Today's date:
Summer 2012

Making Europe Work

Robert Mundell, often referred to as “the father of the euro,” was awarded the Nobel Prize for Economics in 1999 for his work in monetary dynamics and optimum currency zones. He teaches at Columbia University. This article is adapted from a speech by Robert Mundell presented in the Charlemagne Building of the Jean Monnet Centre in Brussels.

BRUSSELS—I do not share the widespread view that today’s crisis is a problem of the euro, but rather it is a crisis of fiscal solvency of some countries in the Eurozone. The challenges are not only to preserve solvency, but to find a way of allocating fiscal responsibility and sovereignty between the Eurozone leadership and its constituent nation-state members.

A European Finance Ministry | As the crisis had deepened over recent months, European central bankers and others have proposed central EU control of national budgets as the means of imposing discipline on countries that failed to keep their public finances in order. Their question is this: in this union of tomorrow, or of the day after tomorrow, would it be too bold, in the economic field, with a single market and a single central bank, to envisage a Ministry of Finance of the Union? This could possibly involve a transfer of power to the central authority in the field of taxation, although many are not completely committed on that.

Would a European Minister of Finance solve Europe’s problem? The answer would depend on his powers. Suppose he had the same power as the Secretary of the Treasury of the United States. He would have power over the federal budget, but none at all over the budgets of the individual states. This would be quite a lot of power in the US, because the federal budget is more than 20 percent of GDP. But in Europe the central budget is only 2% of GDP and that would be hardly any help at all.

A Ministry of Finance in Europe would contribute to a solution only if he had power to control the budgets of the sovereign nation-states. This is a delicate political issue intimately connected with the issue of where sovereignty lies. The nation-states could voluntarily cede that control over their budgets individually but could not be coerced without agreeing to a new Treaty. Should the new Treaty specify new powers of the central government that would shift functions now controlled by the nation-states to a federal government or should it merely shift watchdog control or discipline over nation-state spending and taxing to a federal authority? To make the point clear, should the functions of and revenues for big budget items like social support entitlements and defence be reallocated to the central state or should the central state merely have supervisory control or veto power over budgets, spending or taxation?

The American Experience | The formidable issue facing the constitutional convention in Philadelphia in 1787 was the issue of where sovereignty lies. The conventional wisdom then was that sovereignty had to reside in one place, such as a king. America had had enough of the king and wanted sovereignty to rest with the people. After the 1783 Treaty of Paris ending the revolutionary war, the thirteen states were formed into a confederation that was in some respects similar to the EU today. The “Union” part in the name of the EU is a hope rather than a fact.

Confederations have a bad reputation. They move on to a federation or self-destruct. This was in the minds of the thirteen states that met in Philadelphia in 1787. Defense was an obvious pressure. The possibility that the thirteen states might form three unions not one with a northeastern wing, a southern wing, and a western wing, was an ever-present danger. The need for a common currency, perhaps a central bank like England and France and Holland, regulation of the free trade among the states and the potential for American expansion to the West were important issues. The support of Thomas Jefferson, the brilliant lobbying in the Federalist Papers authored (anonymously) by James Madison and Alexander Hamilton and above all the supportive father figure of General Washington, the hero of the revolution and “first in the hearts of his countrymen” presiding over the Philadelphia Constitutional Convention, won the day, setting up the inaugural term of the US to begin on schedule in March 1789.

Europe already has its euro currency, its monetary union (albeit with ten members left out), and its central bank, so what interests us most here is the consolidation of state debts in a US Public Debt. One of the stumbling blocks in achieving that debt consolidation was the great disparities in debt ratios among the states, but Hamilton managed to finesse the issue with the argument (only partly correct) that the bulk of the disparities were produced in the interests of a common cause, the finance of the Revolutionary War.

After the consolidation in 1792, the states—which were sovereign over their own debts—could start with a clean slate of zero debt and were free to rebuild them. They did so but over a long period of time. About fifty years later, in the deflationary years of the late 1830s and early 1840s, several states defaulted on their debts. The largely British creditors asked their own government to assume responsibility for the debts but the latter pointed out that the states were sovereign entities with respect to their debts and left it up to the creditors to solve their own problems. The possibility of bailouts became a big issue in the US but in the end the federal government left the problem up to the individual states to solve. Of the eight states involved (plus Florida which hadn’t yet become a state), three states paid almost everything, other states shared the losses with their creditors, and two states went to outright repudiation.

