When the Euro was introduced, many analysts predicted that centralizing monetary policy over such an economically diverse area would make the common currency unsustainable and prone to financial collapse.  Why they were right, why they’re being ignored, and what must be done about it.

In 1999, when the Euro was introduced into circulation, economists were divided as to whether or not the monetary union would be a lucrative alternative to the patchwork of national currencies that had covered western Europe up to that point.

On the pro-integration side of the spectrum, economists posited several reasons for their support of the Eurozone.  Among the justifications was the fact that individual states would no longer be able to competitively devalue their own currencies at the expense of the EU as a whole.  At the same time, the cost of exchanging currencies would be completely mitigated, as would much of the risk of investment across European borders.

The Eurozone dissenters, on the other hand, advanced a series of arguments roughly based on the economic theory of the “Optimal Currency Area” (OCA), coined by economist Robert Mundell.  According to the principles of the OCA, a few quantitative preconditions exist for nations before they can efficiently share a common currency.   Included in these preconditions are labor mobility, capital mobility, fiscal integration, and the similarity of business cycles throughout the region.  As the European Union has grown increasingly integrated, capital has begun to flow freely across national boundaries, while labor has proved to be a bit more stubborn.  Fiscal integration is limited, but existent and continually expanding through risk-sharing mechanisms such as the European Financial Stability Facility (EFSF).  Business cycles in the Eurozone, however, are in no way synchronized.

European currency unionization has always had these theoretical pros and cons.  In practice, however, the implementation of the common currency at first seemed to be a resounding success.  It was when the PIIGS started to buckle under their own weight in 2008 that the logic of the Eurozone dissenters exposed the inherent weaknesses of the union.  In fact, the underlying problems that the Eurozone faces now are, by and large, exactly those problems that original skeptics had predicted.

What does Finnish Lapland and the Mediterranean Coast have in common?: Centralized economic policy

At the center of the skeptics’ arguments was the  OCA belief that a common currency zone can only function when there is a consistent business cycle throughout the region.  The Eurozone can hardly be said to meet this condition.  Finnish Lapland, after all, does not grow and shrink at the same rate as Mallorca.

How is this violation of the OCA relevant? It comes down to this: since the advent of the Euro, monetary policy has been, out of necessity, centralized. Interests rates and all other monetary instruments are now vested in the European Central Bank (ECB), which can basically be viewed as a slightly less powerful European equivalent to the Federal Reserve.  By controlling the money supply, central banks strive to jumpstart stagnant economies, or pop speculative bubbles in economies experiencing unsustainable growth.  In 2007, before the financial meltdown, Spain, Greece, and Ireland were all experiencing massive real estate speculation that fueled growth in their increasingly unproductive economies.  Directly after the introduction of the Euro in these countries, borrowing and consumption had skyrocketed to unsustainable levels.   To make matters worse, national governments had just been stripped of their abilities to make corrective actions through the adjustment of interest rates.  Meanwhile, the rest of the Eurozone was widely experiencing relatively modest, stable, export-led growth.  When the market bubbles burst in 2008, the speculation-based economies in the PIIGS were sent into a downward spiral that the necessarily universal policies of the ECB failed to even partially mitigate through monetary policy.  The effects of this failed monetary policy were especially acute in the cushy mixed economies of southern Europe, where needed austerity measures in the public sector added to the private sector woes.  In mid-2007, directly preceding the financial crisis, booming, unsustainable economies such as Ireland and Spain had been operating under significantly lower interest rates than those of the United States, despite growing at a much quicker pace and in a much more speculatively based manner.  This does not represent a policy failure by the ECB.  It represents a structural problem within the Eurozone, in which the central bank is charged with the impossible task of setting interest rates for widely divergent economies.  As the theories of the OCA had forewarned around the turn of the millennium, a lack of business-cycle cohesion throughout a currency union can and will have disastrous consequences.

