The Future of the European Union Lies in Its Past

What makes foreign trade different from a «desperate expedient to maintain employment at home by forcing sales on foreign markets and restricting purchases"? These are Keynes' words, but the issue has been long debated in economic thought, and coincides with the distinction between free competition and mercantilism. The answer is straightforward: it's the monetary system that makes all the difference, in its ability or inability to prevent trade imbalances.

The gold standard implied, at least in Hume's classic formulation, both deflation in deficit countries and inflation in surplus countries. This symmetry reflected an accounting truth: imbalances have to do not only with deficits, but with surpluses, too. This basic truth was neglected in in the euro's architecture, and thus the euro has enabled the buildup of structural deficits and surpluses.

The pre-crisis effects of the single currency

These trade imbalances were absorbed by financial markets, which until the onset of the crisis recycled Northern Europe's surpluses by investing in Southern European short-term debt. The hypothesis, or should we say dogma, behind this flimsy construction was that the euro would engender macroeconomic convergence in member countries, which in turn would balance trade accounts. In fact, its sole effect until the crisis hit was to align interest rates across the eurozone. Certainly this was an advantage for deficit countries which had to pay less to refinance their debt, but was more than offset by the de jure abolition of exchange rate risk in surplus countries. The impossibility of competitive devaluations because of the single currency allowed the accumulation of trade surpluses in exporting countries, without them being exposed to the risk of their currency appreciating. In the name of free markets, a classic mercantilist dynamic was set in motion.

The example of the European Payments Union

With crisis, the same mercantilist logic was imposed on deficit countries desperate for funding: wage deflation has been the substitute of a no longer feasible devaluation, which has not been compensated by wage inflation in surplus countries. The net result? The whole eurozone has been trapped in economic depression due to lack of demand, which is rebalancing accounts by squeezing imports rather than expanding exports.

True, not all economies have achieved "necessary structural reforms", but our monetary system should shoulder part of the blame for Europe's current predicament. We can assess the limits of the euro by comparing it to another European monetary union: the European Payments Union (EPU). The Belgian-American Robert Triffin devised its architecture, and the Italian Guido Carli presided the Union, which acted as compensation chamber for Western European countries from 1950 until 1958. European economies kept their own currencies and maintained capital controls, while EPU used the dollar pegged to gold as account unit for a multilateral payments system, in which a systems of disincentives discouraged the buildup of trade deficits and surpluses alike. In those years, intra-European trade grew at Chinese rates, as European economies expanded and developed.

The morality tale is that accumulated surpluses must eventually be decumulated. But it all depends how it is done. There are those hoping that after deflation markets will start financing deficits again. But does it make economic sense? There are those who aim to achieve a fiscal union based on transfers between federal member states. But does it make political sense? There are those who wish to return to national currencies competing in foreign exchange markets. But what would the economic and political collateral effects be?

Alternatively, we can be a little more modest and reform the euro, so that it prevents imbalances and promotes trade. The history of Europe should give us lessons as to why this is desirable and how it is feasible.