Fixing the Eurozone

The European Union was initially hailed throughout the world as “the European miracle,” a triumph for supranational organizations and international unity. Banded together in a monetary and trade-based union, the EU experienced rapidly rising living conditions and surprisingly harmonious relations. The last few months have shown, however, that the EU’s economic foundations were fundamentally flawed. Monetary and fiscal policy are deeply related, so a monetary union in which each subunit pursues its own fiscal policy is destined to fail. The best and most practical solution for the European Union is to pursue deeper political and fiscal integration, because the status quo is untenable.

In the EU, monetary policy is controlled by the European Central Bank, and most of the member countries have joined the “Eurozone,” the term for the monetary area in which the Euro is used. Thus, one central bank controls the supply of money for the EU, and individual countries do not have control over inflation targeting, interest rates, and other monetary issues. Yet at the same time, each country is in control of how much its central government spends and the solvency of its financial system, so Germany independently controls its expenditures and tax receipts, and Greece does the same.

Basic macroeconomics teaches that fiscal and monetary policy are related; therefore, governments and central banks must sometimes be able to take wide-ranging action on both during crises. As George Soros wrote in the Financial Times on Monday, “When the financial system is in danger of collapsing, the central bank can provide liquidity, but only a Treasury can deal with problems of solvency.” Europe is now experiencing an unfortunate situation where member countries can create unsustainable deficits or be home to failing financial systems and for this reason place the entire economic system and currency at risk. Greece’s current fiscal situation, in which the government is struggling immensely to pay the bills and teetering on the edge of financial collapse, is a prime example of this, as a Greek default could create a dangerous run on the Euro, which would negatively affect all of Europe because of the united monetary policy. And Spain, Portugal, Ireland, and Italy unfortunately are not far behind when it comes to rapidly approaching fiscal crises.

Now, richer member states are understandably hesitant to bail out their flailing colleagues, hesitant at the idea of saving governments that clearly acted as irresponsible economic stewards. Yet they really do not have a choice in the short-term, as any European national failure would absolutely devastate the continent as a whole. In addition, blame does not lie entirely on some admittedly inept governments. While it would be hard to find a country that was managed with as little economic integrity as Greece, all of Europe’s countries had access to easy credit and were members of a very lightly regulated financial system for the last decade. No Eurozone country was complaining about the structure of the economic system when Europe was thriving in the earlier part of the decade, and therefore, everyone now bears the responsibility to save the system and change it going forward.

The major step the EU must take is to develop more political and fiscal integration. The optimal economic solution would be a fully integrated fiscal system in which a central European government made decisions in a structure similar to the U.S. Thus, monetary and fiscal policy would be coordinated on the same scope, and Europeans would not have to worry about a single member state bringing down the entire economy, just as no one worries about California’s fiscal problems hurting the stability of the dollar. European countries, accustomed to full sovereignty, are used to full independence, and therefore an intermediate step to fiscal and political integration might be the creation of a European Monetary Fund that follows a set of fixed processes for assistance to struggling states. In the long term, however, the only feasible solution that will prevent such situations from occurring again is a stronger political union that will coordinate economic policies on a larger scale.

Ravi N. Mulani ’12, a Crimson editorial writer, is an applied mathematics concentrator in Pforzheimer House.