Master programme in Economic History
The Euro, Theoretical Expectation versus Economic
Reality?
Jonathan Pike
jonathan.pike.709@student.lu.se
Abstract: The euro was launched to great fanfare as a physical currency in 2002 but the very
idea of European Economic & Monetary Union (EMU) was and continues to be a
controversial and hotly debated topic. Nine years since that date, this paper revisits the debate
that took place in the lead up to the Euro and the theoretical benefits and costs that were
highlighted at that time. It aims to critically analyse the track record of the single currency to
see whether such costs and benefits have been borne out in the historical record. The paper
argues that the Euro has failed to have the large trade and price convergence effects that were
theorised. In contrast, many of the theoretical costs that were pointed to can be seen in the
Euro’s history as the European Central Bank followed a monetary policy that definitively
failed to suit all its different members and the currency has been a source of asymmetric
shocks and trends. With previously booming periphery countries facing huge debt problems
and deflationary pain, the EMU project stands at the crossroads. This paper finds that
although a break up is very unlikely, steps must be taken to make the project work more
optimally.
Key words: Euro, Eurozone, Economic & Monetary Union
EKHR11
Master thesis (15 credits ECTS)
June 2011
Supervisor: Lennart Schön
Examiner: Jonas Ljungberg
1
Contents
1. Introduction: ............................................................................................................... 3
2.1. The OCA theory:..................................................................................................... 4
2.2. OCA and the Eurozone: ...................................................................................... 5
3. Theoretical Benefits of the Euro: ............................................................................... 6
3.1. Full EMU will increase trade: ............................................................................. 6
3.2. The promise of price transparency...................................................................... 7
3.3. The Euro will help decrease Asymmetric shocks: .............................................. 8
3.4. Inflation discipline and Commitment Gains from it: .......................................... 9
4. Theoretical Costs of the Euro: ................................................................................. 10
4.1. One size does not fit all:.................................................................................... 10
4.2. The Euro and asymmetric shocks: .................................................................... 11
4.3. Lack of adjustment mechanism to asymmetric shocks ..................................... 12
4.4. Loss of devaluation as an instrument of economic policy: ............................... 13
5. The Euro and the historical record: .......................................................................... 13
5.1. Has EMU increased trade?................................................................................ 14
5.2. Has EMU brought price transparency? ............................................................. 16
5. 3. ECBs Inflation performance and ‘One size does not fit all’: ........................... 18
5.4. The Euro, asymmetric shocks and divergences: ............................................... 22
5.5. Lack of adjustment mechanism to asymmetric shocks: .................................... 25
5.6. Loss of devaluation and the debt issue: ............................................................ 25
5.7. Unpopularity of the single currency: ................................................................ 27
6. The Future of EMU:................................................................................................. 28
6.1. The Breakup of the Euro Area? ........................................................................ 28
6.2. Redressing Eurozone fragility........................................................................... 30
7. Conclusion: .............................................................................................................. 33
2
1. Introduction:
The objective of this paper is to analyse the Euro, otherwise known as EMU (Economic and
Monetary Union) to see whether the theoretical costs and benefits highlighted in the lead up
to the inception of the currency have been borne out by the historical record. One can argue
that over 12 years after the Euro was first introduced to financial markets and 9 since its
physical introduction sufficient time has passed with the common currency to pass judgement
on it. Furthermore, the fact that the Euro seems to be in trouble, with some questioning its
very existence, due to the instability on its periphery, the timing of this study is particularly
pertinent.
The paper develops as follows. Before turning to the core issues, the Optimal Currency Area
(OCA) theory, a pioneering work on the costs and benefits monetary unions, is reviewed and
its role in the setting up of the Euro’s institutional and policy framework examined. It is
argued that the theory was largely ignored and instead of focusing on the factor mobility that
was at the OCA’s heart, the Maastricht treaty instead focused on nominal convergence.