It is inconvenient for EU leaders and fervently pro-European analysts to examine the flaws of centralized monetary policy, even though this issue has always been central to the economic debate.   The preservation of the Eurozone is seen by many as a  vital component to the unity of the EU, and thus continued fiscal integration is often seen as a way to save the Euro while fending off the creeping Euroskepticism that has begun to slowly take root on the continent.  As a result, politicians and political economists have found it easier to create ever more complex means of fiscal integration in the Eurozone.  These solutions will always be overshadowed, however, by the fact that monetary policy is and always will be severely ineffective over such a diverse economic area.

Despite these flaws in the Eurozone, dreams of currency unionization need not be scrapped altogether.  Germany could easily share a currency with relatively stable countries such as Austria, Luxembourg, and the Netherlands.  Likewise, France and Italy could be arguably decent candidates for a small-scale monetary union if they worked at it.  The scope of the currency union, however, must be scaled back or divided up into areas that share business cycles in at least a basic sense.

It’s time to stop ignoring the economic debates that sprung up upon the proposition and introduction of the Euro.  Common currencies are not meant for universal and expanding application; in the end, as the OCA implies, they must be separated into sensible, logical economic units, even if this sensibility comes at the expense of continued European integration.  Perhaps just as important as the theory behind the Eurozone, however, will prove to be the practical ability of EU leaders and policymakers to separate into independent categories, the cold rationalism of the dismal science and the qualitative principles of European unity.

Yet over a year later, the story of America’s current economy is one of institutional continuity. Sustained by taxpayer aid, independent firm Goldman Sachs continues to issue stratospheric bonuses, while major automaker GM emerges from bankruptcy less debt-laden but not necessarily more nimble. Consensus regulatory reforms, whether regarding shareholder influence on executive pay or constraints placed on banks , retain a great deal of deference towards financial institutions’ instincts for self-interest. Calls for the Federal Reserve to take a more activist role are rebuffed by experts who emphasize its traditional institutional function, that of overseeing monetary policy. And the mantra of “green jobs” comes in for criticism as mere economic window-dressing, an example of political interests promoting an agenda that cannot be institutionally sustained within the economy.

Meanwhile, whether the economic crisis has redefined the role of our home institution – Harvard University – in the financial system remains unresolved. We sent fewer graduates to Wall Street last year than in previous ones, but opportunities to enter finance were also scarcer. And we cannot yet know whether history will view our many professors-turned-policymakers in Washington as bold innovators, or as modest stabilizers.

The question, of course, is whether the government was so quick to tie achieving economic recovery to protecting institutions that it missed the opportunity for “challenging current conceptions,” as Shaw put it, about how the economy ought to function. On the one hand, “creative destruction” of companies and financial structures sounds more appealing before it throws lives into chaos. On the other hand, as the stock market rebounds but unemployment enters double digits, many Americans are left wondering what we have missed. In a society preoccupied both with its own stability and its sense of progress, such dueling concerns are not easily reconciled.

With the spotlight on the Federal Reserve in the wake of the financial crisis, the Obama administration and Congress have begun debating the Fed’s role in overseeing and regulating the financial sector. Among President Obama’s July recommendations for reform was an expanded role for the Fed, including oversight and expansive regulatory power over giant financial firms and systemic risk. Fed Chairman Ben Bernanke, in his Oct. 1 testimony to the House Financial Services Committee, echoed the White House’s desire for a broader regulatory mandate for the Federal Reserve. Yet while Congress agrees on the need for enhanced oversight and regulation in the financial sector, its concern with a perceived lack of transparency and accountability at the Fed has made it wary of expanding its powers.

Indeed, while there seems to be a remarkable consensus within Washington about the changes needed to fix the current regulatory system, experts and various branches of government differ on how best to achieve these reforms, and what role the Fed should play. In this debate, the ongoing disputes between Congress and the Fed over transparency and accountability are distracting from what experts see as the larger concern: ensuring that the Federal Reserve maintain its independence and focus on monetary policy.

