Can the Eurozone Exist Forever?

The question includes a political and an economic component. The political differences between the member states may increase too much, so that one or more countries decide to leave the currency union. However, the main political differences are currently focused on economic issues. A break-up of the eurozone due to purely political reasons is very unlikely at the moment. Significantly more acute are the economic problems, but commentators seem to understand little about economics.

A common currency area can exist permanently only if current account imbalances cannot emerge in relevant dimensions or if mechanisms will be available that can equalize the imbalances and are cheaper than leaving the currency union.

A balancing mechanism on a national level is labor mobility. When one region generates a “current account” deficit, the located companies lose market share and jobs get lost. The higher unemployment compared to other regions of the country will lead by tendency to an internal migration into the regions with higher employment. This can be well observed in East Germany. Still year after year around 50.000 East German people leave their home and move to the West. This internal migration would be clearly higher without the second balancing mechanism, that is to say financial transfers. A person who is unemployed in East Germany (or Southern Italy) or is retired, he gets a part of his transfer income from contributors living in regions with a more favourable ratio of contributors to transfer receivers. Moreover, between the German states, there is an inter-state fiscal adjustment (“Länderfinanzausgleich”) – most countries have comparable transfer mechanisms between richer and poorer regions. Furthermore, government investments are usually disproportionately higher for poorer regions.

Both mechanisms work adequately at the national level. The lower fiscal transfers are, the higher internal migration should be. This explains a large section of the higher labour mobility in the US compared to Germany and other Western European countries. In general both mechanisms also exist on eurozone and EU level respectively. However, financial transfers are – despite other impressions by many Germans – quite low. Even the largest net receiver countries Lithuania and Greece get only slightly more than 2% of their GDP from the EU, the relatively largest net payer member, the Netherlands, pays just 0.5% of its GDP net to the EU. Given huge current account imbalances of partly 10% of GDP within the eurozone, this is not a sufficient mechanism, particularly since most net receiver countries are not members of the currency union. However, the low fiscal transfers could be compensated by appropriate labor mobility – within the eurozone every employee has the right to work and live freely in other eurozone countries (or in principle even in other EU countries, but there are still some restrictions). However, the language barrier forms a notable obstacle. Moreover, it has to be considered that especially the group that should migrate most, i.e. unemployed persons, is on average rather low skilled and therewith the language barrier is more distinct.

If both compensatory mechanisms are not sufficient, and there is no commitment to prevent larger imbalances or to reduce existing ones respectively, current account imbalances can grow to macroeconomic destabilizing dimensions. Economies with a current account deficit steadily take on debt from surplus economies. Starting with more or less a balanced current account, the country with the lowest increase of unit labour costs runs surpluses. Some day the point will be reached when one or more deficit countries are either no longer able to take on more debt or can’t access any credit. This economy must then cut consumption, government expenditures and/or investments with the consequence of a falling GDP. Lower expenditures will also lead to lower imports, so that the surplus country will slip into recession too. If the previous surplus country will not become a deficit country, the debtor country has just two possibilities. Either it conducts a deflationary policy to underbid the present surplus country, which would force it to become a current account deficit economy; or it leaves the currency union, devaluates its new currency and therewith gets competitive again.

In both cases the previous surplus country is not able to conserve its price competitiveness permanently. The current account surpluses shrink automatically. Therefore they would provide a negative GDP growth contribution that is finally exactly as high as the sum of positive GDP growth contributions during the period of rising surpluses. The decision for the deficit country seems to be easy; currency depreciation appears to be convenient. However, the euro debts would persist and due to the depreciation euro debts would soar measured in the new currency. Moreover, interest rates for new debts would increase. So the question for the deficit country is whether a deflationary policy with decreasing GDP and high unemployment is cheaper or more expensive than this option. Where exactly the break-even lies is probably in practice unascertainable. What is clear is only that this point will be reached someday, and namely, at the latest in the case of a national bankruptcy – when a government is no longer able or willing to repay the existing debts.

The measures – at present are finally being discussed by the governments of the eurozone – are logical in this respect, as they should prevent a national bankruptcy, which would lead to leaving the eurozone. Nevertheless, not a single one of the considered measures solves the fundamental, underlying problem, i.e. the huge current account imbalances within the currency union. As long as this problem is not solved, even the biggest rescue package for any member country will just shift the real problem into the future.

If the eurozone should endure, there are only two possibilities: Either transfer payments between member countries must be increased massively – then the eurozone would have a de facto an economic government, which is unenforceable at the moment – or euro members agree on a rule, with clear sanctions for breaching it, to prevent larger imbalances and to reduce the existing ones respectively by deficit and surplus countries.