The political economy of monetary solidarity : understanding the euro experiment

Creating The European Monetary Union Between Diverse And Unequal Nation States Is Arguably One Of The Biggest Social Experiments In History. This Book Offers An Explanation Of How The Euro Experiment Came About And Was Sustained Despite A Severe Crisis, And Provides A Comparison With The Monetary-financial History Of The Us. The Euro Experiment Can Be Understood As Risk-sharing Through A Currency That Is Issued By A Supranational Central Bank. A Single Currency Shares Liquidity Risks By Creating Larger Markets For All Financial Assets. A Single Monetary Policy Responds To Business Cycles In The Currency Area As A Whole Rather Than Managing The Path Of One Dominant Economy. Mechanisms Of Risk-sharing Become Institutions Of Monetary Solidarity If They Are Consciously Maintained, But They Will Periodically Face Opposition In Member States. This Book Argues That Diversity Of Membership Is Not An Economic Obstacle To The Success Of The Euro, As Diversity Increases The Potential Gains From Risk Sharing. But Political Cooperation Is Needed To Realize This Potential, And Such Cooperation Is Up Against Collective Action Problems Which Become More Intractable As The Parties Become More Diverse. Hence, Risk-sharing Usually Comes About As A Collective By-product Of National Incentives. This Political-economic Tension Can Explain Why The Gains From Risk-sharing Are Not More Fully Exploited, Both In The Euro Area And In The Us Dollar Area. This Approach To Monetary Integration Is Based On The Theory Of Collective Action When Hierarchy Is Not Available As A Solution To Inter-state Cooperation. The Theory Originates With Keohane And Ostrom (1995) And It Is Applied In This Book, Taking Into Account The Latest Research On The Inherent Instability Of Financial Market Integration. -- Introduction : Understanding The Euro Experiment -- The Political Economy Of Monetary Solidarity -- Economic Risk Sharing Between States -- A Short History Of Risk Sharing In The Us Monetary Union -- The System Of Limited Risk Sharing In The Euro Area -- The Euro Area Crisis As A Stress Test For Monetary Solidarity -- Monetary Solidarity By Default And By Design -- Social Solidarity Through Labor Market Integration -- Monetary Solidarity In Financial Integration -- The Experiment Of The Euro. Waltraud Schelkle. Includes Bibliographical References (pages 331-366) And Index. Cover 1 The Political Economy of Monetary Solidarity 4 Copyright 5 Acknowledgments 6 Contents 8 List of Figures 12 List of Tables 14 List of Abbreviations 16 1: Introduction: Understanding the Euro Experiment 18 1.1 The Political-Economic Paradox of Diversity 18 1.1.1 Diversity as Opportunity and as Challenge 21 1.1.2 The Puzzle of Monetary Solidarity 24 1.1.3 Overcoming Collective Action Problems 26 1.2 The Economic Underpinning of Monetary Solidarity 29 1.2.1 Risks to Be Shared in Monetary Integration 30 1.2.2 Risk-Sharing Mechanisms 33 1.2.3 Monetary Solidarity as the Outcome of Institutional Evolution 34 1.2.4 The Non-Solution of Mainstream Economic Theory 36 1.3 Overview 39 Part I: Building Blocks 46 2: The Political Economy of Monetary Solidarity 48 2.1 The Puzzle of Rational Cooperation 49 2.2 The By-Product Theory of Collective Action 54 2.2.1 Origins in the Logic of Collective Action 56 2.2.2 Governing a Commons 59 2.3 Political Market Failures 63 2.3.1 Externalities 64 2.3.2 Asymmetric Information 67 2.3.3 Lack of Commitment 69 2.3.4 Misperception 71 2.4 Forms of Risk Sharing 73 3: Economic Risk Sharing between States 78 3.1 The Idea of Risk Diversification 79 3.2 Sharing the Risk of Output Shocks between States 82 3.2.1 What Are the Main Channels of Risk Sharing between States? 83 3.2.2 How Much Do Various Channels Contribute to Risk Sharing? 88 3.2.3 Does Monetary Integration Lead to More Financial Risk Sharing? 91 3.2.4 What Have We Learnt? 