Why Europe Needs Two Euros, Not One

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Yves here. We remarked recently how the readings we’ve been getting from people who have senior contacts in Europe are increasingly of the view that the economic crisis in Europe is morphing into a sufficiently severe political crisis that the unthinkable – a breakup of the eurozone – is looking like a serious possibility.

One indicator is the article featured below. VoxEU has policy reach in Europe, and this post represents an effort to come up with better economic arrangements within Europe while preserving at least some of the benefits of monetary union. And it is hardly the first to recognize that one of the big problems with the Eurozone is that it put together too many disparate economies without enough in the way of fiscal transfers to buffer the differences. If the Eurozone can’t move towards more economic integration, the next-best remedy might be a structure where more homogenous countries each had their own currency.

By Jacques Melitz, Professor emeritus, Heriot-Watt University, and CEPR Research Fellow. Originally published at VoxEU

As the Eurozone cautiously implements stabilising reforms, Germany is forced to go further with concessions than it would prefer. This column suggests that it would be beneficial for discontented members to consider the formation of a second monetary union. The second euro can be constructed better than the first, bringing the discontented members exchange-rate adjustments relative to Germany, and avoiding competitive devaluations.

One basic feature of the sickly situation in the Eurozone today is that the system does not clearly bear any essential flaw from the standpoint of Germany. All things considered, the country has not done badly since the Great Recession of 2008-2010. And as the Eurozone moves forward gingerly with necessary reforms in order to avoid a break-up of the system, it is evident that Germany is constantly under pressure to go further with concessions than it would prefer.

In these circumstances, it may be time for radically new thinking. I would like to propose that the discontented members would do well to consider seriously the formation of a second euro. Such proposals have been made (Dobbs and Spence 2012), but the lingering unsatisfactory macroeconomic conditions seems to call for a rethink.

Three Advantages of a Second Euro

A second euro would have three fundamental advantages.

• First, the second euro could be constructed in a better manner than the previous euro from the discontented members’ point of view. There is no need to repeat the errors of the past.
• The second argument comes in two parts.

First, the creation of a separate monetary union by the discontented members would bring them exchange rate adjustment relative to Germany, which is the single most important exchange rate adjustment that they need.

Second, by forming a second monetary union rather than reverting to separate currencies, they would still avoid the problem of competitive devaluations that hounded the earlier EU after the breakdown of Bretton-Woods and up to the appearance of the Maastricht Treaty as a possibility on the horizon in 1986 (when the Single European Act came).

• Thirdly, there are strong indications that the discontented members of the Eurozone will get a worse deal from the movement towards reforms of the system that is now proceeding with grudging German approval than they would by forming a second euro.

Every German concession faces major political opposition at home, to say nothing of an occasional legal challenge. Furthermore, these roadblocks are probably in Germany’s true interests.

Of course, these three basic arguments for a second common European currency pave the road to one more.

• A second euro could serve as a bargaining tool in negotiations with Germany.

But I would like to rest the case for a second euro strictly on its own merits and, therefore, strictly focus on the first three arguments.

One issue I shall disregard is the costs of the transition, which prominently include the interpretation of outstanding debts in euros. It is important, however, that the status quo could fall apart in the Eurozone in any event, and if only for this reason, it is a good idea to entertain the best of the alternatives. Furthermore, if the only serious argument against two euros is really that ‘it is better to stick to a bad marriage than to go through the costs of a divorce,’ it would seem good to know it and to behave accordingly.

First Advantage of a Second Common Currency

Any optimal design of a new social regime with broad distributive consequences should be done in ‘the veil of ignorance’ about where the chips will fall in the future, and from this point of view, the Eurozone contained two spectacular flaws.

• First, a monetary union should provide monetary control by the central bank. But the rules of the Maastricht Treaty violated this condition.

