Q3. Has the Euro experiment failed?
Zheng Hao. Hongwen School Qingdao Campus.
Established in 1993, the EU was initially created to curb and prevent political turmoil between
European countries by tying their hands with trade links and greater integration - declaring war
would inflict harm upon one’s opponents and oneself simultaneously. However, the EU has
progressed since the days where its main goals were to maintain peace. Nowadays, the EU
consists of 27 member countries and is the largest trade bloc in the world, boosting of a highly
competitive market economy with price stability, strong trade links, progressive social goals, and
sustainable economic success (European Union, 2021). With a nominal GDP of 17 trillion U.S.
dollars in 2020, the European Union is the third-largest economy in the world (International
Monetary Fund, 2020).
This remarkable experiment - one that has given hope to the possibility of a monetary and
economic union - still needs to be further examined to test for its ability to endure the stress and
challenges that our global economy faces. In the following essay, the extent of the EU’s success
will be discussed by assessing its impact on the economic performance of member countries,
changes in bargaining power, the effects of a common monetary policy, and the possibility of
moral hazard.
The first factor to be considered is the EU’s impact on economic performance. The EU could
improve the performance of its member countries by stimulating economic growth, improving
living standards, and reducing the unemployment rate.
The EU stimulates trade between member countries, allowing the proportion of trade to
increase from 26% of total GDP in 1993 to 43.9% in 2020 (The World Bank, 2021). At the same
time, the value of its export had increased from 1.7 trillion dollars to 7.1 trillion dollars (The
World Bank, 2021), which subsequently increases member countries’ growth rates by
approximately 1%. Economic growth also improves the living standard of citizens in the member
countries, where their citizens enjoy a GDP per capita that is 12% higher than if their countries
were not in the EU (Campos, Coricelli, Moretti, 2014).
Moreover, more liberal immigration policies between EU member states also alleviate
unemployment by supporting geographical mobility (Pettinger, 2017). Between 2010 and 2017,
the unemployment of the EU fell by an average of 30% in both home and host countries,
exhibiting the great mutual benefits yielded by greater mobility of resources. For example,
popular destinations such as Germany and the UK hosted 44% of the long-term mobile workers in
2017 and saw their unemployment fall by 51% and 47%, respectively, much larger than average
(European Parliament, 2019).
Yet, different countries may benefit differently. In 2018, Germany contributed EUR 17.2 billion
more to the EU than it received, whereas Poland received 11.6 billion Euros from its participation
in the EU. However, Germany still benefits as the single market has increased the average
incomes of Germans by over 1,000 Euros, above the EU average of 840 Euros (Buchholz, 2020).
Moreover, as a trade bloc, the EU could also maximise its bargaining power with non-member
countries to secure more favourable terms-of-trade, further benefiting member countries. The
use of unanimity voting, where all states have to concur for legislation to be passed, acts as an
effective way to pressure trade partners into proposing more favourable conditions. Afraid of
being rejected and walking away with nothing, trade partners may be willing to forfeit certain
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benefits to woo all member states into agreeing.
Thus, the negotiation outcome will reach a Nash bargaining solution and achieve Pareto
efficiency (Figure 1). Allocative efficiency would be reached, allowing both the EU and its trade
partners to receive the largest possible benefit given the choice of the other (Meunier, 2000).
Figure 1: Nash bargaining solution
(Gerding, 2004)
A case in point is the Blair House Agreement between the EU and the US. The US aimed to
eliminate EU trade protection whereas the EU members hold different opinions. The main
contributors to Common Agricultural Policy, such as Great Britain, agreed to eliminate protection
whereas the main exporters, such as France, hoped to maintain the protection to protect its
domestic farmers. The negotiation first reached an agreement to eliminate protectionism, yet
France, uncontented with the negotiation result, emphasised the unanimity rule and forced a
renegotiation. They threatened the US with the possibility of terminating the agreement,
consequently forcing the US to allow EU countries to impose procedures against unfair
competition. This agreement favored the conservative members by protecting their trade
without disadvantaging other members (Meunier, 2000).
