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United States of Europe? What it Will Take to Save the Continent from Economic Collapse

The euro is a train wreck. Here's how to solve one of our most urgent economic problems.

The dilemma Europe now faces is complicated -- not least because the European Union comprises 27 separate sovereign nations and the euro area, where the chief problems lie, is a currency union that has 17 members itself. Beyond that, the euro is flawed both in design and in execution. It hearkens back to the gold standard and its fixed exchange rate system which necessitated a deflationary policy response to the deep downturn of 1929, ending in the Great Depression and World War II. Unless drastic action is taken, we will soon find ourselves in another Great Depression.

A Currency Without a State

Before we get too gloomy, let's remember why the euro exists at all, as these motives are still important. Significantly, after the Berlin Wall fell in 1989, there was widespread angst about what the new Germany would look like and whether to even permit its coming into being. Germans, like many other Europeans, felt that a Germany anchored in European-wide institutions was a bulwark against age-old conflicts. So to ensure political cohesion and to allow reunification to proceed, the Germans made a number of political concessions. Germany accepted the Oder-Neisse Line as the definitive eastern border with Poland. Germany paid Russia 55 billion deutsche marks. And the Germans anchored themselves into the western European monetary-political system via a common currency. So the intent behind the euro is harmonization and cohesion.

But the problem is this: no state can have a fixed exchange rate, free flow of capital and independent monetary policy at the same time. Therefore, fixed exchange rate systems always end in trade imbalances that can last for decades and across business cycles, creating so-called debtor or deficit states and creditor or surplus states. This is not a problem during an economic boom. However, if boom turns to bust, the debtor states will become distressed as cash flows supporting debts decline.

In a currency area with a national government like Canada or the United States, the central government alleviates these crises by making transfer payments like unemployment insurance to individual states. A state like Florida or California that is hit hard doesn't go bust easily. But in the euro area there is no fiscal agent making these counter-cyclical transfers; the individual states are on their own. And so the resulting crisis is more severe. The fact is the euro can't work across business cycles without fiscal transfers because some debtor state will always face crisis after each and every business cycle downturn. Put simply, the euro's institutional design was flawed right from the start. In fact, one of its chief architects, Tommaso Padoa-Schioppa, called the euro "a currency without a state."

It gets worse because official euro budget policy virtually guarantees a deflationary response to every business cycle. The euro designers chose the Stability and Growth Pact, which sought to keep government debt below 60 percent of Gross Domestic Product (GDP) and deficits below 3 percent, to prevent large government deficits. And this is the thinking driving euro area policy now. Unfortunately, this approach means that the public sector must cut just when the private sector is cutting too, intensifying downturns, sucking money out of the economy and making the potential for national bankruptcy much greater.

Good Solutions v. Bad Solutions

Of course, the central bank could alleviate this problem by providing national governments with liquidity. Indeed, central banks were founded over 300 years ago specifically to finance budget deficits. The Bank of England was formed in 1694 to help England raise the funds to create a navy to rival France's after England's crushing military defeat by France ended the Nine Years' War in 1690. This kind of funding is out for the euro area. The Lisbon Treaty, the present European Constitution, forbids the European Central Bank from lending to governments, as the euro's designers believed that doing so would weaken the currency.

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