Why asymmetrical monetary unions are bound to fail (unless they feature an effective, extra-market surplus recycling mechanism)

Asymmetrical monetary unions, wherever and whenever tried in combination with free trade and deregulated capital movements, ended up in tears and retribution. The Gold Standard, the various pegs between domestic currencies and the US dollar (S.E. Asia, Argentina, Mexico etc.), the ERM (European Exchange Rate Mechanism), the Eurozone that followed the latter’s collapse etc. they all resembled invasions of Russia – that is, a brisk beginning full of enthusiasm and hope, rapid progress that seemed unstoppable, followed by a heart wrenching slowdown as Cruel Winter took its toll, ending up with blood on the snow and infinite retributions thereafter.

This short paper offers a theoretical explanation of asymmetrical monetary unions’ inexorable slide toward crisis and explains:

(a)  Why the Eurozone’s current response to its crisis (e.g. the so-called banking union decided upon, the ECB’s OMT, the insistence on austerity with ‘structural reforms) will ultimately fail, and

(b)  Why our Modest Proposal for Resolving the Euro Crisis offers a minimalist yet sufficient prospect of reconfiguring the Eurozone in a manner that renders it viable.

1. Introduction: the hypothesis

What is an asymmetrical monetary union?

It is a monetary union between:

  • national economies that comprise large oligopolistic manufacturing sectors, replete with economies of scale (as well as of economies of networks and of scope), with production units operating at excess capacity (that reflects their market power and their capacity to deter competitors) and concentrating much of economic activity on the production of capital goods; and
  • national economies where the capital goods sector is atrophic, where production is much less capital intensive, and where economic rents are not due to economies of scale but due to corrupt practices and socio-political impediments to competition (e.g. restrictive practices, crony relations between authorities and particular business interests).

What is an extra-market Effective Surplus Recycling Mechanism?

Surpluses can be (and often are) recycled by privateers who invest their profits or surpluses (that are accumulated in a region or a country which enjoys large net exports) into a region which is in deficit (vis-à-vis the surplus region from where the investment funding originated).

In contrast, an extra-market surplus recycling mechanism is one which relies on political (as opposed to market) institutions. For example, unemployment insurance or the food stamp program in the US offer automated extra-market mechanisms by which surpluses from the surplus regions or states are recycled to the regions or states with higher unemployment and/or poverty– that is, mostly, to the deficit regions or states. Another example is America’s military-industrial complex, which famously directs large-scale investments into the deficit regions or states of the Union. Europe’s Common Agricultural Policy and so-called structural funds are also examples of surplus recycling mechanisms (even though they are not effective ones, at least in the context of the Eurozone).

For such a mechanism to be effective as a stabiliser of the asymmetrical monetary union it must be sufficiently large enough to counteract the inherent imbalances of an asymmetrical monetary union; and flexible enough to increase its ‘volume’ of recycling pro-cyclically.

Must monetary unions fail?

The answer is: Yes if

  • they involve free trade and free capital movements
  • they are asymmetrical, and
  • they feature no efficient extra-market Surplus Recycling Mechanism that helps stabilise it.

Here is why:

2. Real Adjustment in a Symmetrical Monetary Union

Consider a monetary union between two countries, A&B, in which:

(i) there are no trade barriers and capital can move freely from one country to the other

(ii) each market comprises exclusively price taking firms, customers and workers (i.e. no one has the capacity to influence price by reducing the quantity they supply to the market)

In this case, as each supplier is unable to influence the price she is selling at, the supply of goods, services and labour will carry on increasing until their price exactly equals the cost of supplying the last unit (marginal cost). Prices in each country will, therefore, equal marginal cost while wages will equal the product of the price of the final product (produced by the worker) and of the marginal product of the worker (i.e. the quantity of the final product she produced during the last house she worked).[1]

For there to be an equilibrium in this symmetric two-country (free-trade and free-capital movement) union, there must be no incentive for suppliers in one country to divert output from their domestic to the foreign market. Real prices, in other words, must be the same in both countries. To see how equilibration is achieved here, suppose that (for some unspecified reason) productivity rises faster in country A than in B. As this happens, the marginal cost of producing in A falls and so does the price of goods and services in country A (since we have assumed that competition so vigorous that prices will merely reflect marginal costs). But as the marginal cost of production in B has not fallen, prices in B remain at the original, higher, level. This means that, all of a sudden, A’s producers can make a profit by selling their output in B rather than in A.

