Euro-crisis

EUROPEAN POLITICAL UNION NO MORE STABLE THAN ‘MUDDLING THROUGH’

A political or fiscal union among the eurozone countries will be no more stable than the current ‘muddling through’ approach, according to research by Angela Nolte, presented at the Royal Economic Society’s 2013 annual conference.

She concludes that introducing an orderly default mechanism for countries and inserting an exit clause into the European treaties that allows member states to leave the single currency area may prove more effective in stabilising the eurozone than an institutional overhaul.

The study questions the conventional wisdom that the euro is doomed to fail unless it is complemented by a fiscal or political union. It considers the political and strategic aspects of the eurozone crisis, which are often ignored by standard economic theory.

The research models the benefits and costs of a eurozone break-up and argues that the economic consequences are likely to be different for the core and the periphery. Core countries, such as Germany, are likely to see their new currency appreciate following a break-up, thus hurting their export-based economy.

By contrast, periphery countries, such as Greece, may benefit from a eurozone exit due to the subsequent currency devaluation, which will boost their competitiveness and may lead to an export-led recovery. The analysis argues that this makes eurozone exit attractive for periphery countries and, more importantly, gives them bargaining power.

As a result of the core countries preferring the status quo, the eurozone is more sustainable rather than less. Core countries are able to dictate policies to the periphery countries in exchange for lending while periphery countries know that the threat of eurozone exit will discipline the demands of the core.

The author concludes that this ‘muddling through’ approach leads to ‘policy that is optimal from the point of view of society as a whole’. Political or fiscal union may be less stable because it might disturb this power balance and remove the threat of exit that is empowering the periphery countries.

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The study’s main finding is that the eurozone’s institutional status quo, best described as a ‘muddling through’ approach, is not necessarily more prone to break-up than a political or fiscal union. This casts doubt on the common claim that the euro cannot survive without closer integration.

The research departs from mainstream analysis and questions the conventional wisdom that Europe’s economic and monetary union is doomed to fail unless it is complemented by a fiscal or political union. Motivated by the recent surge of Euro-scepticism across Europe, the research draws attention to the political and strategic aspects of the eurozone crisis that are often ignored by standard macroeconomic theory.

The paper explicitly models the benefits and costs of a eurozone break-up and argues that the economic impacts are likely to be different for the core and the periphery. Core countries, such as Germany, are likely to see their new currency appreciate following a break-up, thus hurting their export-based economies.

Periphery countries such as Greece, by contrast, may benefit from a eurozone exit due to the subsequent currency devaluation that boosts their competitiveness and may lead to an export-led recovery. This makes eurozone exit attractive for periphery countries and, more importantly, gives them bargaining power.

As a result, the eurozone becomes more, rather than less, sustainable. Although this finding may appear counterintuitive at first, it is well established in the literature on public finance and federalism. The intuition is that the core, which – as the periphery’s creditor – can dictate policies in return for cash, has to accommodate the wishes of the periphery to prevent the latter from leaving the eurozone. The outcome is a policy that is optimal from the point of view of society as a whole.

It turns out that a political union is less stable than the institutional status quo if citizens’ tastes for public good provision differ across member states since centralised decision-making tends to be further removed from the people.

By comparison, a fiscal union in which countries can secede from the union is equally sustainable as the status quo. A fiscal union without an exit clause, albeit more stable, makes citizens worse off by reducing EU welfare.

The paper thus concludes that these alternative institutional settings do not provide any advantages over the current ‘muddling through’ approach.

The paper’s main policy recommendation is that introducing an orderly default mechanism for countries and inserting an exit clause into the European treaties that allows member states to leave the single currency area may prove more effective in stabilising the eurozone than an institutional overhaul.

ENDS


Notes for editors

Angela Nolte is a recent PhD graduate from the University of Edinburgh and the paper she is presenting at the RES formed part of her PhD thesis. She now works as an economist for the Scottish Government. The usual disclaimer applies: the views presented in this paper reflect those of the author.

Contact:


Angela Nolte: a.nolte@ed-alumni.net

RES media consultant Romesh Vaitilingam:
+44 (0) 7768 661095
romesh@vaitilingam.com
@econromesh

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