As it turned out, the states which were able to pay in full did so by tapping a new source of taxes—the property tax. Those states which defaulted in whole or in part already had property taxes, and thus could not access this feasible new source of revenue.

The defaults did not have any noticeable effect on the dollar (the US was theoretically on a bimetallic standard, but after the increase in the legal bi-metallic ratio to 16:1 in 1834, overvaluing gold, it was on a de facto gold standard). The problem states were all able to come back into the bond market in a few years. There have not been any bailouts since. It remains to be seen, however, whether historical precedents would be enough to resist intervention in heavily-indebted states like California and Illinois today.

The EU Not Initially a Fiscal Union | The Maastricht treaty contained a no-bailout clause (clause 103) but it was overridden by another clause (clause 104) which condoned help to a state in trouble. Once the ice was broken, it became generalized. The problem was that many nation-states like especially Belgium, Italy and later Greece were allowed in the union with Debt-GDP ratios far above the Maastricht levels. It was widely believed (and I believed it too) that a unique political moment in the integration of Europe had to be seized in 1999 and failing which the momentum of European integration would be lost and Europe’s bicycle might come to a stop and fall over.

After Greece joined—a country with one-third the GDP per capita of its northern partners—the issue of a potential default was widely discussed. Greece was not the only problem. Belgium, the very center of the EU, had a Debt-GDP ratio even higher than Greece and Italy. Belgium would have to be saved, but if Belgium, a rich country, why not Greece, a poor country?

The global boom of 2002-2008—arguably the greatest the world has ever experienced—put these problems on hold despite the fact that little progress was made to scale down the debts of the problem countries. But this optimism came to an end with the housing crash and the financial crisis that struck the US in the summer and fall of 2008.

The soaring dollar against the euro in the summer and fall of 2008 aggravated the recession and brought on the insolvencies of several of the top financial institutions in the US. The strong dollar delayed the spread of the recession to Europe but when it came the increased budget deficits put the high debt-ridden countries on the brink of insolvency. The first bailout, a €110 billion loan from the Eurozone countries and the IMF to Greece, was made in May 2010, followed up by the creation of the European Financial Stability Facility with a comprehensive rescue package of €750 billion in the same month with large amounts being dispensed to Ireland and Portugal. In the next year interest rates of large countries like Spain and Italy had raised the stakes and revolts against austerity had put the solidarity of the Eurozone in doubt.

Whatever current measures are adopted to resolve the financial crisis in Europe, the Eurozone must find a solution to the problem of achieving fiscal discipline in the individual states. There is no point to a grand strategy like debt consolidation or Eurobonds if it does not fix the accountability and responsibility for deficits of the fiscally-weak countries.

We know that there are two corner solutions. One is to restore the fiscal and debt independence of the nation states, playing hardball with respect to bailouts and taking away the immoral hazards of soft budget constraints. This was the direction the Americans took in the years between the creation of the US and the Civil War (but we don’t know if it will still work for the 21st century). The other corner is to move forward towards a strong central state with a Ministry of Finance that has control over national budgets.

Ten years ago I would have been emphatically in favor of the first choice, on the principle of subsidiarity, decentralizing decision-making and self-accountability. But I am not sure that today it is any longer possible. There is hysteresis. The steps taken during the current crisis have foreclosed on some options that might have been possible before the crisis. But it is also difficult to go forward toward increased centralization because it requires a big shift of sovereignty to a central authority that does not yet exist. I wonder if there is any middle way.

Eurobonds, Eurobills and the European Central Bank | An argument can be made today that an EMU (or EU, but let us sidestep that question for the time being) Public Debt would be beneficial? Despite the current crisis the euro is one of the two most important currencies in the world and an alternative to the dollar as a reserve currency and anchor. But the lack of EU Treasury Bills and Bonds severely limits the power and usefulness of the euro as an international reserve currency. Buying individual national debts and bills of different degrees of solvency is a cumbersome alternative to the convenient and vast offerings on the US financial market.

This is not to say that becoming a reserve currency is an unmixed blessing. But the Eurozone could take advantage of an opportunity for a source of funding of trillions of dollars that would be of tremendous use in buying time to resolve the current crisis. It will continue to be way behind the curve in the global competition for bills and bonds used to finance international trade and payments and for use in official reserves as long as its bonds and bills are splintered into 17 national offerings.

