Can a monetary union work without a political union?

Sixten Korkman has described the euro as a currency without a state. The description hits the mark. Although the euro is largely a political project, political unification was not really seen during the first years of the euro. The situation changed after the 2007 – 2009 financial crisis. As a result of the crisis, many euro countries drifted out of the international loan markets, which forced the countries of the eurozone to hastily set up different kinds of support mechanisms. The most recent of these is the bank union, the purpose of which is to reduce the dependence of euro countries on their banks. Can these measures be considered as being sufficient? Can the euro work as a currency without a state?

Unfortunately, world history does not really know examples of successful currency unions between independent states. All successful common currency mechanisms formed by many countries have been confederations or unions of states. Some of the currency unions of independent states have lasted a long time, but they have subjected the participating countries to both external and internal shocks, as a result of which many countries have left them. For example, the Latin monetary union (1865 – 1927) suffered throughout then whole period of its existence from the attempts of certain ones of its member countries to calculate the metal content of its coins. The rouble union set up after the break-up of the Soviet Union (1992) disintegrated in two years through the aggressive credit creation practised by the independent central banks of its member countries. The Scandinavian common currency zone formed by Sweden, Denmark and Norway (1873 – 1913) is generally held to be the most successful of all European currency unions. However, during the forty years in question, the countries of the monetary union still suffered many country-specific shocks, which slowed their growth. The CFA franc zone, which is still in operation in Central and West Africa, may be the most functional of all common currency zones formed by independent countries. However, the economic growth rate of its member countries has been slow and a fixed exchange rate has intensified the effect of external shocks, causing many countries to leave the currency zone.

Common currencies work relatively well during economic booms. In periods of recession and economic crisis a problem that arises for common currencies is particularly the so-called sudden stop situations, in which private capital flow suddenly starts going out of the weakest countries of the currency zone. Sudden stops in a country with an independent floating currency lead to the rapid external depreciation of the currency. This reduces the imports of the country, increases its exports and makes the country a more attractive site for investment, which then reduces the outflow of capital.

However, with a common currency, this automatic balancing is lacking. When common currency zones come across a sudden stop, capital usually seeks out the economically stronger countries. As a result of this, the financial position of countries suffering from a flight of capital gets much weaker while the financial position of the stronger countries of the currency zone gets even stronger. In other words, the currency zone experiences an asymmetrical shock. The flight of private capital quickly leads to the insolvency of the country’s financial sector unless the private capital that has gone out is replaced with other capital. After the 2007 – 2009 financial crisis, this is exactly what was done in the eurozone. Private money flowed out of Greece, Ireland, Portugal and Spain, and it was replaced with loans granted through bilateral agreements between the Target2 system, the EFSF, the IMF and the euro countries. This ensured the solvency of the crisis countries, but the cutback measures that were a condition of the loans caused a recession and large-scale unemployment.

The united States does not suffer from similar problems. There, any possible flights of capital from weaker states are compensated for with the federal state’s gratuitous, i.e. free transfers of revenue, such as unemployment benefits, social benefits and agricultural subsidies. The transfers of revenue are paid for from the taxes and payments collected from strong states. Despite this, many U.S. states would have, according to studies, benefited from their own currency in past economic crises and recessions.

If the countries that belong to the common currency do not share out profits and costs amongst themselves, individual countries of the currency zone will repeatedly suffer from shocks affecting their production and state economy. In many ways, the eurozone has indeed relived through the history of independent currency unions. During the last six years, it has been shaken by both external and internal economic shocks, which have led to a slump in the economic growth of the eurozone. There is no reason to assume that the same situation can be avoided in the future. After all, the eurozone has, in the light of the history of currency unions, only two economically sustainable alternatives: the roads of deeper or reduced integration. Deeper integration leads to the federal state and a reduced one to the partial or complete break-up of the eurozone.