They made monetary control by the ECB contingent on the willingness of commercial banks to lend to individual firms and households. The ECB was not free to buy and sell in open market operations. The term ‘open market operations’ surrounding the ECB describes certain kinds of refinancing transactions with banks and, since 2010 – first, under the ‘Securities Market Program’ and, more recently, under the program of ‘Outright Monetary Transactions’ – purchases of bonds of member government that are under financial stress with effects on the monetary base that must be sterilised. These are not open market operations in the true sense. It is a fact that a number of the central banks in Europe that preceded the ECB operated for decades in the manner that the ECB was allowed to do without any problem, and under ordinary circumstances the ECB would have been able to do the same. However, constitutions must allow for conditions that are only likely to happen once every half a century or more.

In the face of the situation that arose in 2010-2012, where member banks of the Eurozone preferred to rebuild their balance sheets than to lend to their customers, and where the official intervention rate on the interbank market approached the zero interest rate floor, once the ECB had exploited a few loopholes, the new constitution left it powerless to increase the money supply at all without engaging in legally questionable actions or emergency measures that required bending the rules.

• Second, in a monetary union any threat to the payment system resulting from insolvency of the banking sector in any political region of the system is a collective problem to be shared by all. This condition was also not met.

Unlike the situation in the US following the savings and loan crisis in the 1980s and 1990s, the Irish paid for the insolvency of their banking sector, the Spanish paid for theirs, and in Cyprus, it even looked for a while that small bank depositors would have to contribute heavily to pay for theirs. Help from the rest of the Eurozone in these cases came late, haltingly, and moderately, and came to the national governments who avoided the meltdown of their banks (on terms that Spain has never accepted).

Repairing both these problems, of course, is simple. As regards to open market operations, there must be some designated securities that the central bank can buy and sell. To avoid partiality to any private interests, the purchasable securities should be public or semi-public, so that the beneficiaries are essentially taxpayers. To avoid partiality to any country, an international mix of debts is necessary. Avoiding moral hazard is also easy. The central bank should only be able to buy securities that have aged sufficiently. For example, suppose that the required ageing is three years. Then, the outstanding stock of government securities that would be eligible for purchase by the central bank would be enormous and, yet, no new issues could be monetised until the lapse of a significant time.

The euro-nomics group (Brunnermeier et al. 2012) has recently made an interesting suggestion that would permit the central bank to buy a ready-made assortment of securities with different maturity dates satisfying my condition. The group proposes creating a new intermediary (which they call the ‘European Debt Agency’) that would hold an imposed combination of government securities (in fixed, irreversible weights) against which the intermediary would issue new securities (which they term ‘European Safe Bonds’) to the public that the central bank could subsequently buy and sell. This would help but it is not essential.

Joint responsibility for the solvency of the banking sector in any political region of the monetary union also requires some preconditions that are fully manageable. If risks of insolvency are to be borne collectively, evidently all the member banks must be subject to uniform prudential rules and a collective supervisory authority.

Further, in case of a meltdown of the financial sector in a member country, the costs of compensating the depositors or creating new bank capital, or both, must be borne collectively. There has been a move toward some form of banking union (29 June, 2012) and therefore the satisfaction of the first precondition, but little advance toward the second one, which is equally basic (for a good, detailed discussion of the required degree of fiscal union, see Pisani-Ferry et al. 2012). Of major note, the needed degree of fiscal union is quite limited. Even joint insurance of all demand deposits may be going too far. Something like the Single Bank Resolution Fund (as distinct from the Single Resolution Mechanism) that has been mentioned but is nowhere in sight, could well suffice.

Second Advantage

A repeated question about the Eurozone is whether the members form an optimal currency area. But another question – which is actually closer to Mundell’s original contribution (Mundell 1961) – is whether the right number of currencies in the Eurozone is as high as 18, the number of member countries in the system. If the right number is neither 1 nor 18, then 2 may be far, far better than either extreme.

Let me begin by recalling the reasons why 18 would be too many. First, some of the members are probably small enough to have no scope for using monetary or exchange rate policy as a tool of economic stabilisation over the business cycle (McKinnon 1963). Next, the 18 members do form an economically integrated group of geographical neighbours, and therefore their mutual efforts to use monetary and exchange rate policy to their advantage could easily lead them to enter into non-cooperative games with costly Nash consequences. Finally, national monetary policy can mean Treasury-dominated monetary policy, which can lead to very poor outcomes apart from strategic games with any foreigners, near and far.