But there is another argument for Eurobonds and bills that can be made. Quite apart from tapping new sources of funds internationally, the consolidation of national debts into Eurozone debts would contribute to the Eurozone’s survival in its present constituency. There is now some risk that at least one country might decide to leave the Eurozone. That would probably be a calamity for the country in question, but it would to some small extent tarnish the reputation of the euro. If the crisis spreads, the project of European unity could be back for a long time if not undermined forever.

We know of course from American experience that the creation of a US Public Debt in 1792 was not an unmixed blessing. Only a couple of decades later, it had become vexing enough problem to produce a remark by Jefferson who said, in 1810, thinking of course of Hamilton back in 1792: “And we were told that the public debt would be a blessing!”

Today thee words might be echoed in nearly all of the democracies in the world. Ever since the breakdown of the international monetary system in 1971, fiscal discipline went out the window. Keynes was right when he referred to the convertibility mechanism as “a means of strapping down ministers of finance.” Hamilton himself would be stunned today by the fiscal profligacy of democratic governments and onward march of fiscal deficits and debt ratios onward and upwards toward insolvency.

It must be acknowledged that there is some risk that debt consolidation could have a corrosive effect in increasing Europe’s Debt-GDP ratio; the same political pressures that have pushed the debts of the nation-state to unsustainable levels could infect the central government. You can see this process operating in the United States where the federal deficits are close to record highs for a peacetime economy. To mitigate that, some restriction, perhaps even at the constitutional level, should be placed on deficits and debt levels. It would of course also be necessary to impose an outright prohibition on further national debt issues and something close to a balance-budget requirement for each participating nation-state.

What would be the “common cause” argument for the creation of a Eurozone Debt? A Euro-Debt level of about €9 trillion would have a great international market if the risks of a Eurozone breakup could be allayed. It would be a good rival to the US debt which has over $5 trillion held abroad. The creation of a Eurozone Public Debt would provide a strong incentive for non-members of the EU to join the Eurozone and participate in the lower interest rates available to Eurozone members.

The question is whether the creation of this debt would be at the expense of a surplus country like Germany. The equilibrium interest rate on Eurobonds would probably be somewhat higher than that on Germany’s debt, but not necessarily higher than it would be in the absence of debt consolidation and Eurobonds in a situation where the Eurozone crisis deepens. Taking into account the international market for Eurobonds and Eurobills the extra supply of international capital could keep interest rates on Eurobonds at the international level.

Finessing the Problem of Sovereignty | Now we turn to the issue of sovereignty and again we take a look at the American solution. It was the ingenuity of the American founders at the Constitutional Convention (May to September 1787) that they were able to cut the Gordion knot on the question of sovereignty. The states wanted to be sovereign but federalists wanted sovereignty in the central state. The conventional wisdom of the late eighteenth century was that sovereignty could not be shared, and democracy was possible only in small republics; Rousseau had even said that the smaller the state the better. The Constitutional Convention provided for divided and overlapping sovereignties, in contrast to saying that sovereignty had to reside in one place. 

The US was the first country to create a nation-sized democracy dividing sovereignty between the states and the central government. The powers not allocated to the central government were reserved for the states.

At first it might seem that this division of sovereignty might solve the fiscal problems of Europe. But the division of powers was associated with the means of financing them. The central government had the responsibility for financing their mandates, and so did the states. But there was no arrangement for the central state to assume powers over state spending or deficits. What could be achieved either by constitutional amendment or else quasi usurpation was that the central government could assume co-opt for itself new functions like social security, income redistribution and medical entitlements that never existed when the constitution was set up.

The European system to organizes welfare state spending at the nation-state level, whereas the American system achieves this at the Federal level. General government expenditure in both the EU and EM was slightly over 50 percent in 2010 of which social transfers accounted for 43 percent or 21 percent of GDP. If social transfers in Europe were shifted from the nation-state to the Central State Level, the weight of the central government in Europe’s GDP would be at over 20 percent close to its weight in the US. Of course appropriate taxes would also have to be shifted from the nation-states to the central governments.

