In a customs union, which is what the European Union is, the member gives up its sovereign right to determine its own tariffs on traded goods imported from other countries. Likewise, in a monetary union, the member country also gives up its right to adjust the own exchange rate of its currency to meet any national economic contingency. Thus, each country gives up a sovereign right for the benefits that it expects from union.
Prof. Robert Mundell, known as the father of Euro, said three conditions are needed to make a currency union successful.
First, no members of the union are to be hit by economic shocks that are too severe while other members do well. In short, economic shocks cannot be asymmetric among the members.
Second, the members of the currency union have flexible labor markets: that is, labor is mobile across countries and, what is almost equivalent, wages are allowed to adjust downward when conditions are bad in order to keep labor fully employed.
Third, there is a centralised fiscal authority that transfers money and other resources from countries doing well to those doing poorly. The presence of fiscal authority provides stability to the currency. In short, for monetary union success, there ought to be some measure of fiscal union too.
The reality is that all three conditions are not fully met.
Lack of fiscal authority across the EMU was demonstrated when Greece faced its debt crisis. It took the Economic Union a long time to device what turned out to be an inadequate fiscal and monetary support system to avert the impending Greek debt problem from escalating.
Also, the labor markets of individual countries need major reforms, but there is resistance to make the social welfare system conform to the requirements of greater labor market flexibility. So, the social support system remains expensive and unaffordable for many countries.
Mundell said that those highly indebted nations were too generous with their welfare programs.
"Europe's problem isn't because of poverty, but a lack of reasonable fiscal restraint," Mundell was cited as saying, adding that he believes European nations can overcome the current crisis with help from the IMF.
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