The sovereign debt crisis and the costs of currency unions

As the search for a solution to the debt crisis affecting Greece and other European countries continues it's natural to ask exactly what part the constraints associated with monetary union have played in the origins and propagation of the crisis, and what options Greece would now be pursuing if it faced its current financing problems but exercised monetary independence. A first point to note is that Eurozone entry forced down borrowing costs for the Greek government (through raising expectations for Greek GDP growth and putting an implicit guarantee underneath its debts) and created an incentive for rapid debt accumulation. Now that such debt is proving unsustainable Greece needs strategies for relieving the debt burden and creating the economic growth needed to avoid a future debt explosion. A point frequently made in policy discussion is that a freely floating Greek currency would depreciate sharply to provide one ingredient for a growth recovery. The fact that this cannot happen whilst Greece is inside the Eurozone is one of the clearest examples of how current monetary arrangements in Europe have undermined macroeconomic performance.

A point that I think has received less attention is that, in this situation, an autonomous Greek central bank would relieve a large part of the debt/GDP burden through monetizing a component of the national debt, i.e. a permanent increase in the monetary base could be used to purchase and retire a portion of the debt in order to return the Greek state to solvency. In this way the central bank effects a transfer of resources from the private sector (whose nominal assets lose real value when monetary expansion raises inflation) to the public sector. Furthermore, the transfer is achieved without the need to pass austerity measures in the legislature that single out specific groups for the pain from budget tightening. In the Eurozone the ECB is technically able to do debt monetization but is unable to do so in practice. The resulting inflation tax would be distributed much more widely across Eurozone members and this is one reason for constitutional constraints preventing the ECB from conducting unsterilized purchases of sovereign debt. In the absence of central bank Greece is forced into a particularly inefficient approach to public finance -- there is insufficient use of inflation to effect resource transfers and over-dependence on conventional fiscal instruments to close the budget deficit. It seems increasingly likely that social and political pressures will block the use of conventional fiscal policy to return the state to solvency. The result is insolvency and the prospect of a default and fears over contagion that the Eurozone's fiscal and monetary authorities are ill-equipped to manage.

The point in this analysis that I want to relate to academic debate is the following: The formation of the Eurozone has imposed a costly constraint on European economies, in that they cannot pursue unilateral base money expansion for fiscal purposes, and therefore cannot exercise enough independence in the use of the inflation tax. This observation stands in contrast to the textbook analysis of the costs associated with monetary union. The standard example used in textbook analyses is that two members of a currency union may be subject to asymmetric IS curve shocks. In the simple Mundell-Flemming model the two could maintain full employment via a combination of different interest rates and exchange rate adjustment, but inside a currency union such adjustment is precluded and other adjustment mechanisms must be found (cf. Mundell's concept of an optimal currency area linked to labour market flexibility). Based on this logic, one of the criteria for assessing whether two countries should form a currency union is to ask how likely it is that they will experience asymmetric IS curve shocks. This is still an important test for the optimality of a currency union, but the recent crisis in Europe suggests that it needs to be extended. In addition to thinking about the feasibility of a common interest rate policy, it is important to consider the inefficiencies from common base money growth and limited use of the inflation tax. This in turn implies that vulnerability to different IS shocks is not the only threat to members of a monetary union. An equally important threat is differences in their fiscal trajectories (due to deficit bias, ageing populations, institutional failure etc.), which may necessitate differential use of the inflation tax that cannot be put into effect inside the single currency area.