Under these conditions, the proposal for a European Minister of Finance would, if given the powers equivalent to that of the Secretary of the Treasury of the US would put European fiscal policy, from the standpoint of its control over spending, in the same position as US fiscal policy. In Europe total government spending would be about equally divided between federal and nation-state level, whereas in the US state spending would be considerably smaller than federal spending.

I raise this issue now not to propose such a shift in spending at the present time, but to make clear that the share of sovereignty is pretty straightforward when it is accompanied by a shift in the share of spending mandates.

But this is not the situation in Europe today. A shift of welfare-state spending from the nation-state to the federal level would involve a substantial redistribution of income from the richer to the poorer states. In the long run there may be much to be said for this redistribution on grounds of social solidarity but it was not part of the bargain made for entry into either the EU or EMU and in any case it would be unfair to impose the burden of this redistribution all at once on one generation. If, as I assume, this shift of spending power to the central government is not politically feasible at the present time, we have to see what headway can be made with a shift of authority without the shift of spending mandates.

A natural model is the IMF with its 187 members including the seventeen EMU members. The IMF is an institution that imposes adjustment policies as a condition of its aid, and it has a multiplier effect because private-sector lenders (e.g., the Paris Club or London Club) often require compliance with IMF conditions as a prerequisite to lending or debt-rescheduling or forgiveness.

Suppose that the proposed Eurozone Minister of Finance were suddenly interposed between EMU members and the IMF. To abstract from possible differences in expertise let us suppose that the relevant IMF staff is seconded to the Euro Minister of Finance and that existing IMF policies are continued. This arrangement would give power to the EMOF without diminution of sovereignty from the nation-states that has not already been given up to the IMF Board of Governors. But actually, the individual members of the Eurozone affected would have reclaimed some sovereignty because they have a larger stake in EMOF decisions than they have in the IMF decisions. The allocations of funds that would have been made by the IMF to their clients in the Eurozone, would now go through the EMOF.

Independent of an EMOF taking over some power from the IMF, there could be a ceding of sovereignty from the nation-states to a central government in exchange for better defenses against insolvency.

European Political Reform | Actions taken today can promote or derail the cause of European political integration. It is important to look at the political institutions to see the desirable paths for them to evolve. The main institutions are:

• The Commission

• The European Council

• The European Parliament

• The Electorate

What Europe needs is:

• An Executive Power

• An Upper Chamber or Senate that serves as the Electoral College

• A Lower Chamber or Assembly

• The Electorate

The Commission could be turned into the Executive Power with its Cabinet/ Commissioners appointed by the President. The President would be appointed by the Electoral College.

The European Council representing the Governments could be turned into the Upper Chamber or Senate and Electoral College with the Vice-President as its Chairman.

The European Parliament could serve as the Lower Chamber.

The alternative to an Electoral College would be the general election of the President. My own view is that in an area as diverse and heterogeneous as Europe it would be better to elect the President and Vice-President through an Electoral College by majority vote. The extra attention given to the general electors of the Electoral College would create a level of excitement and interest far above that of a Europe-wide majority vote.

The Executive would nominate the Judiciary with approval by the Senate. The Executive makes treaties subject to ratification by the upper chamber, and it proposes bills subject to ratification by both chambers.

The President is the commander in chief with a special protocol for British and French nuclear weapons. The Lower House or Assembly has around 500 deputies distributed among countries in proportion to population. Budget proposals initiated in the lower house must be accompanied by finance solutions. The Council of Ministers is expanded to the upper house and given certain special powers. In this model, with a total of 128 Senators, countries with a population of: over 80 million would have 12 Senators; 65 to 80 million would have 10; 50 to 65 million would have 9; 35 to 50 million would have 8; and so on. You would then have a framework for division which isn’t as rigid as that which determines the composition of the US Senate and it would be a correction for disparities that exist in the Senate, such as having 2 Senators for Maryland, with a population of less than a million people, and an equal number for California with 40 million people.  

In the Electoral College, which votes for the President and the Vice President, each nation has electoral votes equal to the number of Senators and representatives in Congress. The presidential candidates with the majority of votes get the entire vote of the nation-state.

The European Commission is a very successful institution. It is necessary to preserve some of its competence as a technical bureaucracy. Vice Ministers would be drawn from the Civil Service, but Ministers would be members of the Cabinet appointed by the President with the approval of the Senate.

