Since 1950 European nations have incrementally integrated their economies through free-trade agreements, fixed currency exchange rates, and ultimately a single currency and a single monetary authority—the European Central Bank—that decides interest rates for the Eurozone. This monetary integration has reduced transaction costs and enabled the free movement of labor, goods, services, and capital. But there have been negative consequences as well.
My recent research with Massimo Morelli from Columbia University and Jose Taveres from Nova School of Business and Economics finds that the current monetary integration does not provide the adequate means to address expected income shocks, which could lead nations to leave the Eurozone. This is because when member nations joined the Eurozone in 1999, their officials lost a primary fiscal tool to ameliorate the effects of volatility—the ability to adjust interest rates.
The problem of a single interest rate was clear in between 2002 and 2005 when Spain experienced high growth while Germany had low growth. Germany’s influence in the European Central Bank played a crucial role to bring about low interest rates at a time when Spain would have benefited from higher interest rates that could have helped avoid a bubble. The result was a collapse in Spain’s real estate sector.
Given the heterogeneity among the Eurozone nations, a single interest rate may not be optimal for all member nations, particularly when the volatility of income shocks is high. We argue that this difference in volatility among Euro countries may have altered their regime preferences. Countries prefer to form a monetary union, without fiscal policy integration, if volatility is low for all (or some) countries. When volatility jumps for some countries, support for a fiscal union increases because a fiscal union enables transfers across countries to compensate for the lack of independent monetary policy. Without a fiscal union, high-volatility countries, such as Greece, would be better off leaving the Euro.
In separate research Abderrahim Taamouti of Durham School of Business and I argue that the Euro itself has been a cause of low economic growth and high volatility in Greece, Ireland, Portugal, and Spain long before the financial crisis. Adoption of the Euro itself made the realization of volatilities even more extreme.
The main question is how to make the creation of a fiscal union possible. It may be necessary to offer economic and political incentives to countries with low volatility to gain their support for the fiscal union. Moving toward fiscal integration would require allocating more bargaining power to countries that are paying more to fund transfers to nations in recession.
Thomas Picketty has advocated for a wealth tax to fund these transfers. I don’t think that such a tax would be effective because assets can be moved to other jurisdictions to avoid it. Instead, I think the most effective way to ameliorate economic and fiscal imbalances is through a tax on speculative real estate transactions because investors like safe havens such as real estate and because real estate is tangible and stationary. Such a tax would reduce excessive speculation in markets with skyrocketing prices and inject money into economically struggling nations to reduce the possibility of defaults.
The creation of a fiscal union seems less plausible than ever. Greece is close to abandoning the Euro, and political opposition to the Euro is growing in many Eurozone member countries. Currently, taxes are the only tool available to address negative shocks, but those taxes aren’t enough. Transfers are necessary to maintain the union because if one nation were to leave the EU, others, particularly those in recession, would likely follow suit.
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