint fiscal authority, the issuing of common bonds, and the ability to make fiscal transfers to regions hit disproportionately hard by recession. The level of additional fiscal integration required may prove daunting and require considerable time to achieve. Currently, the budget of the E.U. cannot exceed 1.27% of the European Union’s gross national product.(In 2011, the E.U. budget was €141 billion, or about 1% of the EU’s total GDP of more than €12.6 trillion. By contrast the U.S. federal budget in 2011 stood at 40.1% of GDP. That may be too high, but the comparison provides a rough estimate of the order of change in fiscal integration required to deliver any meaningful impact.
Greater fiscal integration, even if achieved, would be insufficient. The private sector needs more flexibility across the euro zone, including greater labor mobility and a unified labor market, to respond to economic shocks.
Still, the odds are stacked heavily against these approaches to the problem. Greater fiscal integration requires the upfront and ongoing commitment of voters and officials across member countries and increases the risk of moral hazard like free riding and breaking of covenants in the future, especially from member states that would be required to execute tough reforms. And greater labor mobility is likely to run up against existing government regulations as well as cultural and language barriers that discourage the movement of workers across borders.
Structural weaknesses have led to economic imbalances. Since 2000, productivity-adjusted wages have increased by about 5% in Germany while rising between 25% and 40% in other E.U. member countries. This has led to a divergence in competitiveness, in growth of exports, in overall economic growth, and in employment among the member countries.
Correcting these imbalances by implementing austerity measures—the tack taken so far—or by pursuing the somewhat higher inflation that some economists have called for, is not easily achievable. If these imbalances persist and there is resistance to greater fiscal integration, greater labor mobility, and more private sector flexibility, the E.U. may be faced with a stark choice: Continue the half-measures that are driving the euro zone ever deeper into recession, or allow the introduction of dual currencies to preserve the euro. Because if the euro goes, the single market may go with it, and likely the half-century-old dream of a unified and uniformly prosperous continent.