The third section outlines the theoretical benefits that were expected from the single
currency. Firstly it was argued that through the elimination of transaction costs and exchange
rate uncertainty, the Euro would increase intra European trade. Although the European
Commission itself did not attempt to quantify such an increase, one paper in particular seen as
a key study at the time, argued that the trade gains would be very large indeed. Secondly,
through greater price transparency and the ‘law of one price’ a narrowing of intra Euro
member price differentials was expected. Thirdly, there was evidence at the time that
European business cycles were becoming more synchronized and this was a process that some
argued would continue with the single currency with even greater trade integration. This
would reduce the chance of asymmetric shocks which affect some members more than others
and it was hoped that the EMU’s fiscal framework would contribute to Euro macroeconomic
stability. Furthermore, it was argued that by anchoring to a credible monetary authority, the
European Central Bank and countries with a low inflation record, member states with
historically high inflation would have commitment gains brought by inflation discipline.
The fourth section highlights the key theoretical costs that were outlined in the lead up to
EMU. Firstly, it was argued that due to business cycle differentials, with one country or group
of country growing faster than others, the ECB would have a ‘one size does not fit all’
problem in the conduct of its monetary policy. Linked to this was the so called ‘Walters
Critique’ which argued that common monetary policy would be more expansionary in
countries with high inflation rates and contractionary in countries with low ones. Secondly, it
was argued that in the absence of political union that the Euro may actually be a source of
asymmetric shocks through member states own budgetary policies. Moreover, in the event of
an asymmetric shock with diverging economic growth within the Eurozone, it was contended
that Europe lacked the institutional and labour market flexibility, creating an adjustment
problem. Lastly, some bemoaned the loss of the devaluation policy option although this was
seen as a benefit to others.
The fifth section weighs such theoretical considerations against the historical record. It is
argued that the theoretical benefits have largely failed to materialise whilst the costs have
been borne out. For, predictions of large increases in trade were found to be wide of the mark
and although some studies have found the Euro to be the source of substantial trade increases,
these studies have been criticised for their methodological weakness, for example by not
taking into account the effect of the single market over time. Secondly, and generally
accepted by the literature, is that the Euro has not brought in a spate of price convergence.
3
Although there may be many reasons for this development, it does not change the fact that a
promised benefit has not happened.
Also, one can argue that the ECB’s monetary policy did not fit all as periphery PIGS
(Portugal, Ireland, Greece & Spain) nations overheated and others such as France and
Germany experienced slow growth. The looser than optimal ECB monetary policy
contributed to the periphery’s boom and the reality of the ‘Walters critique’ can be seen in the
asset price bubble of such nations. Furthermore, boosted by tax revenues from such a bubble
the PIGS countries engaged in a public spending spree that the EMU’s fiscal framework
allowed. Large-scale wage increases and a loss of competitiveness were the result. Such
profligacy can be seen to have been a source of asymmetric shocks as when the bubble burst
these countries faced a debt crisis and many have had to be bailed out by the European Union
and International Monetary Fund. The lack of labour mobility can also clearly be seen in the
Eurozone today as unemployment is stubbornly high in the periphery and falling in Germany
for example. Moreover, with the lack of the devaluation tool and unable to issue debt in their
own currency, these countries are finding it hard to repay their debts and restore
competitiveness. With the Eurozone in such a state it is no surprise that the single currency’s
approval ratings have declined.
This state has led some to openly contemplate the prospect of a Euro breakup. However,
although a country determined to leave EMU could probably do so, section 6 argues that the
legal and technical barriers are huge and would be incredibly costly to overcome. EMU is
indeed irreversible. Therefore, it is better to focus on ways that the Eurozone can function
more optimally. Section 7 argues that a fully fledged fiscal union with automatic fiscal
transfers between member states would be the best way of solving Eurozone fragility but that
this looks politically impossible. Nonetheless, there are other more realistic steps that could
be taken. A more permanent financial support mechanism is a step in the right direction but it
is not in itself enough to offset the effects of the asymmetric trend development in recent
years. National fiscal councils can play a constructive role in tempering fiscal profligacy and
a joint issue of Eurobonds would help a country against a future debt crisis and bad
equilibrium. Also, although linguistic and cultural barriers to labour mobility are likely to
remain high, opening up labour markets by making them more flexible may nonetheless help
alleviate unemployment in stagnant regions. Lastly, the ECB should allow Greece and
potentially others to restructure debt as this will help the Eurozone’s stability in the long term.
It remains to be seen whether European leaders can agree on such sensible proposals but the
clock is ticking.