The trade imbalance will cause both prices and wages in B to start falling relative to A: As supply in country B rises (due to more imports from A), domestic prices fall. As they do, they push down wages – since the labour market is also competitive.[2] [The only way that wages will not fall also is if marginal labour productivity goes up at the same time. But that is another story altogether.]

Meanwhile, in country A, as output produced domestically shifts to country B, due to the price differential, supply in A’s domestic market falls and price pA rises. As that happens, the wage in A also goes up.[3]

The end result? The productivity boost in country A will have left real wages the same in both countries (both prices and wages will have increased in the country with the productivity gain and will have fallen in the other country) but will have increased output in both, thus spreading the benefits of the productivity gain to both countries – even to the country in which there were no productivity gains.

Monetary Union irrelevant: In this ‘world’, whether the two countries are in a monetary union or have their separate currencies is neither here nor there. If they have the same currency, the above holds and prices are expressed in the same, common, currency. If they have separate currencies, nominal levels of prices and wages will not change in either country except that the exchange rate will alter (with A’s exchange rate strengthening vis-à-vis B’s) so that B’s wages and prices are now worth less in terms of A’s wages and prices. Still, trade will be balanced and real wages will remain unchanged in both countries (even though in nominal terms, and measured in A’s currency units, prices and wages will have increased in A and diminished in B).

Concluding remark: In this type of symmetrical Monetary Union trade surpluses and deficits, as well as different productivity growth paths, are auto-corrected though a process of internal devaluation in the country whose productivity growth lags behind and of internal revaluation in the ‘stronger’ country.

3. An asymmetrical Monetary Union

Recall the above definition of an asymmetrical monetary union. In the context of our two-country model in the previous section, this would be equivalent to assuming that country B is as before while A comprises large oligopolistic manufacturing sectors that produce high end consumption as well as capital goods (and featuring significant economies of scale, large excess capacity, entrance deterrence capacities that keep competitors at bay (that reflects their market power and their capacity to deter competitors).

Let us take a closer look at the two quite different countries in terms of their price and wage dynamics

COUNTRY A: Heavily oligopolised, with a strong capital goods sector

Price setting dynamics: Corporations have the (oligopoly or monopoly) power to effect price changes simply by restricting output to levels below the ones that would eliminate profit margins. In analytical terms, as economists like to say, price changes in A are now mediated by the elasticity of domestic demand.[4] The less responsive domestic demand is to supply changes the greater the price-cost margin and the more supply reductions push prices up.

Related remark: This helps explains why the price inflationary dynamic is more of a threat to countries like Germany when output drops than in places like Italy and Greece.

Wage dynamics: Similarly, the lower the elasticity of demand the greater the impact, and the more disproportionate the impact, on the wage independently of the level of marginal productivity. Moreover, the less responsive the labour supply to wage changes, the larger the wage boost (for the same labour productivity) for a given price rise.

Related remark: This also explains the concern of Japanese and German corporations to shift production to regions/countries with a more elastic labour supply – i.e. Portugal and later Eastern Europe for Germany; S.E. Asia in the case of Japan].

In short, a reduction in domestic supply will affect prices and wages disproportionately in countries featuring strong, oligopolistic producers enjoying high degrees of capital intensity and a capacity to deter foreign competitors via the preservation of excess capacity. Real output and employment will fall while real wages will probably rise, unless some corporatist policy is enacted that keeps wages lower while high interest rates preserve price stability.

