The Nobel Laureate Joe Stiglitz has a new book out looking at the euro and his basic conclusion about that is entirely correct - it's a disaster. However, his solution is that it should be broken into two or three separate currencies, perhaps until some time that the whole can be remade again. And that's wrong I'm afraid. The solution is not to break it into two or three, nor even it's original constituent parts (some 18 I believe?). Rather, it is to reverse some centuries of economic centralisation in currencies and move to more than those original 18. I would even argue that the British pound should be split up into at least three and possibly more parts. This flows from an analysis of the basic idea at issue here, optimal currency areas.
It is important that there can be a smooth transition out of the euro, with an amicable divorce, possibly moving to a “flexible-euro” system, with say a strong Northern Euro and softer southern euro. Of course, none of this will be easy. The hardest problem will be dealing with the legacy of debt. The easiest way of doing that is to redenominate all euro debts as “southern euro” debts.
That's an adaptation from the book and this is from a review of it:
Europe lacks such stabilizers. The common budget is only 1 percent of Europe’s economy, a stark contrast to America, where the federal budget is roughly 20 percent. Thus, countries like Greece that are suffering hard times have nowhere to turn. Stiglitz argues for “more Europe,” meaning an expanded budget and common welfare programs, and a mutualized system of deposit insurance (so that failing Greek banks are not dependent merely on other failing Greek banks, but on healthy German ones as well).
This part of Stiglitz’s argument is conventional.
Indeed, his analysis is entirely conventional and flows inevitably from the original analysis of optimal currency areas by Robert Mundell and further commentary by Milton Friedman.
To simplify - if everyone in this Czech town of 80,000 people that I am in today used their own currency then trade would really be rather hard. Trade is a good thing, it makes us richer. So, some modicum of people using the same currency is a good idea. However, the larger the area becomes that uses the one currency the more the rigidities of the one system become apparent. You must have just the one monetary policy for a single currency area, you must have just the one interest rate and so on. And the larger the area the more these become constraints on the efficiency of that area.
For example, say Ireland, Spain and Germany all shared a single currency and the German economy was doing a bit poorly while the other two were fine. The German economy is vastly larger than those other two - monetary policy will be set for Germany. Those lax monetary settings risk setting off massive property booms in the other two economies. And, ooops! that's what happened.
This is why we talk of "optimal" currency areas. To small is inefficient and too large is also inefficient.
We can change what is that optimal size through institutional construction. A central fiscal policy will help - if German taxes pay Greek pensions then this will increase the size of that optimal currency area.
The eurozone is clearly and obviously too large an area without those fiscal changes - and they just aren't going to happen. Thus the eurozone needs to get smaller and Stiglitz's idea of two or three euros has some merit. And yet we should go further here.
What makes a currency area optimal at the small end is that it costs to exchange currencies. And the cost of doing that has been falling for some decades now. In the big currency pairs the wholesale markets now operate on bid offer spreads of 1 basis point perhaps. That's one hundredth of one percent. And we've long known that the Mezzogiorno would be better off if it did not share a currency with the North of Italy. So would the North of England do better freed of currency union with the South.
That is, technology, bringing down the costs of having multiple currencies, has lowered, rather than the current general assumption of having increased, the optimal currency area. So, our solution should be to break up some of the national currencies and return to regional ones. It's not just the euro that needs to be broken up but also the pound, the lira and many more of them.