2.1. The OCA theory:
Mundell’s 1961 OCA (Optimal Currency Area) theory has had a central role in monetary
union debate and today, as in the past, a lot of the work on multinational currencies and their
economic pros and cons are based on the theory. As such pro’s and con’s are evaluated
extensively in this paper, it is worth outlining the key logic of such a theory and also its role
in the creation of EMU.
The central question asked by Mundell in his theory is whether countries should ‘allow each
national currency to fluctuate, or would a single currency be preferable’1 despite losing two
out of the three basic macroeconomic policy tools in the form of monetary autonomy and the
exchange rate.
1
Mundell, (1961) ‘A Theory of Optimum Currency Areas’ American Economic Review, 51 (6): 657
4
The answer Mundell gives is that such a common currency area will be desirable if certain
conditions are met. Firstly, it will be preferable if all members of the union face common
symmetric shocks that treat them equally and if asymmetric shocks that affect one or few
members more than the rest are limited in both time and duration. Secondly, if countries in
the union feature high co-movement of economic variables vis a vis each other and thirdly if
there is high factor mobility, particularly labour, that is flexible at the micro level. Mundell
(1961) saw gains in the form of increased trade due to less transaction costs and increased
transparency and comparability of costs and prices. Nonetheless, if countries face dominating
asymmetric shocks and the factor mobility between member states is poor, they should likely
preserve their own currency.
Mundell later updated his OCA work in 1973 with the argument that the loss of the
exchange rate as a policy tool should not be considered a drawback as ‘it was no longer
considered an affective tool for adjustment, as the central bank should be concentrating on
price stability and not trying to fight market forces’2. For, the exchange rate, rather than an
important policy tool had in itself become an important source of asymmetric shocks.
Furthermore, by eliminating such exchange rate risk this increases cross national asset
diversification which ‘mitigates the impact of asymmetric shocks on the single country,
making the desire for country’s individual monetary and exchange rate policies less
pressing’3.
However, despite this modification, it is still Mundell’s original theory which economists
usually measure any currency union against and as De Grauwe (2006) notes ‘as some Euro
countries have suffered competitiveness losses since the introduction of the new currency,
Mundell’s 1963 ideas are coming back into fashion’4.
2.2. OCA and the Eurozone:
As Wyplosz (2006) has argued ‘the view that exchange rate volatility is harmful to trade
integration has been a mainstay of European official thinking ever since the 1940’s’5. Since
that time there were, therefore, several attempts to fix such exchange rates within certain
bands to reduce such volatility, most notably with the 1972 ‘Snake’ system and the launch of
the European Monetary System in March 1979. Nonetheless, it was not until the late 1980s
with the collapse of the Soviet Union, the declining US role in the European continent and
likely German Unification that a new impetus was created for the further deepening of
European political and economic integration. France extracted German commitment to future
monetary union in exchange for such unification and backed by the continents two
powerhouses, the result was the so called Maastricht treaty which formally established the
concept and basic characteristics of Economic and Monetary Union (EMU). It is therefore
useful to see how the treaty dealt with the OCA theory.
In practice, it paid scant attention to it. In the European Commission report ‘One Market,
One Money’, outlining justification for monetary union, it argued ‘the OCA approach
provides useful insights but cannot be considered a comprehensive framework in which the
2
Mundell (1973) quoted in Chang, M. (2009) Monetary Integration in the European Union, Palgrave Macmillan,
London, p64
3 Rusek, A. (2008) ‘Euro: the engine of integration or the seed of dissolution?’ Agricultural economics –Czech,
Vol. 54, No. 4, p139
4 De Grauwe (2006) quoted by Chang, M. (2009), p65
5 Wypolsz, C (2006) ‘European Monetary Union: The Dark Sides of a Major Success’, Economic Policy, Vol. 21,
No. 46 p212
5
costs and benefits of EMU can be analysed’6. Indeed, as Sapir (2009) has shown, ‘whereas
OCA emphasises real convergence among the candidate countries to monetary union,
Maastricht instead insists on nominal convergence’7 and to this end focused on inflation,
exchange rates, interest rates and public finance rather than possible asymmetric shocks due
to structural differences. Wyplosz (2006) argues that the overlooking of output and
employment stability, at the heart of OCA theory was ‘arguably the monetary union’s original
sin’8.