Related remark: Before the introduction of the euro, for instance, the German Central Bank, the Bundesbank, was notorious for keeping interest rates too high for the likes of France, Italy, Spain etc. (i.e. for its partners in the ERM, the European Exchange Rate Mechanism), thus making it hard for them to join Germany on the ‘glidepath’ that would lead to the common currency they had all agree to work towards. Many Europeans were asking: Why is the Bundesbank doing this? Why is it wrecking the ERM by pursuing high interest rates? The above offers one explanation. (It also points to reasons why corporatism is all the rage in places like Germany – along with a tendency to shift production to a wider ‘vital space’; e.g. Eastern Europe.)

COUNTRY B: Week capital goods, no or low price-cost margins, negligible entry deterrence

My assumption here is that, meanwhile, country B remains one with a minimal capital goods sector, few economies of scale, and no entry deterrence capacities by local industrialists. In short, country B remains as it was under Section 1 above – the symmetrical case. Economically, this is significant because in country B (unlike country A) the movement of prices and wages will reflect a lot more (that in A) the movements of marginal costs and productivity.

Moreover, as marginal productivity tends to be much lower in the more monopolistic economy (A), due to expensive R&D in capital goods, country A’s goods will tend to be more price competitive than B’s in country B even though B’s producers will enjoy no price-cost margin. Which means that A’s output can yield substantial net exports until the point is reached when A’s productive capacity is exhausted (or, more likely, until producers in A suspect that exhausting their excess capacity further will reduce unacceptably their entry deterrence capacities).

Naturally, country A producers would love to practise price discrimination, charging higher prices at home than they do in country B. However, in this union between A&B the scope for price discrimination are severely circumscribed by the free trade agreement. So, since they cannot really price-discriminate, A’s factories will self-restrain and stop producing at a quantity of output well short of the level at which price equals marginal cost (i.e. well before pA=MCA).

In short, A will develop a major surplus vis-à-vis B which no amount of price competition can annul and which is only restrained by the degree of price inelasticity of demand in country A. To be precise, the more elastic A’s domestic demand, the greater the surplus that A has vis-à-vis B.

4. Real adjustment in asymmetrical Monetary Unions

Unlike the symmetrical case (see Section 2 above), where monetary union makes no difference to the dynamics of adjustment following some shock (e.g. differences in productivity growth), in the case of asymmetrical monetary unions monetary union (or fixed exchange rates) make all the difference.

If exchange rates are variable, a large imbalance of trade in favour of A causes a reduction in B’s exchange rate that must, in turn, push down both prices and wages in B as denominated in the currency of country A. Hence the incentive of A’s producers to sell in B should diminish. As their exports to B fall, B’s producers will begin to contribute more output that will replace to the supply of goods in B (even manage to export part of their output to A). In short, B’s deficit will have been checked by an exchange rate adjustment – a devaluation of B’s currency.

But under monetary union, there is no such direct equilibrating mechanism. The only possible adjustment comes from internal devaluation in B courtesy of B’s financial constraint.

B’s financial constraint and its ‘overcoming’ by capital inflows from A

Persistent trade deficits need to be financed somehow. If B is starved of financing, as a result of the permanent transfer of rents to A, at some point aggregate demand in B will wane. As it does, prices will fall and wages will follow – the internal devaluation route toward equilibration being activated by B’s lack of access to sources from which its deficits can be financed.

As A’s trade surplus builds up, rents accumulate in A’s banks and, importantly, savings in A exceeds massively the amount of investment needs of its oligopolistic firms. This glut of savings pushes interest rates downwards and, more generally, rates of return are at very low levels. Under a variable exchange rate regime, financial flows are limited by exchange rate uncertainty. However, under a credible peg or, even better, a common currency, the temptation is too great to resist: capital flows abundantly from A to B, where it finds higher yields, financing B’s aggregate demand for A’s net exports.

