What is really behind the eurozone’s woes?

One of the most popular explanations behind the eurozone’s, and specifically Greece’s, woes is that the common currency area, unlike the United States, lacks a fiscal union. I was a firm adherent of this view until recently, but recent research has led me to question my views.

The case for fiscal union builds on two distinct pillars. While the public-at-large emphasizes the importance of the need to support poorer nations with permanent fiscal transfers, academic economists underline temporary transfers to smooth out the economic cycles of member countries.

As for the former point, I was surprised to learn recently that the U.S. did not have a fiscal union until the early 20th century; the federal income tax was introduced only in 1913. It is true that there is now a fiscal redistribution between poor and rich states amounting to more than 20 percent of their GDP.

However, as Daniel Gros, the director of the Centre for European Policy Studies (CEPS), a leading think tank and forum for debate on European Union affairs, noted in a recent paper comparing Puerto Rico and Greece’s defaults, fiscal transfers amounting to 30 percent of GDP did not protect the Caribbean island from a debt crisis of Hellenic proportions.

As for the more relevant temporary transfers, the International Monetary Fund (IMF) has compiled local data on economic and consumption cycles for federal countries. In the U.S., Canada and Germany, a one percentage point fall in the growth of a state results in a decrease in consumption of around only 0.2 percentage points.

However, almost none of this support is due to fiscal transfers, with the bulk coming from credit and capital markets. Interestingly enough, Jens Weidmann, the president of Germany’s central bank, the Bundesbank, made this very point in a recent speech, arguing (conditionally) for integrated capital markets and banking in the eurozone.

These findings are in line with a very important idea of Maurice Obstfeld, the well-known international macroeconomist who was appointed last week as the IMF’s new chief economist. Students of economics would know him from his undergraduate and graduate textbooks or his seminal papers on self-fulfilling currency crises and open-economy macroeconomics modeling.

However, his most relevant work is a policy paper he wrote for the European Commission in April 2013. There, he argued that currency unions like the eurozone were faced with a “trilemma”: They cannot pursue cross-border financial integration and maintain financial stability without giving up fiscal independence.

According to Obstfeld, “this financial/fiscal trilemma lies at the heart of the eurozone crisis that began in 2009.”

It also “provides a useful organizational structure for ... preserving a unified euro area financial market,” For example, a fiscal union is necessary, not because it would provide transfers to needy countries, but for the banking union and deposit insurance scheme Obstfeld is arguing for. In that sense, it is not an end in itself, but the means to an end.

It would be interesting to see if the IMF would push for this idea and try to convince the Europeans. Such a drastic change in the direction of the eurozone’s economic setup may be the only thing that may hold the common currency area together – with or without Greece.