We knew the euro was a bad idea in 1961. What went wrong?

The eurozone is emphatically not an optimal currency area.

Everyone knows this action-movie story: a heroic, war-scarred veteran is promoted to a prestigious desk job, reluctantly hanging up his rifle in the process. But then the state finds itself under threat and his superiors in the bureaucracy turn out to be grossly inept. Eventually, our hero, fearing for the lives of his men and the good of the country, tells them where they can stuff their desk job, picks up his rifle and leads the troops to an epic victory.

The start of this tale is similar to what has been playing out in the Eurozone over the past decade. Countries, hoping to join the safety, prosperity and exclusivity of the Eurozone, readily hung up their weapons of monetary policy, fiscal flexibility and money-printing. But now they need them again, and they're nowhere to be found.

The dangers of currency unions are not only now emerging: they have been a central part of international macroeconomics literature for over half a century, since Robert Mundell’s seminal paper (£) on "Optimal Currency Areas" (OCAs) in 1961.

What seems to have shocked the Eurogenitors is that this longstanding theory was actually right.

OCA theory highlights the costs and benefits of common currency zones and suggests criteria that all states should satisfy before considering their formation. Benefits include increased intra-zone trade, lowered transaction/conversion costs and increased competition through price transparency, while Costs are mainly concerned with lost flexibility. Countries in the zone no longer have the ability to adjust to asymmetric shocks, whether by externally devaluing via currency pr internally devaluing via inflation.

So, could we use OCA theory to retrospectively solve the Eurozone’s problems?

Sadly not. First, many of the criteria which Europe does not meet – hence the original incompatibility – can never be met by it. And second, the Eurozone has created new problems that OCA theory never envisaged. What started as asymmetric shocks – a banking crisis and property bubble bust – have become a massive symmetric attack across the whole region as unarmed sovereigns are left with no policies to defend themselves whilst their very solvency is called into question.

A good example of the Eurozone’s economic incompatibility can be found in Mundell’s first classic OCA criterion: labour mobility. This represents one of the most marked differences between US states and Eurozone countries. If unemployment rises in Detroit – say, because demand for cars falls – workers can move to a state where there is more demand for work, easing Detroit’s unemployment. And Americans do move, frequently. The same is not true of Europe, partly because of the heterogeneity of labour markets but mainly due to culture and, most importantly, language.

So, would a solution to the Euro crisis be to teach everyone, say, German? Despite the obvious historical faux pas of imposing Deutsche Uber Alles, this would raise employment in the short run for Germans (as teachers) – the opposite of what is needed. Teaching English is out for the same reason, and besides, anything that promotes the meddling Brits would be shot down by the Europeans at the helm.

So, how about Spanish? Great idea. Youth unemployment in Spain is a whopping 52 per cent, and teaching your native language requires only a short course that the indignados could pick up in a few weeks. Eurozone-backed free Spanish lessons would ease unemployment (and the associated social benefits) in Spain, whilst the increased skills would further knowledge transfer across the continent and allow for better trade and business links with the fast-growing economies of South America as well as the US (over 10 per cent of the population are Hispanophones).

But of course this is folly. The Italians/Greek/Portuguese would ask, "why not us"? The French would be furieux; to many French diplomats, the very raison d’être of the European project was to spread the French language in defiance of English. They are not about to sponsor an attack on their langue maternelle from over the Pyrenees or anywhere else.

In fact, try though we might to come up with ingenious solutions, microeconomic reforms will not save the Eurozone. No matter what language you put it in, investors can see the current crisis for what it really is: a vote of no confidence in the currency itself.

But OCA theory may have one last bullet in the chamber. Another founding father of OCA theory, Peter Kenen, highlighted in a 1969 paper the need for fiscal integration.

For example, a demand shock in Detroit would not cause a fundamental questioning of the dollar. Instead, Washington would increase transfers to Motor City to allow it to rebalance without cutting state-level consumption and the Treasury would continue to borrow at low rates reflecting the might of the US economy as a whole.

