EU May Be Too Large to Be Optimal

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 |  Includes: ERO, EWG, EWP, EWU, FXE, IRL, SNF
by: Kimball Corson

First the Euro falls badly against the dollar in large part over worries about what the EU is going to do about Greece and the other southern Euro zone countries. Next, we have concern rising that Spain might decide to bolt and establish its own currency or perhaps a new currency with the other PIGS. Although some see these alternatives as difficult prospects, others do not, if bolting countries in fact decide to individually or perhaps later collectively go their own way. As the story unfolds, it is not at all clear that the Euro zone is an optimum currency area, just as it hasn't occurred to many that the U.S. is not an optimum currency area either. The EU and Euro zone may both be too large to be optimal in several regards. Here is the problem.

Spain is suffering 19% official unemployment and its economy is seriously in the doldrums. It would very much like to devalue its currency to increase tourism and exports, but it cannot do that because of the Euro’s relatively stronger value than the currency Spain would like to adopt is being bolster by Germany’s relatively strong economy. Also, Spain cannot cut interest rates to aid its sagging economy because such decisions are reserved to the EU’s central bank in which Spain plays only a minor role.

As one observer put it, “Spain is fast becoming the test case for survival of the Euro as we know it.” Spain and the other southern nations might well fare better with their own currency and monetary policies now. (Might I suggest any new currency for the southern nations be called the Pig? Slander some would say, but I rejoin that it would help us recall the nations using it.) The Euro could continue to be the currency of the northern countries of the Euro zone, although Ireland might well wish to join the PIGS. In any event, the Euro as we know it is in trouble and centralized banking for the EU is threatened. These are not small matters.

The flip side of the coin, however, is that keeping the Euro zone and EU intact offers benefits to the PIGS they might not otherwise get. If there is to be a bailout or backstop for Greece, for example, membership in the EU and Euro zone is imperative and running off with a new Pig or individual currency and fracturing the EU and the zone might well destroy those prospects. The same is true for Spain. So the problem is a double edged sword.

All of the PIIGGS, except the UK which has already done so, would like to devalue their currency, drop interest rates and engage in other monetary policies that are largely blocked by the relative prosperity of Germany and France, the economic mainstays of the EU. Actually, the problems of Ireland go toward blocking a bolt by the PIGS or some of them because it makes their problems more of a general problem for the EU and Euro zone which needs to be addressed, regardless of France’s and Germany’s current preferences. So far, the two more prosperous nations do not see it that way, but the political dynamics are in flux and discussions are proceeding fast and furiously.

We shall have to wait and see what if anything Spain decides to do. For now, it is the bellwether and instability is afoot.

Disclosure: None relevant