The political economy of monetary solidarity : understanding the euro experiment

Abstract

Creating the European monetary union between diverse and unequal nation states is 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. A comparison with the US dollar area, another diverse monetary union, shows illuminating parallels. 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. The book takes into account the latest research on the inherent instability of financial market integration.