Two trilemmas in Eurozone governance

Following on from Henry and John’s piece on ‘hard Keynesianism’, here is another angle on the politics of the EU. Economic historian Kevin O’Rourke has an excellent paper setting out a very nice framework for thinking about the Eurozone. It was presented at a conference of the Institute for New Economic Thinking held recently in Bretton Woods (yes, surely a good venue for such an event). There is also a short summary here.

Kevin’s creative insight is to combine the impossibility theorems from two bodies of literature – Mundell-Fleming on monetary policy, and Dani Rodrik on global governance – and to show that the Eurozone occupies an uneasy half-way house in both economic and political governance. The particular merit of setting out the issues like this is that it demonstrates why there are no optimal policy solutions, only difficult trade-offs, with different potential losers in each case. It is an innovative and stimulating exercise in political economy that deserves to gain a wide readership.

Mundell and Fleming’s economic trilemma posits that you can only achieve two of three objectives in monetary policy: that is, open capital markets, domestic control over monetary policy, and fixed as opposed to floating exchange rates. ‘European Monetary Union has thus solved the economic trilemma in a particularly radical way: capital mobility combined with the complete abandonment of national monetary sovereignty’.

The political trilemma, drawing on Dani Rodrik’s work, says that if you go for increasing globalization, you cannot simultaneously have both nation-state politics and democratic accountability. If you want the latter two (as in the ‘Golden Age’ of postwar capitalism), you need restrictions on capital mobility. If you go for closer economic integration, you could do it by imposing all the adjustment costs onto your own citizens, as in the era of the Gold Standard. But as Polanyi and others have pointed out, this is hard to sustain without massive repression, and pretty well impossible in the long run with universal enfranchisement. So the alternative is to construct a collective decision-making capacity at the transnational level. As O’Rourke notes:

What makes European Monetary Union such a radical solution to the political trilemma is that it not only abandons national monetary policy-making, but delegates it to a technocratic Central Bank… Moreover, this has occurred without common Eurozone policies in complementary areas, notably financial and banking regulation; and it has occurred without a move towards a common fiscal policy, which most economists also regard as a desirable complement to a common monetary policy.

But the European project is also premised on the primacy of democratic politics and joint decision-making, and recent Treaty reforms have been aimed at bridging the ‘democratic deficit’ in the central institutions. This is difficult because national parliaments continue to enjoy greater legitimacy. There is strong citizen resistance to shifting more power to a federal EU level, however beefed up its democratic credentials. Similarly, the more fully institutionalized ‘Europe’ becomes, the more contentious the embedded policy commitments, particularly to the pro-competition pro-market agenda.

So the EU is a political halfway house that is both intergovernmental and technocratic. What the effects of the current crisis may be on all this is still a work in progress. Europe needs a common approach on banking regulation and resolution; it would benefit from having a centralized budget to smooth shocks. As O’Rourke notes, there are inter-country conflicts in democratically expressed preferences on both these issues.

There are also major class cleavages within countries in attitudes toward the EU itself, where ‘support for EMU is positive correlated with support for both globalization and the EU, …and is higher among the better educated, white collar workers, and retirees. On the other hand, it is lower among the unemployed, and those who consider themselves to be on the right politically’.

Looking jointly at the economic and political trilemmas, and at the peculiar EU hybrid, O’Rourke comments that, at the moment, ‘the combination of democracy and the national state is winning out, implying that we are stuck with a monetary union with serious design flaws’.

What will happen so? O’Rourke goes with Rodrik in noting that ‘when globalization collides with domestic politics, the smart money bets on politics’. On the other hand, he also notes the immense political capital that has been sunk into EMU and the enormous political as well as economic damage that its unravelling would cause.

Unfortunately economists only have two hands; it would be nice to know if there was a clear way through these troubled times.