Incredible commitments: why the EMU is destroying both Europe and itself.

• Jurisdiction: United States
• Date: 01 January 2013
• Author: Selgin, George

When the merits of a European Monetary Union were first being debated, many skeptics fell into one of two camps. The first camp consisted of "Keynesians" (for example, Eichengreen and Bayomni 1997, Salvatore 1997) who, referring to the theory of optimal currency areas, doubted that Europe constituted such an area, and believed that the proposed monetary union would eventually fall victim to country-specific ("idiosyncratic") shocks. Unemployment and other burdens stemming from such shocks would, these critics argued, eventually force the monetary authority to either abandon its commitment to price-level stability in order to offer relief to adversely affected members, or cause the members to abandon the union so as to be able to realign their exchange rates. The other camp was comprised of "Hayekians" who, drawing upon theories of international currency competition, claimed that monetary unification, by reducing the extent of such competition, would give rise to a relatively high seignorage-maximizing eurozone inflation rate, and therefore result in a level of actual eurozone inflation that was bound to disappoint the monetary union's more inflation-phobic members. (1) It was in light of such reasoning that British Prime Minister John Major made his alternative proposal for a parallel European currency--the "hard ecu"--to supplement rather than supplant the British pound and other established European currencies.

Today the euro is indeed failing. But its failure has in large part been the result of fundamental shortcomings other than those pointed out by either of these prominent croups of early euroskeptics. Rather than merely being wrenched apart by pressure from idiosyncratic shocks, or by disappointments stemming from the ECB's temptation to profit from its monopoly status, the euro is unraveling because commitments upon which its ultimate success depended---commitments that had to be credible if it was to work as intended have instead proven to be perfectly or almost perfectly incredible. The euro, in other words, was built upon a set of promises that the authorities concerned were unable to keep. Orthodox theory--theory that is neither particularly Keynesian nor Hayekian in flavor--suffices to explain (with the help of hindsight) why the promises in question could not possibly have been kept so long as the EMU's members enjoyed substantial fiscal sovereignty. The combination of effectively unconstrained fiscal sovereignty and a lack of credible commitments to avoid both centralized debt monetization and outright member-state bailouts created a perfect storm of perverse incentives.

The Time-Inconsistency Problem

The theory in question builds upon Kydland and Prescott's (1977) well-known treatment of the time-inconsistency problem that confronts ordinary central banks. That analysis, it bears observing, takes for its starting point a benevolent (social-welfare maximizing) though discretionary central bank, while making no reference to region-specific shocks or imperfect factor mobility. Greg Mankiw (2006) offers the following summary of the standard time-inconsistency problem:

Consider the dilemma of a Federal Reserve that cares about both inflation and unemployment. According to the Phillips curve, the tradeoff between inflation and unemployment depends on expected inflation. The Fed would prefer everyone to expect low inflation so that it will face a favorable tradeoff. To reduce expected inflation, the Fed might announce that low inflation is the paramount goal of monetary policy. But an announcement of" a policy of low inflation is by itself not credible. Once households and firms have formed their expectations of inflation and set wages and prices accordingly, the Fed has an incentive to renege on its announcement and implement expansionary monetary policy to reduce unemployment. People understand the Fed's incentive to renege and therefore do not believe the announcement in the first place. Monetary policy will 'also tend to be time-inconsistent when unanticipated inflation is capable of lowering the real value of outstanding nominal debts, thereby reducing file government's fiscal burden. In this case the central bank has an incentive to announce a low inflation target so as to achieve a favorable inflation-taxation trade-off. Once again, were the central bank able to establish low inflation expectations, it would have an incentive to exploit those expectations so as to reduce the debt burden. Consequently the announced, low inflation target is not credible.

Monetary Free Riders

In the context of a monetary union whose members enjoy unlimited fiscal sovereignty, the usual time-inconsistency problem is compounded by a free-rider problem, with far more serious consequences. Here, as Chaff and Kehoe (2007: 2400) have shown, a discretionary monetary authority's optimal (benevolent) policy consists of setting "high inflation rates when the inherited debt levels of the member states are high and low inflation rates when they are low." Assuming that costs of inflation are borne equally by the member states, the ability to free-ride off of other members of the union causes member states to become more indebted than they would in a cooperative equilibrium, thereby bringing about an excessively high rate of inflation. Moreover, the free-rider problem gets worse as the number of countries gets larger, with the noncooperative inflation rate rising, other things equal, as union membership increases (Chari and Kehoe 2008). The incentive to free ride will, finally...