Reasons for Eurozone Crisis: Keynesian or Hayekian?

As I keep saying no matter how much you read on EZ crisis, it can never be enough. There are always some different and interesting perspectives to follow.

George Selgin of Univ of Georgia in this note points that there were two critique schools when formation of EZ was being considered – Keynesian and Hayekian:

When the merits of a European Monetary Union were first being debated, many skeptics fell into one of two camps. The first camp consisted of “Keynesians” (for example, Eichengreen and Bayoumi 1997, Salvatore 1997) who, referring to the theory of optimal currency areas, doubted that Europe constituted such an area, and believed that the proposed monetary union would eventually fall victim to country-specific (“idiosyncratic”) shocks. Unemployment and other burdens stemming from such shocks would, these critics argued, eventually force the monetary authority to either abandon its commitment to price-level stability in order to offer relief to adversely affected members, or cause the members to abandon the union so as to be able to realign their exchange rates.

The other camp was comprised of “Hayekians” who, drawing upon theories of international currency competition, claimed that monetary unification, by reducing the extent of such competition, would give rise to a relatively high seignorage-maximizing eurozone inflation rate, and therefore result in a level of actual eurozone inflation that was bound to disappoint the monetary union’s more  inflation-phobic members. It was in light of such reasoning that British Prime Minister John Major made his alternative proposal for a parallel European currency—the “hard ecu”—to supplement rather than supplant the British pound and other established European currencies.

So who won? Neither of them:

Today the euro is indeed failing. But its failure has in large part been the result of fundamental shortcomings other than those pointed out by either of these prominent camps of early euroskeptics. Rather than merely being wrenched apart by pressure from idiosyncratic shocks, or by disappointments stemming from the ECB’s temptation to profit from its monopoly status, the euro is unraveling because commitments upon which its ultimate success depended—commitments that had to be credible if it was to work as intended—have instead proven to be perfectly or almost perfectly incredible.

The euro, in other words, was built upon a set of promises that the authorities concerned were unable to keep. Orthodox theory—theory that is neither particularly Keynesian nor Hayekian in flavor—suffices to explain (with the help of hindsight) why the promises in question could not possibly have been kept so long as the EMU’s members enjoyed substantial fiscal sovereignty. The combination of effectively unconstrained fiscal sovereignty and a lack of credible commitments to avoid both centralized debt monetization and outright member-state bailouts created a perfect storm of perverse incentives. 

He points to several reasons why it failed –  The Time-Inconsistency Problem, Monetary Free Riders, Hostage Taking, Another “Impossible Trinity”? etc.

Finally why it lasted despite having design problems? Well, simply because it took some time to test the design falws:

In examining the cause of the euro’s failure, it may seem that I’ve only succeeded in raising a different question, namely, How did the euro manage to survive for so long? The answer hinges on the fact that the credibility of various commitments made at the time of the euro’s launching was not something that could be ascertained in advance. Instead, it had to be discovered. In particular, the public had to discover whether European authorities had avoided the Impossible Trilemma by adequately limiting participants’ fiscal independence.

Nice read..


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