Ideas live on

Last Updated: Thu, Dec 27, 2012 19:02 hrs

Academic economists discussing the future of the euro tend to bring up the theory of optimal currency area. It explains that the merger of currencies only makes economic sense if the economies are more efficient with one rather than with many currencies and if the additional efficiency is more valuable than the loss of policy flexibility inside the zone. Peter Kenen, a leader in this approach, died on December 18.

The theory is cited by both supporters and opponents of the euro. Supporters think the Euro zone passes these tests. Opponents argue that it fails one or more. Kenen, for example, was less optimistic about the euro’s prospects than Robert Mundell, who first developed the theory.

The disagreement demonstrates the theory’s weakness. It is always formulated with too many simplifications — assume that productivity in one region is fixed, assume that fiscal deficits always have the same effect on output, assume that workers will or will not move to get a better job — to deal with the real world’s ambiguities.

For all the debate, the underlying insight remains pertinent. A single currency will run into trouble if citizens, governments and banks in one political jurisdiction within the zone are persuaded that they are getting an unfair deal. The theory identifies the forms this perceived unfairness can take: excessive losses on loans from one jurisdiction to another, crippling constraints on government borrowing or unjust transfers of tax payments to unworthy recipients in foreign lands.

Kenen’s successors need to move beyond arguments about efficiency and flexibility. They should consider what might be called the commitment factor — the willingness of politicians, central bankers and ultimately residents to change their policies and practices for the sake of preserving the single currency. This factor has led both Greece and Germany to unprecedented changes.

In the Euro zone, the commitment factor is political: peace is a more important motivation than prosperity. Economists could learn by listening to political discussions of the euro’s future. They almost always include a passionate discussion of the need to move away from Europe’s destructive past.

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