EC Deep Dive: Is EMU Irreversible Or Not?

A jacket or shirt may be reversible. This optical illusion posted here is reversible. A man is evident even when the direction is looked at “upside down”. Time is unidirectional, we are taught and some things simply cannot be reversed, like  a hard-boiled egg.

However, science has once again pulled the rug out beneath our feet. Earlier this week, ABC reported that scientists have discovered a way to un-boil an egg white. Apparently boiling an egg folds the proteins, and scientists have learned to unfold them. They can reverse the boiling process within a few minutes. 

In the most basic sense that question facing investors is whether European monetary union is like a hard-boiled egg. Can it be reversed? 

The simply answer is of course it can be reversed.  A building can be knocked down; political agreements torn up. Currency unions have been dissolved in the past. They can be dissolved again. 

The answer then hinges on will. Are the members committed? Will alone may be insufficient as some historians teach us about the start of WWI.  Is there the institutional capacity to implement the will?  

The euro-skeptics’ arguments have well-publicized and are well known.  Even if a monetary union is desirable, which is not often a conceded point, it cannot be without fiscal union. Some argue that Europe put the cart before the horse–political union has to proceed monetary union. They argue that countries are too economically diverse to make an optimal currency zone. Owing to the linkage of fiscal and monetary policy, there were agreed limits on deficits and debt that have been respected primarily in the breech. 

Such arguments had been quieted over the last couple of years, following ECB Draghi’s pledge to do whatever is necessary to preserve monetary union. However, the belief lurked just below the surface and have arisen anew, spurred by Syriza’s victory in Greece.  

The US experience is instructive up to a point. First, political philosophers going back to Aristotle and Plato through the mid-18th century argued it was not possible to have a representative form of government over a large territory. It had never been done successfully. It was a great experiment. The great experiment of our time is the European Economic and Monetary Union.  

Second, the US was not an optimal currency zone when it was founded. Some would argue it still is not because of the economic diversity.  While the rest of the country will benefit from the decline in oil prices, Texas, North Dakota, and Alaska will not. Federal fiscal transfers can make up for the heterogeneous economy. And yet, the states with the lowest incomes are still in the parts of the country that tried to leave 150 years ago.  

Plans for EMU grew out of the fall of the Berlin Wall. The problem it was solving was not an economic problem, but a political one that has vexed several generations. As Kissinger put it, “Germany is too big for Europe and too small for the world.” Under what conditions could Europe allow Germany to be re-united? The solution was to tie German irreversibly to Europe. The economic answer to the political challenge was two-fold:  Germany had to share the uber-mark, the super-Deutschemark. It is the euro. Germany also had to share the Bundsesbank’s anti-inflation credibility, which means low interest rates. It is the ECB, headquartered in Frankfurt, not far from the Bundesbank.