The International Monetary Structure | The international monetary picture will have a great bearing on the future of Europe. In the world currency system, the biggest currency area is the dollar area, the second biggest is the euro area, the third biggest is the Chinese yuan area, the fourth is the Japanese yen area, and the fifth is the pound sterling (or the ruble). A major problem in world finance since the early 1970s has been the huge swings in major exchange rates.

All the major systemic crises have been associated with large swings in the major exchange rates. Associated with these swings is a proliferation of crises including debt crises.

Over most of history since the invention of coinage, a kind of fixed exchange rates has characterized in the monetary world because of the use of one or more of the precious metals as currency anchors. Currencies were names for different weights of the metals.

Whether the system was the gold standard or bimetallism or the Bretton Woods brand of fixed exchange rates based on the gold-convertible dollar, monetary and fiscal policies were constrained by a hard budget constraint—at least in the middle run. If during wars debt levels were run up, they were regularly brought back down after the war with surpluses invested into a sinking fund. If in the rare instance a country had a crisis or a large budget deficit there would be a run on its currency, and a currency crisis.

With the introduction of flexible rates, however, there came a very soft budget constraint. It was thought incorrectly that flexible exchange rates added another degree of freedom; this was true only if monetary stability were thrown to the winds.

The only worry might be that you would end up creating inflation in the long run if you allowed too much money into the system, but you would not worry about the early warning system of a deteriorating currency. The Federal Reserve, for example, did not apparently worry about the depreciating dollar in the late 1970s and the two-digit inflation of the years 1979-1981 came to it as a complete surprise.

You can see the analogy when a country like Greece gets into the euro with habits that it had formed in relation to what would happen to the drachma. When it got into the Eurozone it could run deficits and pile up its debt level, polluting the debt pool of the whole euro area, without any constraint falling entirely upon itself.

Somehow, you need to keep discipline in the system. This has been a major problem for countries on flexible exchange rates leading up to all kinds of crises such as the sovereign debt crisis in 1982 starting with Mexico and Poland, the Savings and Loan crisis, the Asian crisis, and finally the 2008 crisis.

The Unit of Account | Now we can see huge swings in the rate of the dollar to the euro. Under the Bretton Woods period, and even in the early 70s, the dollar represented the mainstream of the world economy. Now, with the rise of the EMS bloc and its culmination in the single euro currency, the mainstream has been split into two parts with violent swings between them.

A big problem now is the absence of a universal currency and a global unit of account. John Maynard Keynes, in his Treatise on Money wrote about the importance of the unit of account. The first line in his two-volume work reads: “the unit of account is the most important function of money.” This is very important in today’s world of international currencies. The euro is starting to become the currency for pricing certain things, such as airline fares, and you could argue that oil prices and the price of gold are more stable in euros than in dollars. It would be a shock to the system if oil prices began to be denominated in euros rather than dollars.

Stabilizing the Dollar-Euro Exchange Rate to Reform the System | The big swings in the dollar-euro exchange rate have not been to the advantage of either the United States or Europe. Both areas would be much better off with a stabilized rate and policy coordination that would keep the balance of payments in equilibrium. If you stabilized the dollar-euro rate you would have an anchor for the global economy. There is no possibility of a genuine international monetary system with big swings in the exchange rates between the two biggest currency areas.  However, if the rate was fixed you would have a zone of stability that would represent over 40% of the world economy. This could be the anchor for a global monetary system. You could build upon that with monetary coordination and stability of the common price level of the two areas.

In the long run, a fixed exchange rate requires compatible monetary policies. As the (moving) band between them narrowed, there would have to be increased coordination of interest rates and quantitative measures. You can’t have any fixed exchange rate system in the long run without monetary coordination if there are two independent producers of money.

It is interesting to note that for some time, the Chinese yuan has been tied to the dollar almost de facto, trending upward now and then. In 1997-2005 it’s been fixed to the dollar and after that allowed to rise with a crawling peg until 2008. After that, with the dollar soaring the yuan was re-stabilized until the dollar returned to normal. My question is: Could the yuan be part of the solution? It would be very easy to fix because China has found that a fixed rate with the dollar is the best way for a command economy to import the scarcity relationships of the rest of the world. The yuan would have to be made convertible and it would have to follow a monetary policy that brought about equilibrium in its balance of payments. The coordination of monetary policies in the dollar, euro, and the yuan—what I call the DEY—would create a central core for the world economy, just by fixing two exchange rates and having policy coordination. You would then have 50% of the world economy in that monetary reform, and other countries would have the benefit of a stable DEY bloc upon which they could fix their own currencies.