Crucially, B’s capital inflows alter the structure of B’s economy. A large intermediation sector (services) develops in B while B’s manufacturing wanes under the inexorable pressure of A’s exports. While manufacturing wages collapse in absolute and per worker terms, the portion of the wage bill that comes from this parasitic, import-and-debt financed sector rises. As it does, aggregate demand in B is bolstered in this manner and, therefore, B becomes immune to the standard internal devaluation dynamics that standard trade theory predicts. Additionally, the capital flows into B prop up asset prices which create an internal financialisation drive which further boosts domestic aggregate demand within B.

Interestingly, B’s bubble economy grows faster than A’s. Why? Because asset prices are kept stable in A courtesy of the capital outflows. Moreover, to preserve its mercantilist stance, in the absence of a monetary union (e.g. under the ERM’s quasi-fixed exchange rates which were combined with different interest rates in each country), country A has a tendency to keep interest rates higher at home in order to prevent a further capital exodus from A. This has the effect of limiting domestic aggregate demand, suppressing both growth rates and well as inflation rates. The end result is a deepening of the productivity and competitiveness differential between the two countries causing a reinforcement of the bubble dynamics in country B.

In short, A exports to B not only goods but also (a) a recession in B’s real economy and (b) an asset inflation in its financial and real estate sectors – until some shock (external or internal) bursts these asset inflation bubbles proving beyond doubt that the earlier ‘growth’ phase was, indeed, unsustainable.

5. Crunch time

What happens when the bubbles burst (e.g. as a result of over-extension of some developers, borrowers, financiers in country B)? Capital flows are instantly reversed and private sector debts turn bad. Banks in B then begin to fail, causing stress in A’s banks (due to their exposure to B’s banks, developers, and intermediaries), the state has to intervene (in both countries to keep banks open) and, therefore, private debts are transferred to the public purse.

Without a monetary union, the major shock absorbers in B are (a) devaluation, (b) default on foreign denominated debt (but not on domestically denominated debt as the Central Bank can cover those), and (c) bank nationalisation (in conjunction with the nation’s Central Bank that pumps liquidity and capital into them).

Under a monetary union, B’s government has no Central Bank to back its debt refinancing. Yields rise massively and the state is forced either to default or to turn to austerity. Default creates more problems for the banking sector (which is going under anyway) and cannot work within a monetary union – unless the default is used as a negotiating tactic by B within a monetary union, demanding a new architecture that makes it viable. Austerity, on the other hand, serves the role of imposing a proportional reduction of wages and prices – one that, as we have seen, works only if (a) we live in a perfectly competitive world of price takers in both A and B, and (b) there is no debt (private and public) overhang (see Section 2 above).

Why austerity is bound to fail in an asymmetrical monetary union

Wage and price reductions must be huge to stimulate domestic production in country B to a degree that makes a difference. The reason, of course, is that marginal costs in A are so much lower; indeed, many of the goods that A produces are no longer being produced in B (e.g. white goods in Greece after the takeover of that industry by German companies during the ‘good’, boom, times).

But even if these reductions are enormous (as a result of the depth of the recession in country B), and thus manage to boost domestic manufacturing output, such reductions will destroy the parasitic non-manufacturing sector which is where, following the boom years, B is deriving most of its income from. Which means that neither private nor public debts can be repaid.

6. Summary

Following a financial crisis, the debt dynamics of the weaker member of an asymmetrical monetary union, in combination with the logic of oligopoly market power in its stronger partner, ensure that the internal devaluation effected by austerity will fail at bringing about the necessary real adjustment in the indebted deficit country – while undermining the net export position of the surplus economy.

What of the so-called ‘structural reforms’ that reduce labour and non-labour costs to business in the less developed deficit economy? The problem here is twofold:

First, it is not at all clear that such reforms will cause the advanced country’s corporations to be interested in investing in the deficit country when they are already choosing to maintain high levels of excess capacity at home (for the purpose of maintaining their market power via entry deterrence).

