The Mess that is the Euro – and What May Keep it Together

As I pointed out before, the basis of a monetary union is the agreement of all member states on a uniform development of the price level across the member states and nothing else.

So, ensuring that Unit Labour Costs and prices across member states develop in line with inflation in the European Monetary Union (EMU) as a whole is the only condition that needs to be fulfilled for the EMU to work. However, once Unit Labour Costs and prices across member states have been allowed to substantially diverge, the realignment of relative prices is extremely painful due to the absence of fiscal transfers and because (mainly due to language barriers) labour mobility is significantly restricted within the EMU.

Thus any substantial divergence of Unit Labour Costs and prices across member states threatens the survival of the EMU because member states are, of course, tempted to avoid the high cost of ‘internal devaluation’ by leaving the currency union (i.e. by devaluing externally instead).

Given that (due to lack of labour mobility and lack of fiscal transfers) a realignment of wages and prices is so costly, the EMU needs a mechanism to prevent asymmetric shocks from leading to substantial differences in Unit Labour Costs between member states.

Given that member states don’t have their own monetary policy any more, fiscal policy is the only tool left to achieve such a mechanism. That is, instead of the nonsensical 3% deficit limit, there should be a fiscal rule requiring member states to set the budget balance in such a way that Unit Labour Costs and prices develop in line with inflation in the EMU as a whole.

Using fiscal policy in such a way involves inefficiencies and may not work anyway. But if Euro policymakers want to prevent the Eurozone from breaking apart, they should at least try this approach because the EMU’s current framework virtually guarantees failure.

Do I believe the necessary adjustments to the Eurozone’s architecture are going to be implemented, preventing its break-up?

No, I don’t.

Most of the European policymakers haven’t even recognised the problem.

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