This article originally appeared in Forbes
International political and economic news in recent weeks was filled with stories and analyses of the United Kingdom referendum to leave the European Union (EU). The immediate results of the vote included the resignations of the British Prime Minister and other government leaders, as well as a substantial decline of the foreign-exchange value of the British currency. Because the United Kingdom was not a part of the Eurozone (countries which share a common currency provided by the European Central Bank,) the British referendum to leave the EU was not a vote to also leave the euro. However, the decision by a majority of British voters will have significant implications for the viability of the euro.
The timing and terms of the British “divorce” from the political and economic union with 27 other countries will be negotiated in coming months, but the challenges for the remaining countries in the EU and for the euro are starting to become clear. In the week following the British vote to exit the union, members of the European Council issued a statement effectively declaring that the drive toward a future “United States of Europe” has been abandoned—at least for the foreseeable future. That means that the goal of achieving a common fiscal union—EU level tax and spending policies—is off the table. That result endangers the viability of the common currency.
The 11 countries of the EU that originally agreed to abandon their respective national currencies and adopt the “euro” were never considered a natural “optimal currency zone.” Expansion of the use of the euro to more than 20 diverse countries is even further from optimal. Knowing this, the agreements among countries adopting the euro included some fiscal conditions about deficits and national debts that were intended to harmonize fiscal policies until such time as a deepening of political union among the countries could evolve into a common fiscal union. This was viewed as essential in order to facilitate the fiscal transfers (redistribution) from the more prosperous regions and countries to the less prosperous.
That vision was never achieved, and now must be abandoned as a result of the British vote. The initial fiscal conditions were never achieved by even the major countries, and the Greek tragedy of the past several years revealed the vulnerability of the plan. Without further progress toward a fiscal union—let alone a United States of Europe—the necessary conditions for sustaining a common currency in a non-optimal currency area cannot be achieved.
A couple of months ago, I wrote about the political pressures in Italy that underlie the rising calls for a “consultative referendum” about remaining in the euro. The financial fragility of Italian banks was already critical. While there is no provision for exiting the euro as there was for a country exiting the EU, a strong desire on the part of Italian voters and political leaders to restore a national currency would inevitably become a desire to leave the Union.
A small country like Montenegro can use the euro without participating in policy decisions of the European Central Bank—much like Ecuador and El Salvador use the U.S. dollar without participating in Federal Reserve policy meetings. However, larger countries will insist on a voice in setting monetary policies that affect standards of living of their citizens. Currently, Germany benefits by being in a currency zone with less productive and competitive countries—a euro zone that includes Greece and Italy (among others) is not as strong in foreign exchange markets as the German Deutschmark would have been. It is important to understand that a smaller euro zone would mean a stronger euro, vis-a-vis major trading partners. Ultimately, shrinking the euro zone to an “optimal currency area”—that is, Germany and any countries that want to enter into a common fiscal union with Germany—would be much stronger in foreign exchange markets than is a euro zone that includes poorly performing economies.
The rather short history of the euro has been clear; it has been overvalued for those countries with low productivity growth–Greece, Italy, et. al.–and undervalued for high productivity countries like Germany. The Brexit vote did not create the associated pressures and problems, but British voters have marked the beginning of the reversal of the grand “European Project” of the last several decades.