Ignoring the OCA theory was likely due to a number of factors, chiefly because
macroeconomic shocks were seen as less likely in a monetary union and, as demonstrated
later in this paper, there was an expectation that a single currency would promote greater
business cycle symmetry. However, one must also take into account, as Rusek (2008) has
contended, that ‘it is necessary to recognise that the Euro and its existence today is much
more the result of the political will to advance European integration than the economic
logic’9. Nonetheless, it is useful to carry out an economic cost benefit analysis as ‘it gives an
idea of the price some countries will have to pay to achieve these political objectives’10. For,
the Euro was launched virtually to great fanfare in 1999 and it was hoped it would generate
large economic gains for member countries. However, sceptics were unsure of this and
instead pointed to imbalances and future asymmetric shocks. An in depth analysis of such a
debate is now looked at.
3. Theoretical Benefits of the Euro:
3.1. Full EMU will increase trade:
One of the main benefits expected from the creation of monetary union was an increase in
trade among member states of such a union. Mundell (2002) argued that ‘the basic gains from
currency unification in the international sphere stem from the extension of national free trade
areas to a wider unit. The larger the common currency area, the greater will be the gains from
trade and lending’11. The two mechanisms that were pointed to through which monetary union
could do this were fewer transaction costs and less exchange rate uncertainty. In terms of the
former, transaction costs are effectively those incurred when exchanging one currency into
another and is one of the most visible gains from any monetary union. Such costs are as De
Grauwe (1998) demonstrated ‘a deadweight loss in that they are like a tax paid by the
consumer in exchange for which he gets nothing’12. Although, savings from such costs were
expected to be in the low range, around 1% of EU Gross Domestic Product (GDP) according
to the European Commission (1990), it was argued that ‘since the reduction in transaction
costs should stimulate intra-EU trade, the overall savings in transaction costs could actually
be larger than 1% of GDP’13.
EC Commission (1990) ‘One Money, One Market’ European Economy. 44, p46
Sapir, A. (2009) ‘Panel Statement on Optimal Currency Areas’ In Mackowiak, B, Mongelli, FP, Noblet, G &
Smets, F. (eds.) The Euro at ten: lessons and challenges. European Central Bank, Frankfurt am Main, Germany,
p264 ‘
8 Wyplosz (2006) p216
9 Rusek (2008) p140
10 De Grauwe (1998) p84
11 Mundell, R (2002) contribution to Submissions on EU from Leading Academics, in Schwarz, P. (2004) The Euro
as Politics, Profile Books, London, p52
12 De Grauwe, (1998) p53
13 Gros,D. & Thygesen,N. (1998) European Monetary Integration, Longman, New York, p290
6
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6
In terms of the effect of exchange rate variability and its effect on trade, there was not an
academic consensus on such effects in the period leading up to the Euro. For, ‘exchange rate
volatility will, in fact, increase average profits under standard assumptions about profit
functions and should therefore serve to increase trade’14. However, a theoretical approach that
Euro enthusiasts pointed to was to see trade decisions along the framework of the option
theory of investment developed by Majd and Pindyck (1987)15. For, a decision to start
exporting or importing will involve investment costs, such as market research and marketing
and perhaps building new production capacity, costs that are only partly reversible and take
place over a time period. A firm may put off expanding trade due to the positive option
relating to this as the exchange rate may become more favourable, making the investment
more profitable. The firm may also wait as the exchange rate becomes unfavourable in which
case the investment can become unprofitable and should not be undertaken. The value of the
option to wait increases with the degree of uncertainty, in other words the volatility of the
exchange rate. This led some, such as Flam & Jansson (2000) to conclude that ‘uncertainty in
exchange rates therefore represent an important cost element in any decision to start
exporting, importing or investing in a foreign country’16. Monetary union would eliminate
such a cost element.
Thus, there was an economic rationale that showed that EMU was likely to boost trade but
there was little attempt to quantify such a gain until Andrew Rose (2000) presented his
econometric study that argued that such a gain would be rather large. Using cross-section data
and controlling for a number of other variables that affect trade flows (including income,
distance, trade restrictions and others), Rose found that pairs of countries which are part of a
monetary union have trade flows among themselves that were, on average 200% higher than
those among pairs of countries that are not part of a monetary union. His conclusion was that
‘Even after taking a host of other considerations into account, countries that share a common
currency engage in substantially higher international trade’17. Rose’s findings, in the absence
of other empirical studies, formed an important part of the Euro debate. Indeed even Milton
Friedman (2000) who was highly sceptical of the single currency cited the study in an
interview saying ‘if it (the Euro) has a major effect on trade, it may enable trade to substitute
for the mobility of people’18.
