The only plausible fix for the euro won’t work

A much proposed way to make the eurozone work is to turn it into a monetary, fiscal and political union. But Europe already has a single-currency area like this. It is called Britain. And that doesn't work either, says Matthew Lynn.

What does the euro need to make it work better? The conventional answer is that it needs to be turned into a fiscal union, with large-scale wealth transfers from the richer regions to the poorer ones. Of course, a caveat or two is usually thrown in. The political obstacles are formidable. The Germans might never agree to their taxes being sent to bail-out Greece or Portugal. The treaties may need to be re-written, which would require the agreement of all the European Union's members. Still, if only those obstacles could be overcome, a fiscal union would smooth out most of the problems.

The trouble is, the fundamental assumption here may well be wrong. Europe has another monetary union between countries at very different stages of economic development. It is called Britain, and the currency is sterling. The UK has a rich south and a poor north, rather than a rich north and a struggling south, but otherwise the sterling area has many similarities to the euro area. It is made up of a group of countries with very different levels of prosperity. It has huge transfers between the richer regions and the poorer. And it doesn't do any good at all. True, it holds the currency area together. But it only does so at the cost of creating regions that are ever more dependent on state aid. The truth is, a transfer union wouldn't save the euro even if it was politically feasible. Nothing will. The project is doomed.

Yet that doesn't stop people from trying. The most common critique of the single currency is that it is an economic union without a political union. George Soros has argued for a year that without a single government the currency won't survive. But Britain's experience suggests that even if it happened, it wouldn't work. Britain used to be a fairly homogenous economy, with wealth relatively evenly spread out across its major industrial centres, much as it is in modern Germany. Not anymore. Post-industrial Britain has a very prosperous capital surrounded by equally wealthy suburbs. The Midlands and east are doing fine. The rest of the country has been falling behind at an increasingly rapid rate. The result is that there are huge disparities between output per head in the south and Wales, Scotland and Northern Ireland. It isn't quite as dramatic as the gulf between Germany and Greece but it isn't that far off.

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That gets fixed by fiscal transfers. Britain, which has of course a single government and single finance ministry, shuttles large sums of money from the richer regions to the poorer ones. Oxford Economics, the consultancy, has calculated the amount the government spends per person employed per taxpayer, in other words for the different parts of the country. In the South-East, the government spent £14,100 per working person. In Northern Ireland, it spent £21,200. Wales, Scotland and the North-East were all way above average. The East, East Midlands, and London were all below average although London (which has pockets of real poverty amidst its wealth) not by as much as you might think. It also looked at expenditure relative to gross value added, which is the actual output of the region. Taking the average for Britain as 100, Northern Ireland scored 155 and the South-East just 84. So a lot of the wealth from the South-East gets sent to the periphery'.

Britain is, therefore, a monetary union with significant transfers between its richer and poorer regions. The trouble for the euro's would-be fiscal unifiers is that there is little evidence that it fixes the problem. Northern Ireland, for example, has had a consistently lower growth rate than Britain as a whole this year it will grow by 1.1% compared with 1.7% for Britain, estimates Northern Bank. Much the same is true of Wales and the North-East. The regions with the biggest fiscal transfers have grown consistently more slowly than the rest of the UK, with the result that the ratio of state spending relative to their local economies has grown steadily over time. Between 1999 and 2010 state spending rose from accounting for 50% of the Welsh economy to 69%, according to the Centre for Economics and Business Research.

Fiscal transfers can hold a monetary union together. There is no sign of the sterling area breaking up, although the Scots might eventually go their own way. But such unions won't close the gap between the rich and poor regions. They are a permanent subsidy and one that will probably grow over time. If anything, fiscal transfers probably make things worse. They crowd out private investment after all, why would anyone in Northern Ireland set up a business when there are relatively few industries where it has much strength, and when they could just get on a plane to London, or get a secure job in the public sector? It creates whole regions where the fiscal transfers are the only thing keeping the economy afloat.

That just about works in Britain. It has been a unified state for several hundred years and has close ties of language, culture and family between its regions. But it is very hard to see it working for the euro zone. Voters in Munich and Eindhoven already seem outraged by paying for the Greeks and Portuguese. When they get told that the transfers are permanent, and will rise steadily over time, they will surely refuse to pay. The scary truth is that even the one plausible fix for the euro crisis doesn't work.

This article was originally published in MoneyWeek magazine issue number 544 on 2 July 2011, and was available exclusively to magazine subscribers. To read all our subscriber-only articles right away, subscribe to MoneyWeek magazine.

Matthew Lynn

Matthew Lynn is a columnist for Bloomberg, and writes weekly commentary syndicated in papers such as the Daily Telegraph, Die Welt, the Sydney Morning Herald, the South China Morning Post and the Miami Herald. He is also an associate editor of Spectator Business, and a regular contributor to The Spectator. Before that, he worked for the business section of the Sunday Times for ten years. 

He has written books on finance and financial topics, including Bust: Greece, The Euro and The Sovereign Debt Crisis and The Long Depression: The Slump of 2008 to 2031. Matthew is also the author of the Death Force series of military thrillers and the founder of Lume Books, an independent publisher.