If 18 is wrong, there are a couple of reasons to veer toward 2, if not all the way. First, studies of the question whether the Eurozone is an optimal currency area generally tended to show no more than one major possible fault line in a single monetary policy for the 12 initial members (including Greece, which entered in 2001, but excluding the UK and Denmark) – roughly between north and south (see, e.g., Bayoumi and Eichengreen 1992). Subsequent events since the crisis of 2008-2010 have underlined this fault line. In particular, the under-pricing of German goods relative to southern European ones in the current debacle in the Eurozone is too well-known to require new development. The recessionary and deflationary consequences also need not be rehearsed. My main point, though, is that judging from past studies of synchronisation of business cycles and asymmetries in economic performance in the Eurozone (and therefore excluding the UK and Denmark), two currencies may be enough – one including Germany, the Netherlands, and Austria, and another comprising the countries bordering the Mediterranean and stretching to Portugal.

Next, history provides an important reason for 2 instead of 18 in the case that 1 is wrong. The only experience with freely floating exchange rates in the EC – the EU’s predecessor – was short-lived and unfortunate. It followed the breakdown of Bretton-Woods in 1971. Soon after this experience, the members of the EC tried to return to some semblance of exchange rate stability, and in any scenario of a break-up of the Eurozone, it is difficult to imagine that the members would tolerate general floating. The strategic game aspects, if nothing else, weigh too heavily against this alternative. Yet, the past also teaches us that no system of fixed exchange rates ever worked in the EC. The main effort to bolster exchange rate stability after the ineffectual ‘snake,’ the European Monetary System (EMS), led to major realignments every nine months in 1983-1985. It is highly questionable that the EMS was dynamically stable and would have survived much longer despite major capital controls, had not the prospect of Eurozone come to save it. Thus, a further reason to envisage a second euro is that neither floating nor fixed exchange rates would work in the event of a break-up of the Eurozone. On the other hand, having three major currencies in the EU seems tolerable. The floating of the British pound relative to the euro has raised no difficulty, even though it means having two major currencies in the system. The Common Agricultural Policy also now depends heavily on direct subsidies rather than price controls, so that exchange rate movements cannot wreak the havoc in agriculture that was possible in the 1970s and 1980s. Two euros would be a far cry from return to separate liras, pesetas, francs, escudos, drachmas, etc.

Third Advantage

We are now living through a veritable tragicomedy in the Eurozone. Faced with a situation where Greek, Spanish, Portuguese, and Italian governments were forced to borrow at unsustainable interest rate premiums, the ECB was compelled to step in to lower the interest rates in order to prevent defaults that would have spread to the banking system and forced some countries out of the Eurozone. But at every step along the way, the question raised in Germany, and that has now come up twice before the German Constitutional Court, is whether the ECB is acting within its mandate. And the tragicomic aspect is that the ECB probably is not and the Court of Karlsruhe thinks so but simply forestalls crises for political reasons. However, in its most recent decision (7 February 2014), the Court has left little room for future manoeuvre by explicitly dismissing the ECB’s argument that the Outright Monetary Transactions program is legitimate on grounds that it ensures the proper functioning of monetary policy and avoids the breakup of the Eurozone. Therefore, the scope for expansionary monetary policy in the future in the Eurozone is now more circumscribed than ever.2

Is this then a game that the large section of the Eurozone membership with grave need for expansionary monetary policy has an interest in continuing to play? It would be easy to write a new set of rules that would impose tough inflation targets on another central bank, yet still allow expansionary monetary policy in deep recessions, and provide the central bank the ability to engage in selective aid measures in circumstances that threaten the very survival of the monetary union without inviting such circumstances to arise. Very significantly, no joint bonds backed by ‘joint and several’ guarantees of the member governments would be called for. Let us remember too that the Eurozone courted some of its current problems by announcing early on that the whole system hinged on the Stability and Growth Pact despite the no-bail-out rule, instead of warning markets that government defaults remained possible (despite the Pact), and the organisation would only intervene to insure the safety of the banking sector and the payment system.