New Roles for the Fed

The Fed plays an important role in times of crisis. Vincent Reinhart, former director of the Federal Reserve Board’s Division of Monetary Affairs, believes the Fed is uniquely situated to act quickly under these conditions. “There are many situations with no possibility for immediate action by Treasury or Congress, so it is appropriate for the Fed to act,” he explained to the HPR. However, the Fed’s involvement must be time-limited so as not to undermine its primary long-term goal of executing sound monetary policy. Reinhart argued that the Fed should only hold a loan on its balance sheet for a short while, perhaps a month or two, and then should transfer liability to the Treasury. Furthermore, Reinhart continued, Treasury should hold the loans because it is ultimately responsible to Congress, and Congress alone should have the power to determine whether to put taxpayer dollars at risk. Concerned about expansive Fed lending capabilities with little oversight, he maintained that, “Congress needs to be brought back into the deal.”

While these concerns over power and accountability dominate the current debate about the future of the Fed, a larger concern looms: whether expanded powers for the Fed would undermine its ability to carry out its monetary policy responsibilities. Alice Rivlin, the first director of the Congressional Budget Office and a former Federal Reserve Governor, insisted to the HPR that, “The main job of the Federal Reserve is, and should be, monetary policy.” While she believes the Fed is well equipped to look for systemic risks, and could successfully take on an expanded role, she is thus wary of giving it new tasks as a consolidated regulator.

Putting Monetary Policy First

Jon Faust, an economist at Johns Hopkins University, thinks along similar lines. He recognizes the importance of the Federal Reserve in times of crisis, but noted to the HPR that, “Most of the time, we need the Fed to run sound monetary policy. History has shown that can be a politically sensitive job, so the most important thing in any reform is to make sure we don’t threaten the independence of the Fed to conduct normal monetary policy during non-crisis times.” Reinhart concurred, worrying that, “Monetary policy is too important to risk trading off to other goals, and if you give the Fed too many functions, it, Congress, and the public will be confused about how it should balance them.”

So, while the debate in Washington about the future of the Federal Reserve centers on questions of blame for the financial meltdown, concern over a lack of Congressional oversight, and political jockeying for power between the branches of government, the key issue remains underappreciated. Lawmakers and government officials would do well to focus more on ensuring that the proposed reforms protect the Fed’s ability to set sound monetary policy, and do not sacrifice its main purpose for secondary roles of consumer protection and the regulation and oversight of financial institutions. With a ballooning deficit and real concerns about inflation, the Fed needs to be able to focus on fulfilling its principal duty.

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Over the past month, the U.S. Congress has held a series of hearings to debate the Obama Administration’s proposal to overhaul the American financial regulatory structure. The fates of the SEC, CFTC, and other regulators have been discussed and the failures of consumer protection railed upon. The debate, though, has not yet satisfactorily answered an important question: What are the implications of placing consolidated supervisory authority for the most systemically important banks and non-banks in the Federal Reserve?

In other words, should the Fed be fat or skinny? I believe it should be skinny.

Senate Banking Chairman Chris Dodd himself told the Fed chair earlier this year, “Chairman Bernanke, I’d say your plate is full. As this Committee works to modernize our nation’s financial regulatory structure, the question is whether we should be giving you a bigger plate—or whether we should be putting the Fed on a diet.”

Simply put, a fatter Fed could lead to regulatory “capture” as it forms a cozy relationship with large financial firms, and possibly lead to looser monetary policy to benefit struggling banks. A skinnier Fed could focus more on monetary policy, and leave regulatory responsibilities to an efficient, consolidated supervisor of all banking, securities, and insurance firms.

The White House proposal for a fatter Fed—to vest systemic risk regulation in the central bank—is to address the problem, as the Treasury Department white paper asserted, that “no regulator saw its job as protecting the economy and financial system as a whole.” By deeming the Fed the ultimate supervisor of the nation’s largest financial services firms—those systemically important firms that operate in the banking, securities, and/or insurance markets—the Obama Administration has decided that the central bank is in the best institutional position to ensure sound business conduct and to cooperate with other regulators around the world.