Joining the Euro for many countries has meant surrendering their economic self-determination even while the bazooka-holding Germans have ignored the pressing need for action in the on-going war of attrition against their shared currency.

The Banking Union agreed to on June 27th may sever the link between insolvent banks and insolvent governments but the risk to the currency remains, and thus the unsustainable borrowing costs for peripheral countries will continue.

Everyone can see what Germany’s role in this tale is: either agree to fiscal integration, debt mutualisation and a genuine guarantee of the currency (the markets will know otherwise) or unlock the arsenal, give the Eurozone countries back their self-determination and bring the project to its conclusion.

The story of the European project has been one of peace, prosperity and co-operation for decades, but it is time the next chapter was written.

Robert Mundell, who knew the euro was a bad idea fifty years ago. Photograph: Getty Images

Dom Boyle is a British economist.

Photo: Getty
Show Hide image

Like it or hate it, it doesn't matter: Brexit is happening, and we've got to make a success of it

It's time to stop complaining and start campaigning, says Stella Creasy.

A shortage of Marmite, arguments over exporting jam and angry Belgians. And that’s just this month.  As the Canadian trade deal stalls, and the government decides which cottage industry its will pick next as saviour for the nation, the British people are still no clearer getting an answer to what Brexit actually means. And they are also no clearer as to how they can have a say in how that question is answered.

To date there have been three stages to Brexit. The first was ideological: an ever-rising euroscepticism, rooted in a feeling that the costs the compromises working with others require were not comparable to the benefits. It oozed out, almost unnoticed, from its dormant home deep in the Labour left and the Tory right, stoked by Ukip to devastating effect.

The second stage was the campaign of that referendum itself: a focus on immigration over-riding a wider debate about free trade, and underpinned by the tempting and vague claim that, in an unstable, unfair world, control could be taken back. With any deal dependent on the agreement of twenty eight other countries, it has already proved a hollow victory.

For the last few months, these consequences of these two stages have dominated discussion, generating heat, but not light about what happens next. Neither has anything helped to bring back together those who feel their lives are increasingly at the mercy of a political and economic elite and those who fear Britain is retreating from being a world leader to a back water.

Little wonder the analogy most commonly and easily reached for by commentators has been that of a divorce. They speculate our coming separation from our EU partners is going to be messy, combative and rancorous. Trash talk from some - including those in charge of negotiating -  further feeds this perception. That’s why it is time for all sides to push onto Brexit part three: the practical stage. How and when is it actually going to happen?

A more constructive framework to use than marriage is one of a changing business, rather than a changing relationship. Whatever the solid economic benefits of EU membership, the British people decided the social and democratic costs had become too great. So now we must adapt.

Brexit should be as much about innovating in what we make and create as it is about seeking to renew our trading deals with the world. New products must be sought alongside new markets. This doesn’t have to mean cutting corners or cutting jobs, but it does mean being prepared to learn new skills and invest in helping those in industries that are struggling to make this leap to move on. The UK has an incredible and varied set of services and products to offer the world, but will need to focus on what we do well and uniquely here to thrive. This is easier said than done, but can also offer hope. Specialising and skilling up also means we can resist those who want us to jettison hard-won environmental and social protections as an alternative. 

Most accept such a transition will take time. But what is contested is that it will require openness. However, handing the public a done deal - however well mediated - will do little to address the division within our country. Ensuring the best deal in a way that can garner the public support it needs to work requires strong feedback channels. That is why transparency about the government's plans for Brexit is so important. Of course, a balance needs to be struck with the need to protect negotiating positions, but scrutiny by parliament- and by extension the public- will be vital. With so many differing factors at stake and choices to be made, MPs have to be able and willing to bring their constituents into the discussion not just about what Brexit actually entails, but also what kind of country Britain will be during and after the result - and their role in making it happen. 

Those who want to claim the engagement of parliament and the public undermines the referendum result are still in stages one and two of this debate, looking for someone to blame for past injustices, not building a better future for all. Our Marmite may be safe for the moment, but Brexit can’t remain a love it or hate it phenomenon. It’s time for everyone to get practical.