The prospects for banking union are admittedly better than those for adequate monetary control. Yet, as mentioned before, the fiscal implications of banking union have not received the attention they need. The Single Bank Resolution Fund that has been mentioned will require a separate treaty and remains only a vague possibility.3 However, without a mechanism assuring the collective bearing of the costs of a major insolvency, there is no reason to expect that we can avoid a repetition of the experience since 2010 with ‘the diabolic loop’, as the euro-nomics group (Brunnermeier et al. 2012) terms it between bank risk and government bond risk (Ireland, Spain, and Greece, see also Shambraugh 2012.)


Germany was unquestionably the leader in the pre-euro European Monetary System. It was never clear when Eurozone got started why the country agreed to renounce its monetary independence. The question ‘What’s in it for Germany?’ never got a satisfactory answer. But, in compensation, the country did obtain virtually free rein to set the rules in the Eurozone. At first supporters of a single currency (including the present author) vaguely expected that the constitutional problems that might arise would be ironed out as they appeared. But this overly sanguine expectation has proven false. In these circumstances, isn’t it time to give some serious thought to a second euro?

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  1. paul

    What did Germany gain? It put a ceiling on the deutschmark and locked in its patiently built commercial advantages, and they got to set all the rules, even the moral tone of the euroborus. Poor old German elites, wasn’t that enough?

    1. Lafayette

      You seem to have forgot why Germany feels it has a right to “instruct” others.

      When Schroeder was leaving office (permanently) he brought about some very difficult reformations as regards German labor-laws. They are were harmful to the vested-interests of German unions that had ensconced themselves in a “never-change” attitude. One of “worker gains are not negotiable”.

      Worker gains, in terms of government taxation (healthcare, unemployment benefits, reemployment training) were making German labor inflexible and expensive. Germany went through 2 years of hell swallowing the medicine – but now is the most prosperous of the European countries. Too many Germans live near or below the poverty line, which has a threshold equivalent to that of the US – about 15%.

      Still, it is in a far better position than it was before.

      If Renzi in Italy wants to destroy the fashion of government to be in the hands of a select coterie of politicians, it is high-time for Italy to do so.

      In a word, there is nothing wrong with the Euro that a general economic reprise cannot cure. But abandoning the Euro to return to the pre-euro currencies would be a fate worse than death for Europe. People who suggest it have either forgot or never understood how Europe functioned before badly, despite the economic post-war growth. Neither do they understand that about 60% of all EU-exports is to other EU-countries, facilitated by a common currency.

      The post-war growth was over and done with in the early 1990s – there is no going back. To return to the Deutschemark, Lira and Franc would be foolish, to say the least. Since its inception, Europe has had to suffer from the fact that it has one currency but 27 heads of state sitting on that one currency. It needs badly a central government, one that would reduce Prime Ministers to the level of state governors. Just like in the US. (Which would be an insult to a great many men’s pride … )

      Unfortunately, too many Europeans can’t see the judiciousness of that evolution at present. But, in time they will … till then, there is no disaster on the horizon threatening economic disaster. Even financial …

      1. Pepsi Girl

        Where the hell did you get this bag of bullshit? The cure for the Euro is an even stronger 4th Reich? Are you serious?

      2. BigRed


        but now is the most prosperous of the European countries

        So, in your opinion, the solution for achieving prosperity is not to improve one’s own population’s standard of living but instead to undermine those of others? This is precisely the same argument that’s currently being made in favor of reducing work benefits because workers in low-salary countries don’t have any. In fact, you make this argument yourself when you decry that the average German had it too good.

        A decade of real income stagnation hasn’t done anything to make the German population prosperous but vastly increased corporate profits. And now you suggest this as the solution for the rest of the Eurozone. Should you not even give the appearance of giving a shit about people?

