Will chronic fiscal troubles prompt Greece to leave the Eurozone and possibly the European Union? It’s an urgent question, but it’s even more important for us to acknowledge that the European Union’s problems are not uniquely Greek. Deeper concerns should prompt us to rethink the wisdom of the Eurozone itself.
First we must recognize that while an economically integrated Europe is good for peace and prosperity, some types of integration are sustainable and some are not.
Free trade is, of course, an indispensible component of sustainable economic integration, and no economist worth his salt wants to see the European Union’s free-trade zone diminished in any way. Economists almost universally believe that free trade enriches countries that practice it, and they have long observed that when goods are not allowed to cross borders, armies are more likely to.
Luckily, once established, a free-trade zone creates the incentives for the participating countries to maintain it. When a country deviates from free trade, it harms its trading partners, but mostly it harms itself. Recognition of such an outcome leads most countries to follow the rules and not impose trade restrictions.
Unlike free-trade zones, however, monetary integration does not necessarily create self-enforcing rules. To see why, let’s look at the incentives created by the Eurozone and compare them with those created in a more competitive environment.
Central banks conduct monetary policy by purchasing and selling government debt. In the United States, the Federal Reserve buys and sells U.S. Treasury bonds. The European Union, in contrast, does not issue any securities that the European Central Bank could use. Instead, the bank buys and sells the government debt of its member countries. But this creates perverse incentives.
Each country in the European Union knows that the European Central Bank will buy many of the bonds they issue to finance their budget deficits. Each country also knows that the central bank will be reluctant to allow members to default on their debt, because this would create losses for the bank.
This awareness creates a classic moral hazard problem: Member countries know that bailouts are likely if their fiscal policies get them into a debt crisis. But that very knowledge makes fiscal recklessness more likely.
The Europeans anticipated such risks when they created the Euro. Hence they created rules in the Maastricht Treaty that limit a country’s budget deficits to three percent of GDP and keep accumulated government debt below 60 percent of GDP.
But hardly anyone follows the rules. At the end of 2014, Eurozone countries on average had accumulated government debt equaling 92 percent of their total output. Greece, at 177 percent was the worst, but the debt burdens of Italy (132 percent), Portugal (130 percent), and Spain (98 percent) are also worrisome. Even Germany, the country that anchors the Euro, breaks the rules with a debt-to-GDP ratio of 75 percent.
These problems were predictable, and the late economist Milton Friedman saw them on the horizon shortly before his death in 2006. “The euro is going to be a big source of problems, not a source of help,” the Nobel laureate told an interviewer. “To the best of my knowledge, there has never been a monetary union, putting out a fiat currency, composed of independent states.”
The Euro will ultimately fail because the member countries have no incentive to keep their debts in check.
Fortunately, the main benefit of the Euro – a single dominant currency that can be used across a wide geographic expanse and large number of people – can be had without a formal monetary union.
The solution is to allow competition in currencies. This can be done by abolishing legal tender laws and letting people buy and sell using any medium of exchange they agree upon. Weak currencies such as the drachma wouldn’t circulate outside of Greece, but the deutsche mark would likely be used beyond German borders.
Ideally, private note issue, whether based on a commodity such as gold or on new technology like bitcoin, would also be allowed. As people transact we would learn what “optimal” currency areas look like throughout Europe.
A currency is what economists call a network good: As more and more people adopt a particular currency, other people gain incentives to adopt it. The result is a self-enforcing cycle that promotes reliance on sound currencies.
Competition in currency also gives note issuers, whether governments or private institutions, strong incentives to remain solvent. If an issuer doesn’t balance its books, people might lose confidence in it and stop using its notes.
An economically integrated Europe is good for Europe and for the world, but the Euro will not, and need not, be part of that integration. Freedom, in the trade of goods and services, and in the adoption of currencies, is all that is required.
Benjamin Powell is a senior fellow with Independent Institute in Oakland, Calif., and director of the Free Market Institute and professor of economics in the Rawls College of Business at Texas Tech University.
