A history lesson: Greek exit from EMU is not suicide
No monetary union among equal-sized economies without fiscal union
‘The great scenarios of the end of the world have never been realised.’
by Gabriel Stein
Wed 6 Jun 2012
Is ‘Grexit’ – Greece leaving EMU – suicidal? Or is it rather staying in and submitting to austerity that will kill off the country? Both views have recently been heard in the Greek political debate (as well as outside Greece). While both views could in theory be right, it is unlikely that either is.
History makes two things clear. First, monetary unions frequently break up. Second, when they do, the consequences are seldom catastrophic. Wolfgang Schäuble, the German finance minister, becoming increasingly ready to accept the idea of Greek departure, said in a German newspaper interview yesterday that Greece had to decide itself, adding sardonically: ‘The great scenarios of the end of the world have never been realised.’ Merely since the Second World War, more than 70 monetary unions have come to an end around the globe. And, as Schäuble noted, we managed to live through them all.
The lesson of history is that a monetary union that is not a fiscal union can work between a large country and a small one. That is because the large country sets monetary policy to suit itself, regardless of the situation of the small country. However, for a monetary union between (roughly speaking) equal-sized economies to survive and prosper, a fiscal union is a necessary, but not sufficient condition.
There is not a single case of a monetary union between equal-sized economies surviving without becoming a fiscal – and that means political – union. But there are plenty of cases of political unions breaking up, in whole or in part, with the new entities intending to retain the same currency and quickly failing to do so.
A fiscal union is needed is because there is always a risk in a monetary union that one country will allocate to itself resources at the expense of the other members by running a fiscal deficit. In the absence of a fiscal union, which regulates such issues, the union will have to be policed by the strongest country. This was partly the undoing of the Latin Monetary Union (LMU).
True, the LMU lasted from 1865 to 1927 (although it de facto broke down with the outbreak of the First World War). While the LMU initially had only four members (France, Belgium, Switzerland and Sardinia), the intention was to expand it. In 1867, a conference was held in Paris (coinciding with a move to the gold standard) with a view to adding more countries.
However, it quickly turned out that the countries that wanted to join the LMU – Greece, the Papal States and Romania – were also the countries that existing members least wanted. By contrast, countries that were welcome – such as the UK, which would have brought in Portugal, the Netherlands and perhaps some northern German states, or the US – were unwilling to make the necessary minimal adjustments to the gold content of their respective currencies.
This is a clear parallel with EMU, where the UK, Sweden and Denmark – none of which is willing to join – would most likely be made far more welcome than some of the Balkan states. It also highlights another parallel between the LMU and EMU, namely the heterogeneous nature of the member countries.
This meant that the LMU ended up saddled with countries with weak public finances, which would – and did – destabilise the union’s finances by issuing excessive divisionary coinage and allocate to themselves seigniorage profits at the expense of the other countries. That strengthened the opposition to expanding the union and brought the whole concept of monetary union into disrepute.
The conditions for joining were made harder and so onerous that only a weak and desperate country would be prepared to accept them. This is reminiscent of the criteria set by the Maastricht treaty and Stability and Growth Pact and especially of the recent repeated terms imposed on countries needing rescue packages from their EMU partners. The only country that formally joined the LMU after the founder members was therefore Greece; and Greece was only allowed to join on condition that its coinage was carried out in France under French control and with limits on its notes issuance.
The LMU could flourish only as long as France was willing to police it. After its defeat by Prussia in 1870-71, France had neither the will nor the strength to continue to do so, and although a number of countries unilaterally aligned their currencies to the LMU, the union never regained its vitality. The LMU could have limped on after the First World War, but the fundamental misalignments between the participating nations had widened so much that this was no longer possible without significant realignments. That was also the situation for the LMU’s northern contemporary, the Scandinavian Monetary Union.
The history of other monetary unions confirms that, without a fiscal union, a monetary union will not last. Perhaps the best example is that of the Czech-Slovak monetary union. After the break-up of Czechoslovakia on 1January 1993, the Czech and Slovak Republics intended to maintain the same currency. Six weeks later, they already had separate currencies.
Similarly, the monetary travails of the states formed after the break-up of the Soviet Union, of Yugoslavia and (following the First World War ) of the Austro-Hungarian Empire, clearly show that, at least with disparate economies, even with the best will in the world it is not possible to maintain a joint currency without a single fiscal authority.
All this shows that monetary unions can dissolve – and it is not the end of the world. Nor does their dissolution have to lead to war and breakdown. Admittedly, there has been no dissolution of a monetary union with EMU’s advanced and integrated financial system. But that does not make it impossible – just complicated.
The same goes for legal aspects. True, there is no treaty provision for a member to leave EMU. But a Greek government, in the face of its partners’ refusal to hand over any more money (likely to happen in 2012) and a complete meltdown of its financial system coupled with a breakdown of society, is not going to let treaty obligations stand in the way of saving the nation.
Nor will Greece’s partners, confronted with a country that – in the words of the OECD – is structurally incapable of reform and therefore needs huge transfers for the foreseeable future – let the absence of treaty provisions stop them from trying to arrange such an exit if they perceive that to be in their national interests. The threats by Bundesbank president Jens Weidmann to cut of the Bank of Greece’s emergency liquidity assistance support this view.
No one thinks leaving EMU is easy, smooth or painless. It will be difficult, rough and painful – for everyone concerned. But it is not impossible, nor necessarily disastrous.
Gabriel Stein is a director of Lombard Street Research. On 1 July, he becomes OMFIF chief executive.
This is an updated version of his article in the Lombard Street Research World Economic Forum Special Report Full Storm Ahead, January 2012.
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