Germany’s ECB battle exposes the central problem with the Eurozone

As is well known, economists only make predictions to make astrologers look good. Yet those who foresaw the inherent contradictions of the Euro were in fact correct.

Those contradictions still have not been resolved, and doing so will require the creation of a common European treasury, not just a common fiscal policy but a mutualised flow of funds. It’s this imperative that underlines the current battle between the German constitutional court and the EU and ECB, described by the Telegraph‘s Ambrose Evans-Pritchard here.

The reason the prediction from the 1990s has worked is because this is about markets and how they work, which is what neoclassical economics does normally get right.  The particular area in question is Robert Mundell’s theory of optimal currency areas. 

In colloquial terms, the problem with the single currency as currently constituted is that either Germany pays for everything or the Euro fails – not necessarily fails as in disappears, but fails to increase the incomes and wealth of Europeans, which ought to be the point of having economic policies or structures in the first place.

The central fact is that a common money requires common interest rates – everything else flows from that. It’s obvious enough that groups of people do better when they’ve a common money. However, a common means of exchange must also mean a common interest rate.

Over a small area, a town or county, the benefits of that outweigh the problems. But as the geographic area increases, the system starts to incorporate wildly different economic areas, which require different monetary policy – different interest rates – to deal with their local economic conditions. By this measure, the eurozone is simply too large. European economies differ too much to usefully all have the same interest rate.

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