  2. The Dork of Cork

    Two Trojan horses rather then one ??
    Its a diabolical currency – used to inject a second American materialist revolution with predictable catastrophic results.
    So you decide to pick a more gentle trajectory into the abyss………….
    All EU trade is a artifact of a extreme scarce money ecosystem. (you must export or drive around in circles to gain enough fiat to exist which causes extreme shortages of basic goods as almost all energy is used to “add value” to goods which don’t need such absurd devices.)
    Talk of more balanced trade is beside the point.
    The village & market town – the very core of real interactions between people is no more in Europe
    The very nature of trade within the EU entrepot is of course highly destructive.
    It was designed as such.

  3. Jim Haygood

    ‘The second euro could be constructed in a better manner than the previous euro. There is no need to repeat the errors of the past.’

    Nor is there any need to reinvent the wheel:

    The Spanish peso de ocho is a silver coin, of approximately 38 mm diameter, worth eight reales, that was minted in the Spanish Empire after a Spanish currency reform in 1497. Its purpose was to correspond to the German thaler.

    The Spanish dollar was the coin upon which the original United States dollar was based, and it remained legal tender in the United States until the Coinage Act of 1857. Because it was widely used in Europe, the Americas, and the Far East, it became the first world currency by the late 18th century.



    How much silver does the German euro contain?

  4. John

    Breaking up the euro is a different animal than breaking up the eurozone. A eurozone breakup I would have thought possible at some point, is just not going to happen anytime soon. Recall the ousters of Papandreou and Berlusconni. They tried the unforgivable sin of putting legislation through referendum, to the angst of Germany. Ms Merkel had them forced out. You see, what sounds good on paper will not work politically — even it means curtailing democratic processes.

    Even introducing another currency is questionable. When Greece quitely uttered the words of a national currency, they were threatened with expulsion. Never mind that was the sensible thing to do. Politics over-rides the economic well-being of a nation. What people must understand is creditors have a lot riding on seeing national governments squeezed. The thought of another euro currency would smack of hypocrisy since Greece was forced to swallow the awful euro elixer.

    But herein lies concerns. Treaties would need to be amended to accommodate the new currency. From what I can see governance will cause it to fail right from the outset. Smart money would be on national currencies. They can then measure and respond to conditions much better than the ECB.

    I see lots of studies from think tanks on possibilities — it is just the political elite are hard core tone-deaf federalists and change is just not in the cards for these folks even when it means millions are unemployed, or loss of health-care, cuts to social programs like education, etc… The bottom-line is kleptocrats see huge potential on getting state assets on the cheap. Any doubts? Take a look at Greece. Think tanks seem not to factor the unflappability of federalists running the show in Brussels.

    A banking union is another problem. People the world over thought Europe was some kind of warm, get along collective until they witnessed the elections of May. What they saw was a growing body of ultra-right wing parties win EP seats. These right-wingers are anti-foreign — meaning people not originating in the country — want these people gone. On the other hand Germany has made it clear they are not in favor of spending any of their tax money on the those lazy people in the south. They have a deep cultural bias against such a thing. The trust is not there for a banking union.

    For the political elite, it is status quo. Nothing to see here.

  5. William C

    What did West Germany (as it then was) gain ? As I recall, the deal was that France agreed to German reunification in exchange for monetary union. The French were fed up with the Bundesbank calling all the shots with the ERM (all other ERM countries had to move their interest rates in lockstep with the Germans to maintain their fixed exchange rates), France wanted a say in monetary policy. I am not sure they feel they have much more say now but you would have to ask them.

    The mainland Europeans have long failed to share the Anglo-American enthusiasm for floating exchange rates – look back to the 1970s and the so-called ‘snake’. They like the certainty of fixed exchange rates – essential really if you are going to build a proper single market.

    Mrs Thatcher lost the diplomatic manouevring, being deserted by Mitterand – who had hitherto shared her opposition to German reunification – as he achieved this deal. And indeed that was the immediate spark that led to her downfall following her famous declaration of ‘No,No,No’ to monetary union.

    I have heard it said Mitterand had little understanding of economics.

    1. digi_owl

      “I have heard it said Mitterand had little understanding of economics.”

      Then again, so does few economists…

    2. BigRed

      Well, rumor has it that he used the Maastricht criteria to deny his ministers financing – so at least he thought he knew his politics.

  6. craazyman

    we were talking about this in the peanut gallery years ago.

