I was asked this week whether it was possible under any circumstances for member states of a monetary union to operate different monetary policies. The standard response is simply "no" but it's worth going into it a bit deeper and I thought I'd at least out write down a few thoughts on the subject of monetary union in one place. And advertise a couple of very good books in the process.
The Postwar International Money Crisis was published in 1981 and written by the late Victor Argy, an Australian economist who worked for the IMF and the OECD but finished his career teaching at Macquarie University. At that point, the EEC's attempts at any form of monetary union (the post-Bretton Woods "snake" were deemed a failure). Argy describes monetary union as "weak" if it is a system of pegged exchange rates, or "strong" if it involves a single currency. A strong monetary union is assumed to have a common currency and a common central bank. Capital markets are unified and independent monetary policy becomes impossible. Some independent fiscal policy continues to be feasible. And he goes on to list the conditions which make the costs of joining a union smaller, or the benefits larger. They are 1) that differences in growth rates and labour productivity are not large; 2) that intra-union trade is large; 3) that there is no long-run trade-off between inflation and unemployment; 4) the differences in propensities to inflate are relatively small; 5) differences in degree of domestic instability are relatively small; and 6) there is a significant degree of labour mobility.
Some of that sounds as if it was written at the end of the 1970s, as it was. But what strikes me, over 30 years later, is that 3 of those conditions represent the root causes of some of current woes; labour productivity (and competitiveness; propensities to inflate (Buba); and domestic instability (Spain's construction bubble).
Parts of Europe suffered from a massive credit bubble, particularly in housing and construction, and when it burst it left devastation behind. The textbook solution in a monetary union is for there to be either fiscal transfer or labour movement. Both have happened in a very modest fashion. Large competitiveness and productivity gaps always existed but have become more apparent in the recession. And because the biggest country in Europe is much less inclined to inflate than most of the others, the only 'cure' to the productivity crisis is lower wages in the lower productivity economies, with huge knock-on implications for debt, fiscal policy and economic activity.
The situation has been exacerbated by the fact that while Europe shares a single monetary policy and a unified capital market, the way the capital market behaves is that there is no so single 'risk free' interest rate that all countries can borrow at. Rather, there is a tendency for regional borrowing costs to diverge dramatically.
A monetary union where the weaker members pay more to borrow, where the dominant member is the least inclined to inflate and therefore where productivity differentials can pretty much only be cured through falling wages in the lower-productivity member states, looks like a recipe for labour migration and social unrest. Is the fact that so far, migration has been relatively limited, a good thing or just a sign that we haven't yet reached that stage of the crisis?
Which brings me to my second book! I'm sure that when John Steinbeck wrote The Grapes of Wrath, or when Henry Ford made the film, they weren't thinking of it as a case study in the problems of economic shocks on a monetary union. But that's what it means to me. It's the story of a farming family from Oklahoma that migrate to California in search of work during the Depression in the 1930s. The fruit growers and pickers in the west of the United States are no more enthusiastic about the arrival of vast numbers of work-seeking 'Oakies' than you would expect and trouble follows. Oklahoma would have devalued its currency to cope with its economic woes, in a different era. Indeed, the east of the US might have devalued relative to the west. The United States share a common currency and use a mobile labour force and fiscal transfers to cope with regional and industry-specific shocks.
The economics of fixed and floating exchange rates, of monetary unions, are all about pros, cons and compromises. Steinbeck's tale is a cautionary one for Europe because if the US coped poorly with large scale economic migration in the 1930's, surely it would be even worse in the more disparate Euro Zone. That hasn't been a problem - at least until now. There are huge regional economic variations, and the fiscal transfers to soften the blow aren't big enough. But mass movement of labour hasn't really been an issue. However, the image still lurks in my mind because one possibility is that people only really up ticks and move in large numbers when things get really bad. Worse than they are now, but perhaps not worse than they could be if the remorseless rise in (particularly youth) unemployment goes on.
Now to that question of whether you can have different interest rates in member states of a currency union. The simplest answer is that you need capital controls to do it. The Asian economic crisis of the mid/late 1990s was caused in large part by a foreign currency credit bubble. Central banks fixed their exchange rates to the US dollar, but operated separate monetary policies so that banks were tempted to borrow cheap dollars (where rates were very low in 1992/1993) and lend in domestic currency at higher rates. hotel and golf course developers, and home-buyers, were tempted into foreign currency loans as well, and when the US raised rates and the global economy slowed, disaster followed. This seemed, at the time, a damning indictment of a fixed exchange rate system and a clear argument that either floating rates or a full monetary union were preferable.
The Asian example is relevant because to the borrowers, it 'felt' like a monetary union. Exchange rates were fixed so it made sense to borrow at the cheapest rate possible. I am sure that is how it felt when Hungarian borrowers took out Euro or Swiss franc mortgages, too. So the borrower thought he was 'arbitraging' the system. At this point the regulator is supposed to either educate the market or regulate the market to make sure that foreign currency borrowings are not excessive. It is possible to have fixed rates and different polices ,as long as the flow of money is regulated. And surely, by extension, the same is true in a monetary union with a single currency, at least theoretically. But here's the problem - it may be possible to raise the cost of borrowing in some parts of a monetary union through regulation (tighter rules for German banks, and no access to foreign banks for German borrowers, say), but what Europe needs, is (even) lower rates in other countries and that's much harder to regulate. Because the perception that weaker countries and borrowers are inferior credits, raises their cost of borrowing and turning that upside down is pretty hard.
So, theoretically possible but not feasible? In the meantime, avoiding mass unemployment causing massive labour migration would be a good start....