Flip Side of a Currency Union

The sovereign debt crisis of South European countries intensified once again in September. There is widespread fear within markets that Greece may default. The troubles of these peripheral European nations have once again raised questions about the wisdom of having currency unions. It is not my contention that the currency union within Europe was a bad idea per se. By removing nominal exchange rate risk for trading partners and reducing transaction costs, such unions promote trade among member countries. But the implementation of the European currency union was flawed from the beginning. Moreover, the peripheral European nations, while enjoying the benefits of such a union, behaved in an irresponsible and profligate manner. Now it is payback time. And now that they are in trouble, the biggest disadvantage of a currency union, the lack of an independent monetary policy, will prevent them from finding their way out of the hole that they have dug for themselves. Treaty obligations ignored The Maastricht Treaty of 1992 had laid down certain preconditions for the countries joining the currency union. One, they had to ensure that their annual rate of inflation was not above 1.5 per cent. Two, they had to contain the budget deficit at below 3 per cent of GDP. And three, they had to maintain a debt-to-GDP ratio of less than 60 per cent. At the time of formation of the union, many countries were allowed to join it despite not meeting these conditions. Subsequently these criteria were not strictly enforced. To meet them the weaker economies would have had to reduce their public spending and raise taxes. This they were reluctant to do

This article was originally published on November 03, 2011.