Over the past month in The National, the Bahrain-US economist Omar Al Ubaydli has explained the pros and cons of a single currency, with a focus on the European experience and what it suggests for the six countries of the Gulf Cooperation Council, which are considering a move towards a common currency. Here as a useful primer to readers we present Mr Al Ubaydli's series, which was written in a question-and-answer format.
QUESTION ONE: What are the advantages and disadvantages of a single currency?
In 1999, the year in which the European single currency was launched, the Nobel Prize in Economics was awarded to Robert Mundell for his theory of the conditions under which it is desirable for multiple countries to use a unified currency rather than each having their own one. Today, due in part to the euro’s challenges, the GCC countries have decided to further review the best way to implement their own single currency.
The pros and cons of single currencies revolve around the fact that prices do not instantly adjust in a manner that balances supply and demand in markets. Changing a price can be physically costly (as in the case of the price on a restaurant menu), and those setting them may suffer from information deficiencies that stifle optimal price readjustment. Moreover, humans are psychologically sensitive to price changes, especially wage cuts.
Slower price adjustment means lengthier mismatches of demand and supply, and this is undesirable in the context of a persistent excess of supply over demand in labour markets, commonly known as unemployment.
Qatar exports natural gas to the UAE, while the UAE exports diamonds to Qatar. Each has its own currency. If natural gas prices suddenly drop, then one of two things has to happen: either Qatari gas workers have to earn less or some of them have to be laid off. Neither is politically desirable. However, the pressure on Qatari gas wages and employment to change is diminished if the Qatari riyal decreases in value, as it constitutes a backdoor way of decreasing Qatari gas workers’ wages: the price of international goods rises, including UAE diamonds, meaning that Qatari gas workers’ wages purchase less than before.
Changes in the value of a currency are politically far more palatable than disrupting labour markets directly; this constitutes the biggest advantage of currency autonomy.
In contrast, Greece’s adoption of the euro has meant that it has had to suffer cripplingly high unemployment.
So why would any country surrender its currency? The first reason is facilitating trade with currency partners: there are no transaction costs, and price comparisons become easier. Some types of market speculation can lead to volatility in exchange rates, which makes long-term investment riskier; currency unions eliminate that problem by eliminating exchange rates.
Second, the inflexibility of prices creates a dangerous temptation for the government: if it can surreptitiously print money faster than prices adjust, it can redistribute wealth in its favour in the short run, which it can use to pay off debt and fund programmes. Ultimately, prices do catch up, and this creates cycles of high inflation and high interest rates. Some governments are forward-thinking enough to avoid the temptation to abuse the money supply but for those that are not, joining the currency of a “credible” country is a quick way to impose restraint (like Odysseus tying himself to the mast).
Thus, countries that cannot resist the temptation to print money face a quandary: high inflation and interest rates outside the currency union or bouts of high unemployment inside it. Mr Mundell outlined an escape route: if workers can relocate across the political boundaries of single currency countries, then when unemployment rises the excess workers can simply move to the country with more jobs. That is why the EU implemented free labour mobility as a precursor to the euro’s launch.
The problem for the EU, however, is that there exist many non-legal impediments to labour mobility, such as language and cultural differences (imagine a Finn moving to Portugal). While GCC citizens tend to prefer living in their home country, potential mobility is much higher than in the euro zone, so the foundations of a single currency are arguably preferable.
QUESTION TWO: What is the Eurozone Greek debt crisis, and what lessons does it offer for the GCC single currency?
In part one above, we learnt that when a government struggles to manage its finances, it will suffer from inflation and high interest rates and that one remedy is to join the currency of a fiscally disciplined country. By surrendering control of its monetary policy, the joining country gains credibility, earning lower interest rates. We also learnt that the downside of a single currency is that when the economy recedes because, for example, there is a financial crisis, unemployment will increase sharply as wages are slow to fall and the country’s currency cannot devalue.
The Greek debt crisis is a perfect illustration of these principles. It also serves as a warning to the GCC countries as they plan their own single currency.
Throughout the 1980s and 1990s, when Greece had the Drachma, the government mismanaged its finances in two primary ways. First, it ran up a large debt (more than 75 per cent of GDP in the mid-1990s). Second, it used that debt to fund public-sector hiring that featured generous benefits, such as low retirement ages, and that was useless, if not damaging, to the economy. As expected, the drachma’s value tumbled and inflation and interest rates rose to more than 25 per cent.
Just as the music was about to stop for Greece, the EU introduced a fortuitously timed, but ill-conceived, single currency and the European Commission was very keen on Greek membership for political reasons. Greece obliged and in so doing, saw its interest rates fall below 5 per cent. This allowed it to delay domestic reforms and the government persisted with of borrowing to fund an extravagant and ineffective public sector.
After the global financial crisis of 2008, Greece’s lenders began to question its creditworthiness and markets started to differentiate between the different eurozone government bonds, with Greece’s interest rates shooting up beyond 30 per cent. Government insolvency ensued – this time the music did stop. If wages didn’t fall immediately, then unemployment would rise sharply.
As mentioned last week, wages are stubborn, especially public-sector ones, but a devaluing currency is a good substitute. The single currency ruled that option out but there was the alternative of Greeks relocating to more prosperous parts of the euro zone to ease unemployment. However, cultural barriers, as well as the poor health of the European economy in general, largely scuppered such plans.
A series of bailouts ensued but they were of limited help because they were designed to bail out the private European banks that had lent to Greece. Greek unemployment now exceeds 20 per cent and it will take a long time for the economy to readjust.
The Greek government’s irresponsible spending habits during the past 40 years are the biggest cause of the crisis but the European Commission also played a role by politicising the single currency, which is the mistake that the GCC countries must avoid.
