Fiscal union for the Euro? ‘Merkozy’ to the rescue

The Euro currently fails any test for a coherent monetary union.

The ‘convergence criteria’ for membership of the Eurozone laid down by the Maastricht treaty, whereby government deficits  should not exceed 3% of GDP and gross government debt should not exceed 60% of GDP, are no longer met by any Eurozone countries (although Germany’s ‘stability programme’ has recently brought its budget deficit within the limit).

Robert Mundell in his 1961 work on Optimal Currency Unions identified some key criteria that a successful currency union should meet:

·         Labour and capital mobility across the region

·         Wage/price flexibility across the region

·         Similar business cycles across the region

·         A risk-sharing mechanism to allow stronger members to support weaker members.

Although capital is mobile across Europe, it fails the other tests. The Eurozone has significant language and cultural barriers that lead to much lower labour mobility than, say, the USA. When the ECB put up interest rates in the first half of this year to combat inflationary pressure in France and Germany, it did so knowing it would likely hurt the growth of weaker Euro members. And the Stability & Growth Pact contained no provisions for any form of risk-sharing mechanism – indeed it explicitly contained a ‘no bail-out’ clause. This was abandoned during last year’s sovereign debt crisis, and the European Financial Stability Facility (EFSF) effectively formalises the bail-out arrangements.

So what’s the answer?

Three possibilities: muddle through, a partial break-up of the Euro, or full fiscal union. International bond investors are signalling the first alternative is unacceptable by demanding higher and higher interest rates to buy Eurozone government debt. German Chancellor Angela Merkel and French President Nicolas Sarkozy are jointly proposing full fiscal union (individual Eurozone members will lose their economic independence on decisions such as government spending), combined with strengthened bail-out arrangements via the EFSF.


A Level Business and Economics questions tend to be topical. We had prepared last year’s students for a question on the Eurozone, and the June 2011 Unit 4 Edexcel Economics A Level paper included a 30-mark question on the costs and benefits of Eurozone membership for the UK. The paper this year may include a question on the implications of full monetary and fiscal union.