That is the way I think the world could go, looking outside the problems of just the euro area. It could move on from that to global monetary reform, creating a global currency and using the DEY currencies as the anchor for it. The euro-dollar could then become the central pivot for a restored international monetary system. A world currency, the INTOR, based on the euro-dollar as an anchor pivot, could be created for the IMF system as a whole in which every member of the Fund would share. It may be something which will materialize over the long term, but it is something that is necessary. It is not just ivory tower academics who think so. Paul Volcker, the former chairman of the Federal Reserve and former advisor to Obama, has uttered what I call the VOLCKER IMPERATIVE: the global economy needs a global currency.

The Urgency of Reform | Great benefits could be achieved by the creation of a European Ministry of Finance, with some authority over the spending and deficits of the nation states. Great gains can be got for the euro area by the creation of Eurobonds and Eurobills, but it would be dangerous to create them without putting ceilings on government spending and deficits. Bringing the future to the present, the centralized fiscal authority should be put into place at an early date, Eurobonds could follow, and in the interim, the ECB’s firepower and tools for maintaining price stability could be built up.

It seems likely that the ECB will on occasion have to intervene in some markets to prevent insolvency when interest rates rise to dangerous levels over or at 7%. “Discount freely in a crisis,” Bagehot said.

The choice might be that either the central bank intervenes, or the Eurozone breaks up. The problem with intervention by the ECB to avert insolvency is that the amount of intervention might conflict with the ECB’s mandate to give priority to macroeconomic stability and in particular inflation rate stability.

Some degree of expansionary monetary policy on the part of the European Central Bank is necessary for a solution to Europe. My own view is that the European Central Bank has been erring substantially on the side of being too tight in the context of the de-leveraging crisis Europe has been in. The Federal Reserve has gone far beyond what the ECB has done in satisfying the demand on the part of the banks for excess reserves. We are all aware of course of the ECB’s mandate to avert inflation. But some risks have to be taken to avert insolvencies, which, theoretically, could result in higher inflation than otherwise. I’m suggesting here not a big step to inflation but a temporary movement up of inflation targets to say 3.5%. That kind of shift could do much to relieve the situation and start a speedier recovery in the euro area.

I think that Europe should have a somewhat more expansionary monetary policy. But there is a possibility that the monetary expansion resulting from support for a particularly weak national bond market may exceed the rate needed for even a higher inflation rate. In this case, however, my suggestion is that the ECB can have recourse to a financial innovation that would let it support the bond market of a potentially insolvent country without causing excess inflation. The ECB could issue its own bonds to keep “bailout policy” in line with monetary stability, in effect to sterilize the some of the monetary effects of bailout policy.

Other central banks have done the same but in a different context. Which banks? The answer is China. The People’s Bank of China issues its own bonds to mop up any excess reserves created by the purchase of dollars in the foreign exchange market to keep the yuan from appreciating (or from appreciating at too fast a rate).

?ECB bonds would add a new instrument for preventing inflation. Suppose for example, €400 billion is needed to avert a solvency crisis. But only €200 is needed for monetary policy objectives. If the ECB had no other tools of stabilization, it would have to restrict its intervention to what was needed for monetary policy alone. But with ECB bonds available, the ECB can go ahead with its €400 billion anti-insolvency intervention, and then sell €200 billion of ECB bonds to sterilize the excess inflationary component of the intervention.

Ultimately, ECB bonds are debts of the European Union. Eventually when Europe creates its own Eurobonds these ECB bonds could be absorbed into the debt of the EU. But the ECB bonds could be useful instruments during the transition period before Eurobonds and Eurobills are established.

There is an urgency for fiscal reform, but it seems hard to make such weighty changes quickly. But when we look back at what those Americans accomplished, back in 1787, it is astonishing to see how quickly they were able to act. Within a year or two of the Constitutional Convention, they had a first-rate government in place and in the last year of Washington’s first term as president, they had created a national money, a monetary union of thirteen states, a central bank and a consolidated public debt. When the chips are down, there is much that Europe can do too.