Secondly, and more importantly, once in the clasps of the kind of crisis described above, the monetary union’s common Central Bank is forced to push interest rates close to zero – the infamous liquidity trap of John Maynard Keynes (also known in the US as zero lower bound – ZLB). Once ‘there’, structural reforms may well fuel expectations of prolonged deflation (a fall in the absolute value of prices and wages) which, as nominal interest rates are stuck, give rise to an increase in real interest rates; precisely what the monetary union’s more depressed country does not need!

Epilogue: What should we do when caught up in such an asymmetrical monetary union at a time of crisis?

A prelude to the Modest Proposal

Monetary Unions that contain no Surplus Recycling Mechanism are bound either to collapse or to place the economies within into a never-ending, vicious, recessionary dynamic.

The question then becomes: What should a country whose social economy is caught up in this vicious cycle do? If the monetary union is loose (i.e. the currencies are pegged) the answer is simple: Away with it! Sever the peg, float the currencies and allow for exchange rate adjustments to do their trick. While asymmetrical oligopoly power will remain, continuing to curtail the less advanced country’s developmental possibilities, at least the debt-deflationary spiral will end.

However, when the monetary union is of the Eurozone kind (i.e. national currencies have been abolished and replaced by a common one), a decision by the weaker country to return to the national currency is tantamount to announcing a massive devaluation eight to twelve months before it is to come to effect (since this is the length of time it takes to create a new currency, to rejig the relationship between the banks and the Central Bank etc.). This will cause a prolonged exodus of capital, liquidation of assets and an almost total cessation of economic activity for anything up to a year. For that period, it is questionable whether the government of the departing country will have access to the foreign reserves it needs for the importation of basic goods (pharmaceuticals, energy etc.). Last, but not least, the breakup of this monetary union will necessarily cause a large recession in the advanced economy, as its own currency appreciates violently and its exports to third countries drop (e.g. German exports to Asia); a development that is bound to reduce demand for the weaker country’s potential exports to its former monetary union partner.

However awful the above scenario may be, a breakup of an asymmetrical monetary union caught up in such a downward spiral is inevitable. And because it is inevitable it is best to break it up sooner rather than later unless it can be recalibrated in a manner that addresses its faulty architecture. As this paper has argued, asymmetrical monetary unions that contain no effective extra-market surplus recycling mechanisms are guaranteed to fail. But what if an effective extra-market surplus recycling mechanisms were to be introduced? Might this not allow us to avoid the horrendous costs of the union’s breakdown?

The major problem with this idea is that, during a crisis, the political will to bring the asymmetrical monetary union’s economies closer together, via institutional changes, is weakened. Citizens turn their back to the monetary union, understandably, and begin to crave more (rather than less) national sovereignty. So, the great, big question becomes: Is it possible to give the peoples of such an asymmetrical monetary union more sovereignty while, at once, introducing an effective extra-market surplus recycling mechanism?

We believe that this is possible. And it is to this purpose that we have developed our, so-called, Modest Proposal for Resolving the Euro Crisis. In effect, its contribution is precisely that: To recommend four simple changes that can be immediately effected within the Eurozone, without any Treaty changes, and in a manner that enhances our Parliaments’ sovereignty, such that our asymmetrical, crisis-ridden Eurozone can be given the automatic stabiliser it misses: an effective extra-market surplus recycling mechanism.


[1] i.e. pA=MCA, pB=MCB, wA = pAXMPAL, wB = pBXMPBL, where pA is the price of output produced in country A, MCA is the marginal cost of output produced in A, and MPAL is the marginal product of workers in country A – and similarly for country B.

[2] Recall that wB = pBXMPBL. Hence, as price pB declines (following a flood of cheaper imports), the wage wB also diminishes.

[3] In A, wA = pAXMPAL. As the exodus of goods and services from A to B restricts supply in A, price pA goes up thus driving wage wA up along with it.

[4] In case of firms with a power to influence price, price exceeds marginal cost by an amount that is inversely related to the firm’s elasticity of demand: pA(1-1/ε)=MCA