92 3.3 From Channels to Interfaces of Risk Sharing 96 3.3.1 Negative Feedback Loops 98 3.3.2 Fiscal Backstops 99 3.3.3 Monetary-Financial Transmission 100 3.3.4 Variable Fiscal Multipliers 101 3.4 The Limitations of Financial Risk Sharing 101 Appendix 104 Part II: Evolving Monetary Unions of Limited Risk Sharing 106 4: A Short History of Risk Sharing in the US Monetary Union 108 4.1 The Relationship between Monetary and Political Integration 109 4.2 The Emerging Interfaces of Money, Banking, and Federal Public Finances 112 4.2.1 Alexander Hamilton ́s Plan for Central Risk Pooling 113 4.2.2 Experimenting with Federalism and Free Banking 116 4.2.3 Panicking towards the New Deal 119 4.2.4 The Fiscal Underpinning of the Great Society 125 4.2.5 Deregulation and the Return of Financial Instability 127 4.3 The Political Economy of Monetary Solidarity in the US Dollar Area 129 4.3.1 The Interface of Public Finances and Banking 131 4.3.2 The Interface of Banking and Money 133 4.3.3 The Interface of Money and Public Finances 136 4.3.4 Comparative Political Economy 138 5: The System of Limited Risk Sharing in the Euro Area 142 5.1 Currency Unification against the Odds 142 5.1.1 The Trauma of the 1992-3 Crisis 143 5.1.2 Joining the Risk Pool of a Hard-Currency Area 146 5.2 The Interfaces of Money, Banking, and State Budgets 152 5.2.1 The Set-Up of the Euro Area System 152 5.2.2 Elements of Risk Sharing before 2008 156 Convergence criteria against adverse selection 156 Fiscal surveillance against moral hazard 157 Central bank independence and mutual insurance 160 Collateralized ECB lending as social insurance 162 Lending of last resort with a residual fiscal backstop 165 5.2.3 Exemptions from Monetary Solidarity 167 5.3 The Political Economy of Monetary Solidarity in the Euro Area 170 6: The Euro Area Crisis as a Stress Test for Monetary Solidarity 175 6.1 The Puzzling Crisis and Its Costly Management 176 6.1.1 Multiple Crises in One 176 Greece 177 Ireland 178 Portugal 179 Spain 180 Cyprus 181 6.1.2 Unprecedented Assistance in an Unprecedented Crisis 183 6.2 Explaining the Crisis of the Euro Area 191 6.2.1 Revenge of the Optimum Currency Area? 191 6.2.2 Incompatible Growth Regimes? 196 6.2.3 Incompleteness and Reversal of Risk Sharing? 202 6.3 Monetary Solidarity at Crossroads 213 Appendix: Drivers of Debt Accumulation before and after Troika Programs 214 7: Monetary Solidarity by Default and by Design 216 7.1 Changing Risk-Return Profiles through Integration 217 7.2 Reforms at the Interfaces of Risk Sharing in Response to Crisis 222 7.2.1 Early Interventions to Contain Fiscal Risk Sharing 223 7.2.2 Fiscal Capacity Building and Lending of Last Resort to Sovereigns 227 Emergency funds 227 Quasi-fiscal monetary policy 231 7.2.3 Banking Union and an Expanded ECB Mandate 234 7.3 Reforming the Governance of the Commons 240 Part III: Solidarity in Action 244 8: Social Solidarity through Labor Market Integration 246 8.1 Labor Mobility in a World of Welfare 247 8.2 The Social Right to Internal Migration in Two Monetary Unions 251 8.2.1 Territorial Access and Welfare Entitlements 252 8.2.2 Dualism in Labor Markets and Risk Sharing 258 Reservation wage levels 261 Competition from imported services 264 Competition from self-employment 266 8.3 Interstate Risk Sharing through Free Movement in a Monetary Union 268 8.3.1 Sharing the Risk of Economic Fluctuations? 269 8.3.2 Sharing the Risk of Income Divergence? 273 8.4 Free Movement and the Political Economy of Labor Market Integration 278 9: Monetary Solidarity in Financial Integration 283 9.1 The Political Challenge of a Payments System 285 9.2 Payments Systems of Two Monetary Unions 293 9.2.1 Payments Systems in Normal Times 293 9.2.2 Payments Systems in Extraordinary Times 296 9.3 The Beneficiaries of TARGET Insurance 301 9.3.1 Insurance against Sudden Stops of Trade Finance? 303 9.3.2 Insurance but also a Conduit for Capital Flight? 