    Imagine sitting in a sports bar in Rome spending a Euro-lite on a Bud-lite before heading to McDonald’s for a burger & fries then wandering around aimlessly on the streets looking at employed Italians. The only thing missing in this scene is ketchup. What’s not to like?

    If I want to see a statue I’ll look at pictures in a book.

      1. susan the other

        That’s not to imply i do not condone their sense of social equality… lately screwed up by us somewhat. I mean regardless of ketchup.

  7. Rodger Malcolm Mitchell

    The nations adopting the euro surrendered the single most valuable asset any nation ever has: Its Monetary Sovereignty. That nation, like all cities, counties and American states, all businesses and all individuals, requires continual input of money from outside its borders.

    It cannot, independently, create money, to survive long-term.

    Though long-term, all euro nations require this continual input of money, i.e. a positive balance of payments, not all can have this positive balance long-term.

    Mathematically, many, if not most, euro nations always will teeter on the edge of financial disaster.

    I predicted this back in 2005, when in a speech at the University of Missouri, Kansas City, I said, “Because of the Euro, no euro nation can control its own money supply. The Euro is the worst economic idea since the recession-era, Smoot-Hawley Tariff. The economies of European nations are doomed by the euro.”

    There are two, and only two, solutions to the ongoing euro crisis — a crisis that cannot be cured or even ameliorated, by austerity measures or by loans:

    1. Each nation return to Monetary Sovereignty by re-adopting its own sovereign currency
    2. Form a United States of Europe, in which the EU supplies each nation with money, as needed.

    There are no other solutions.

    All other attempts will devolve into Rube Goldberesque machinations, leading nowhere.

      1. BigRed

        And which they don’t have to play along with because as issuers of their own currency there’s no need for them to “borrow” it.

  8. Gibby the Fifth

    I remember an article in the FT, about 2 years ago I think, discussing the split of the Euro into 2 separate currencies. The first currency, for the Northern countries, would naturally be called the Neuro. The second, for the peripheral countries, could inevitably be the Pseudo.

    Joking apart, the experience of the UK at various stages in trying to shadow or maintain parity with European currencies, shows how difficult it is for very different economies at different stages of “development” to try to have the same currency and interest rates. Just ask people in Hong Kong, whose property market is perpetually subservient to US interest rate policy for further evidence.

    My latest preference is simple: just detach Germany,let them run their own affairs in the way they think fit, and allow everybody else to do what they want, or their electorates dictate or will swallow.

  9. H. Alexander Ivey

    Mighty nice of them to admit to their failure: “(including the present author) vaguely expected that the constitutional problems that might arise would be ironed out as they appeared.”

    But, again, they show their ignorance on how politics is played. As noted by Matt Stoller in earlier NC posts (links), the powerful in politics will fight over power and money. At present, with a mix of weak and strong countries in one house, the strong can, and do, beat up the weak. But if you make two houses, one of the strong and the other weak, the members of the strong house, rather than cross the street to the weak house, will start to fight each other. But with no weak ones to easily intimidate, their in-house fighting will only wreak havoc on themselves. And then, the weak house may find strength in numbers and further barricade the street against the strong house.

    It’s rather telling that the authors don’t list out who would be in the two Euro zones.

  10. Alberto

    If the euro will last for more than 5 more years it will be the least of the problems. Europe imports 40% of its oil from Russia and there are 4 big problems 1) russian fields have peaked and will start to decline within this decade 2) russians are moving for a closer integration with asians countries very fast (not just China, Japan too will sign energy deals with them in the near future) 3) OPEC oil peaked in 2006 and even Saudi will not be able to export a drop of oil after 2035 4) european are cutting investments on anything so there is no green economy coming. How far is 2035 ? If you are 70 years old it’s too far, but from any other point of view is very close. We’re going back to 1900, some countries will walk back faster than others, that’s all.

  11. Mike

    The idea that a country with a huge trade surplus can share the same currency with countries that have a huge trade deficit, and have nothing terrible happen is a pipe dream. The people who setup the Euro knew very well what the outcome would be: one of the largest wealth transfers in human history.

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