The Challenges of Monetary Union

Paul Krugman’s recent analysis of the “Spanish Tragedy” deserves more consideration than it’s received. Krugman’s argument is essentially that the current problems faced by several European Union members (chiefly the high rate of sovereign debt) are the result not of irresponsible governments spending recklessly. Rather, the fundamental problem is the European Monetary Union itself.

Monetary Unions are interesting things. When the Euro was established as the single currency for many European Union members, there were two schools of thought. The first (pro-integration) position was that it would lower transaction costs, increase efficiency, and make the European Union an important global player. The second (anti-integration) position argued that the single currency would be difficult to manage because of the competing impulses and demands of the individual member states. A single currency makes using monetary policy [glossary] to manage the economy across a large area increasingly difficult. Encouraging economic expansion in Spain, for example, by expanding the money supply could only work if the other monetary union members went along. If the European Central Bank is concerned about inflation in Germany and stagnation in Spain, what is it to do? The two problems require fundamentally different (indeed, opposite) policy approaches under monetarism. 

As Krugman summarizes the situation:

Spain is an object lesson in the problems of having monetary union without fiscal and labor market integration. First, there was a huge boom in Spain, largely driven by a housing bubble — and financed by capital outflows from Germany. This boom pulled up Spanish wages. Then the bubble burst, leaving Spanish labor overpriced relative to Germany and France, and precipitating a surge in unemployment. It also led to large Spanish budget deficits, mainly because of collapsing revenue but also due to efforts to limit the rise in unemployment.

The Spanish crisis, in other words, resulted from the monetary union. Can the monetary union now be its savior? Doubtful, but we’ll see.

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