Unfortunately, just as there are both sides to a coin, the EU is not without its own set of
problems. In particular, moral hazard and the limitations of common monetary policies could
jeopardise the stability of the EU.
A critical flaw in the implementation of the EU is its attempt to encourage further monetary
and economic integration through the introduction of a common currency - the Euro. Though not
all member states engaged in this transition, those that did face strict limits on their monetary
policy. The implementation of the same policy under different economic situations threatens the
ability of these countries to solve their economic problems, putting them under monetary stress,
which is the difference between the optimal interest rate for that country and the interest rate
set by the European Central Bank. For example, the interest rate in Germany should have been
0.6% lower due to its lower inflation and growth rate, yet it had to adopt a relatively high interest
rate, debilitating its economy. On the contrary, the interest rate in Ireland should be 2.8% higher
due to the persistent higher inflation expectation (Sturm, 2008), which could result in rapidly
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increasing costs of living if a common interest rate were used.
Participation in the EU could also breed moral hazards, where individual countries takes
greater risks as they gain the full benefits but do not have to bear the full costs of their actions.
This is especially evident in the continuous accumulation of debt by some members, with the
belief that the European Central Bank will come to their rescue if things were to spiral out of
control (Pettinger, 2019).
Due to debt mutuality and the lack of enforcement of rules, such as the Maastricht Treaty
convergence criteria, member countries have incentives to overspend. This could be represented
by a game theory model (Lane, 2012). An EU member, represented by Member A, can choose
either to borrow or refrain, yet the payoffs show that borrowing would always offer a larger
payoff than refraining as the political party in power could attract greater support due to a boost
in short run spending. The payoff of borrowing is also larger when the default is covered by the
EU, as the country would face lower risks of economic instability. Therefore, borrowing is the
dominant strategy for Member A. For the EU, the payoff from covering the debt is always higher
as it avoids the subsequent financial contagion (Richards-Shubik and Glover, 2013). Hence,
covering Member A’s debt is EU’s dominant strategy. This will result in a Nash Equilibrium of
(borrow, cover the debt), encouraging overborrowing and overspending by members.
Figure 2: Game matrix in the Euro debt crisis
To contextualise this analysis, we can examine Greece’s behaviour leading up to its default
(Lane, 2012). Due to its fiscal profligacy, Greece generated a large amount of debt from wasteful
and excessive spending (Picardo, 2021). Then, in 2009, the global financial crisis increased the
cost of borrowing, making Greece unable to service its debt. As Greece’s default imposed
significant burdens on the EU, the EU provided it with EUR 80 billion to mitigate its crisis (Council
on Foreign Relations, 2021). This illustrates that the Nash Equilibrium holds in reality and that
moral hazards leave tangible and pernicious effects on the EU.
However, the problem of moral hazard could be alleviated. The key is to change the dominant
strategies of the member countries by changing their payoffs (Lane, 2012). The EU could build a
credible reputation for punishing countries that default, such as expelling them from the Union.
This would reduce the payoff of excessive borrowing for member states, making it a rational
decision to choose to refrain. At the same time, the preference of the EU is unchanged, such that
the EU still provides aid to countries who have made efforts but are unable to support their
economy due to the external factors. This will allow a new Nash Equilibrium of (refrain, cover the
debt) to be achieved and reduce the burden on the EU.
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Figure 3: New game matrix to eliminate moral hazard
To conclude, despite the problems within the EU, it has not failed. In fact, its great
contributions to trade, mobility, and efficiency make the Euro experiment a success; by
addressing its problem of moral hazard through more stringent membership policies, the EU can
hope to alleviate its current drawbacks while preserving its advantages. Perhaps, the increase in
the number of member countries and the reluctance of countries to forfeit their membership is
prime proof that the EU has not failed - instead, the EU simply needs to augment its current
measures to enhance this phenomenal economic and monetary union.
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