306 9.3.3 Hedging against the Break-Up of the Euro Area? 312 9.4 TARGET and the Political Economy of Insurance 314 10: The Experiment of the Euro 320 10.1 Diversity as Economic Opportunity and Political Challenge 322 10.2 Policy Implications 328 10.2.1 Solidarity and Integration 331 10.2.2 Fiscal Risk Sharing through Reinsurance 333 Fiscal stabilization 334 Fiscal backstops 336 10.3 European Political Economy 339 10.3.1 Political Legitimation of Monetary Solidarity 340 10.3.2 Reflexive Policy Advice 344 Bibliography 348 Index 384 Creating the European monetary union between diverse and unequal nation states is arguably one of the biggest social experiments in history. This book offers an explanation of how the euro experiment came about and was sustained despite a severe crisis, and provides a comparison with the monetary-financial history of the US. The euro experiment can be understood as risk-sharing through a currency that is issued by a supranational central bank. A single currency shares liquidity risks by creating larger markets for all financial assets. A single monetary policy responds to business cycles in the currency area as a whole rather than managing the path of one dominant economy. Mechanisms of risk-sharing become institutions of monetary solidarity if they are consciously maintained, but they will periodically face opposition in member states. This book argues that diversity of membership is not an economic obstacle to the success of the euro, as diversity increases the potential gains from risk sharing. But political cooperation is needed to realize this potential, and such cooperation is up against collective action problems which become more intractable as the parties become more diverse. Hence, risk-sharing usually comes about as a collective by-product of national incentives. This political-economic tension can explain why the gains from risk-sharing are not more fully exploited, both in the euro area and in the US dollar area. This approach to monetary integration is based on the theory of collective action when hierarchy is not available as a solution to inter-state cooperation. The theory originates with Keohane and Ostrom (1995) and it is applied in this book, taking into account the latest research on the inherent instability of financial market integration. -- Provided by publisher "Creating the European monetary union between diverse and unequal nation states is arguably one of the biggest social experiments in history. This book offers an explanation of how the euro experiment came about and was sustained despite a severe crisis, and provides a comparison with the monetary-financial history of the US. The euro experiment can be understood as risk-sharing through a currency that is issued by a supranational central bank. A single currency shares liquidity risks by creating larger markets for all financial assets. A single monetary policy responds to business cycles in the currency area as a whole rather than managing the path of one dominant economy. Mechanisms of risk-sharing become institutions of monetary solidarity if they are consciously maintained, but they will periodically face opposition in member states. This book argues that diversity of membership is not an economic obstacle to the success of the euro, as diversity increases the potential gains from risk sharing. But political cooperation is needed to realize this potential, and such cooperation is up against collective action problems which become more intractable as the parties become more diverse. Hence, risk-sharing usually comes about as a collective by-product of national incentives. This political-economic tension can explain why the gains from risk-sharing are not more fully exploited, both in the euro area and in the US dollar area. This approach to monetary integration is based on the theory of collective action when hierarchy is not available as a solution to inter-state cooperation. The theory originates with Keohane and Ostrom (1995) and it is applied in this book, taking into account the latest research on the inherent instability of financial market integration." -- Résumé de l'éditeur