A correctly conceived monetary union involves a series of economic qualifications before entry of a new member as well as automatic sanctions that prevent irresponsible fiscal management by member states. The European Commission established both nominally but overlooked egregious violations because all it cared about was the aggrandisement and empowerment of the central European institutions. Bureaucracies specialise in engineering situations that result in an expansion of their influence and resources, which is why we see former president of the EC Jacques Delors now calling for fiscal union as the “solution”.
QUESTION THREE: Have the post-eurozone crisis reforms solved the crisis and are they applicable to the GCC?
During the eurozone debt crisis, the central authorities took emergency stabilising measures and adopted a series of preventive reforms. To understand them, one has to go back to Mr Mundell’s theory of optimal currency areas.
A single currency is like “going Dutch” to settle a restaurant bill. Whereas separate currencies are like separate bills for each diner, a single currency is like sharing the bill equally – also known as “going Dutch” – but that creates an incentive for people to order more than they would if they were paying for themselves exclusively. Economists refer to this as the “moral hazard” problem.
Anticipating this, Mr Mundell laid down “convergence criteria”, which help to prevent single currency moral hazard in debt. The two most important criteria are that total debt should not be too high (capped at 60 per cent of GDP in the case of the euro), and neither should budget deficits (capped at 3 per cent of GDP). Enforcing these rules largely eliminates the moral hazard problem.
The euro zone got off on the wrong foot by violating these rules at the euro’s launch, then continued to violate them, especially after the global financial crisis, when many countries were egregiously exceeding the budget deficit cap, including France, a supposedly anchor member. This happened for two reasons.
First, despite the public rhetoric, the euro was never really about economics; it was about political integration, and the empowerment of the European Commission. Thus, exacting criteria were an impediment to the covert mission and were ignored.
Second, fiscal discipline is politically unpopular, especially during economic recessions of historic proportions, such as 2008. The situation quickly resembled going Dutch, with extravagant diners about to break their fast.
The eurozone reforms were an attempt to rehabilitate these criteria but with convoluted extra conditions and penalties that would overcome the inevitable tendency for members to cut each other slack as they grapple with their own recessions. So, have the European Stability Mechanism and the European Fiscal Compact done the trick?
In the short term they have worked but in the long term, even the European Central Bank’s former, and first, chief economist, Otmar Issing, has described the system as a house of cards that will inevitably collapse.
The problem is that the system involves implausible commitments by member governments. When the next crisis arrives, the penalties will be politically unacceptable to the people of the violating country, as they will be perceived as external interference in critical internal affairs. As before, politics will trump economics and the cycle will repeat itself.
That is why some claim that the only viable solution is to convince the countries to surrender their fiscal policy just as they surrendered their currencies under monetary union.
The key lesson for the GCC is to keep governments in the driver seat and power-hungry bureaucrats at bay. Economics must always trump politics in single currencies, a lesson that the European Commission obstinately refuses to learn.
QUESTION FOUR: What is fiscal union and does it solve “moral hazard” issues in single currencies?
In a fiscal union, the member countries surrender their tax revenues to a central authority, which then spends the money, possibly via the intermediation of member governments. A fiscal union typically involves harmonised taxes across members, to avoid complaints about differential treatment.
Practically speaking, a combination of fiscal and monetary union strips member governments of much of their power, although there is some variation. For example, the US is involved in fiscal quasi-union: the federal government collects a large proportion of taxes, as well as contributing a large proportion of public spending; and, state governments retain the right to levy taxes and pass their own laws. In contrast, two different cities in England are part of a much stricter fiscal union: municipalities have comparatively little latitude in their local affairs.
Fiscal union addresses the “moral hazard” issue by constitutionally taking most fiscal affairs out of the member governments’ hands permanently. Moreover, the supranational authorities are constitutionally charged with operating in the interests of the entire union, eliminating the problem of governments free-riding on the fiscal discipline of their currency partners in the monetary union. That is one reason why the former European Commission president Jacques Delors and his fellow Europhiles have been angling for fiscal union for many years.
Will it work? In some cases, such as the GCC, it may well work. But first let us understand why it is likely to fail for the euro zone.
Together, monetary and fiscal union constitute a de facto political confederation. Europe’s peoples have an affinity for their brethren but not enough to become their fellow citizens. The countries have a strong sense of national pride, rich histories and widely divergent cultures, especially when one starts comparing north to south, and east to west.
The project was initiated in an effort to end centuries of bloody conflict that culminated in the two worst wars in history – an admirable goal. However, seeking a method that prevents mutual annihilation is very different to loving each other enough to become a single country. Many countries that have had a history of conflict have successfully ceased without needing to politically merge, such as France and the UK, or Portugal and Spain – both sets of conflicts ended long before the European project.
If a fiscal union is imposed upon the euro zone, the economic stability will be a mirage, as political discontent will eventually lead to calls for secession and the possible collapse of the entire European project. Via a combination of domestic and European Parliamentary elections, citizens of the EU’s member states have made it clear to policymakers that European integration needs to slow down, rather than speed up.
In the GCC, fiscal union could work. While the governments have their disagreements, the cultural foundations for a political union are sound: common language, religion, tribal ties and traditions. The German and Italian unifications of the 19th century were partially the result of people rejecting foreign imperialism. The Middle East has always attracted the attentions of would-be hegemons, and in the present climate that could be enough to make GCC fiscal union work.
Omar Al Ubaydli is the programme director for international and geopolitical studies at the Bahrain Center for Strategic, International and Energy Studies, and an affiliated associate professor of economics at George Mason University in the US.
We welcome economics questions from our readers via email (omar@omar.ec) or tweet (@omareconomics)
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