Globally, however, developed countries have moved towards skinnier central banks, stripping them of much of their regulatory mandates. As banks and non-banks have increased their global operations and activities across different financial markets, they have generally preferred consolidated supervision; it’s more efficient, effective, and easier to interact with a single regulator responsible for all major financial markets. Since the mid-1980s, dozens of countries have decided to form consolidated supervisors that oversee all financial firms.

Yet, as I discovered while writing my undergraduate thesis, U.S. policymakers do not face the same pressures to consolidate supervision and regulation. Foreign banks’ share of the GDPs of other developed countries is much higher than in the United States. A higher level of internationalization in a country’s financial sector means politicians worry about losing firms to other countries. The U.S. does not face the same competitive pressures because the domestic financial services industry is so large and deep. Moreover, the U.S. financial sector is not as highly conglomerated; the proportion of large, interconnected firms relative to our GDP is less than the conglomeration witnessed in many other developed countries.

But, a severe crisis makes options available that might not otherwise be considered. Due to the federalist political system, the benefits of regulatory arbitrage—playing federal and state regulators off each other—seem to be particularly large in the U.S. And it is precisely these large, interconnected firms, such as Citigroup, Goldman Sachs, and Bank of America, which are most important to the stability of the global financial system because of their size and the reach of their operations.

An efficient, consolidated supervisor of all financial services firms would make sense for the United States. A department of the supervisor could primarily focus on systemically-important firms, doing the job now proposed for the Fed. Banks and non-banks would be better able to understand rules and regulations coming from a single supervisor. Distinctions on the cost of compliance and regulatory burden could be made to lessen the requirements for community banks and credit unions. Pooling financial regulatory expertise would increase information-sharing about risk across the system.

Yet, Congress seems to be hewing closely to the Administration’s proposal. What are the consequences of a fatter Fed? As the regulator of huge banks and non-banks, the Fed would be drawn into ever-closer relationships with them. In the past, the Fed has been a useful convener of the nation’s largest financial players, as in the New York Fed’s handling of the Long-Term Capital Management (LTCM) collapse in 1998. It proved the usefulness of this convener role again last fall when bringing Wall Street together to prevent a collapse of global finance. Mindful of his actions, Bernanke has rightly expressed outrage that firms had to be bailed out on the backs of taxpayers. After all, these are extraordinary times.

In ordinary times, though, a fat Fed as systemic risk regulator may have an even cozier relationship with large firms—a relationship that politicians could fear and smaller banks may resent. Across the Atlantic, for much of its history, the City of London enjoyed a wink-and-nod relationship with the Bank of England. The fear of firms’ “capturing” the central bank is one important reason that many developed countries decided to create consolidated financial supervisors instead.

Bernanke defends a fatter central bank, countering that the Fed’s expertise, daily monitoring of markets, and relationships with the banking sector make it the most effective regulator of the country’s largest banks and non-banks. These are indeed significant positives.

But, regulatory “capture” of the Fed could influence its monetary policy making. As David Singer and Mark Copelovitch find in a study of 23 industrialized countries from 1975 to 1999, inflation rates are significantly lower in countries where the (skinnier) central bank does not have regulatory responsibility. (This finding applies to countries like ours with floating exchange rates and large domestic financial sectors.)

Bernanke and Geithner have testified that the Administration’s systemic risk regulatory proposal is only an incremental extension of the Fed’s current supervisory authority. (It’s just one more cookie!) They would likely add that countries with central banks without a regulatory mandate, such as England, are experiencing financial crises just as bad as or worse than ours. Notably, their statements only sometimes discuss the underlying huge budget and trade deficits and exceeding loose monetary policy that enabled the crisis.

This question of the Fed’s institutional fitness has not been answered yet. It seems that Congress has taken the Administration, on face value, that the Fed is in the best position to supervise systemically important firms. But, a viable alternative exists: a skinnier Fed focused on monetary policy working independently of a national-level consolidated supervisor of all financial services firms.