international analysis and commentary

Some advice from Hayek on monetary union


Whatever the short-term result of the clash between Greece and its creditors, who gave Athens three days to completely revamp its economic governance, chances are the problems of the eurozone will not go away. The point has not been made by Paul Krugman, Joseph Stiglitz or the many European economists critical of the EU’s policies but by the patron saint of free market believers, Friedrich von Hayek himself. And it was 1939, not 2015.

Seventy-six years ago, Hayek published a short article, “The Economic Conditions of Interstate Federalism,” where he analyzed the possibility of a union of various states. A common economic regime, he pointed out, would realize tremendous economies of scale and, more important, would permit “the free movements of men and capital between the states of the federation,” precisely what the European Single Market is supposed to achieve. This situation appealed to Hayek because capital mobility would prevent the states from imposing excessive costs on business: every country needs to “avoid all sorts of taxation which would drive capital and labor elsewhere.” Hostility to the nation-state is a constant theme in Hayek’s work and it was in a tone of clear approval that he wrote that freedom of movement would “limit to a great extent the scope of the economic policy of the individual states.”

The Austrian-born economist continued stating that “the states within the Union will not be able to pursue an independent monetary policy.” With a common monetary unit (like the euro today) “the latitude given to the national central banks will be restricted at least as much as it was under a rigid gold standard – and possibly rather more (…) Indeed, it appears doubtful whether, in a Union with a universal monetary system, independent central banks would continue to exist.” The members would lose fiscal powers because of “considerable difficulties with many kind of [direct and] indirect taxation.”

And here was the problem: in a large federation “it would be much more difficult to place a burden on the inhabitants of one region in order to assist the inhabitants of a very distant region who might differ from the former not only in language but also in almost every other respect.” Was Hayek thinking six decades ahead of his time? His intuitions apparently fit perfectly with today’s sentiments of German public opinion toward Greece.

The point was that “in the national state, the submission to the will of a majority will be facilitated by the myth of nationality” while “people will be reluctant to submit to any interference in their daily affairs when the majority which directs the government is composed of people of different nationalities and different traditions.” And the results of the Greek referendum are strong evidence of this.

For these reasons, Hayek returned on the topic in the 1970s, explaining that he considered “utopian” the idea of “a new European currency, which would ultimately only have the effect of more deeply entrenching the source and root of all monetary evil, the government monopoly of the issue and control of money.” In his essay “Denationalisation of Money,” he wrote: “I strongly sympathise with the desire to complete the economic unification of Western Europe by completely freeing the flow of money between them, I have grave doubts about the desirability of doing so by creating a new European currency managed by any sort of supra-national authority.”

Aside from his hostility to any monetary authority (he preferred private banks issuing different currencies competing among them), Hayek was certainly aware of the problems of the “optimal currency areas,” first described by Robert Mundell in 1961. Europe, according to many economists including Milton Friedman (another icon of conservative, free market economic thinking), was a situation unfavorable to a common currency. Not only is it composed of nations speaking different languages, with different economic bases and levels of productivity, but it has only limited mobility of labor and wage flexibility, two important conditions set by Mundell. Last but not least, Europe (then as well as now) lacks a risk-sharing system such as provisions for fiscal transfers to the areas or sectors adversely affected by the integration of national economies. Such a policy, as it’s now abundantly clear, is politically difficult to implement also because the EU/Europe has inserted a “no-bailout clause” in the Stability and Growth Pact, meaning that fiscal transfers are not allowed (the so-called European Stability Mechanism is a limited way to circumvent what the treaties forbid).

Therefore, any solution to the Greek problem cannot be but provisional and it’s only a matter of time before a Spanish, Portuguese, Italian or French “problem” will surface. The euro places too heavy a burden on the inhabitants of one state or another, and it is a machine almost designed to torture the losers in global competition. No matter how strongly we sympathize with the desire to complete the economic unification of Europe, its currency is sapping the EU’s legitimacy and threatening its future – just as Hayek predicted in 1939.