3.2. The promise of price transparency
Another expected gain from EMU was price transparency which was expected to contribute
to price convergence in products and services across the Eurozone. This was highlighted by
the European Commission in ‘One Money, One Market’ as that report argued ‘the addition of
a single currency to a single market will perfect the resource allocation function of the price
mechanism at the level of the Community as a whole’19. Furthermore, at the time of the Euro
cash changeover of January 2002 the ECB argued ‘the introduction of Euro bank notes and
coins increases price transparency across borders which in turn should increase the strength of
competition and, over time, reduce price level dispersion in the Euro area’20.
14
De Grauwe, (1998) p56
See Majd, S. & Pindyck, RS. (1987) "Time to build, option value, and investment decisions," Journal of
Financial Economics, Elsevier, vol. 18(1), pages 7-27
16 Flam, H. & Jansson, P. (2000), quoted in Flam, H. (2009) The Impact of the Euro and International Trade and
Investment: A Survey of the Theoretical and Empirical Evidence, Swedish Institute for European Policy Studies,
Stockholm, p77
17 Rose, AK. (2000) “One Money, One Market: Estimating the Effect of Common. Currencies on Trade”
Economic Policy 30, p27
18 Friedman, M. (2000) quoted from “An interview with Milton Friedman. Interviewed by John B. Taylor, May
2000” Macroeconomic Dynamics, 5, 2001, p128
19 EC Commission (1990) ‘One Money, One Market’ European Economy. 44, p19
20 ECB (2002) ‘Price level convergence and competition in the Euro area’, Monthly Bulletin, August 2002, p39
15
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This expected price convergence, it was argued, was based on sound economic rationale
based on the law of one price. According to that rule, the existence of national currencies can
lead to large indirect costs as it can allow firms to engage in price discrimination between
nations as consumers cannot easily evaluate and compare prices in different countries, even
with fixed exchange rates. For, ‘these artificial differences in prices imply economic losses of
economic welfare because they give a signal that is not related to the true scarcity of the
good’21. However, with the advent of monetary union, such price discrimination would be
much harder to achieve as consumers could easily compare prices. Thus, the prices of
identical internationally tradable goods at different locations would converge. Where this was
not the case risk free transactions would be possible whereby the product would be purchased
at the cheaper location and then sold on at the more expensive one, this arbitrage would
therefore even out any price differentials.
In the lead up to the Euro’s inauguration there was little empirical evidence to substantiate
the law of one price economic gain but one study that was oft pointed to was by Engel &
Rogers22 (1995) who analysed the factors that influenced price differentials of the same goods
in different locations in 14 North American cities. Their key finding was that consumer prices
were significantly more variable, by a big margin, for pairs of cities located across the US
Canadian border than for pairs of cities located within the same country, even controlling for
the effect of distance. It was thus considered that ‘borders are quite powerful in introducing
large variations in the movement prices and the fact that at borders moneys have to be
exchanged is a significant factor in explaining why markets remain segmented’23. In other
words, the different US and Canadian currencies were interpreted as a large factor behind
price differentials in those countries’ cities and thus it was expected that the different
currencies in Europe were having a similar effect.
3.3. The Euro will help decrease Asymmetric shocks:
Asymmetric shocks are defined as ‘when something unexpected happens that affects one
economy (or part of an economy) more than the rest’24. However, it was argued by some that
such shocks would not be a big problem due to increased past and expected future European
Business Cycle symmetry with EMU. For, in the lead up to the Euro, there was indeed some
evidence that European business cycles were becoming more synchronized over time. For
example, a study by Artis & Zhang (1995) found that the formation of the Exchange Rate
Mechanism (ERM) may have bred a ‘European Business Cycle’ centred on Germany. The
authors argued that ‘contemporaneous correlation shows very clearly that before the ERM
was formed, most countries business cycles were linked to that of the US and that, afterwards,
the group of ERM countries moved clearly into the German business cycle orbit’25.
Another important contribution to the literature on such an issue was provided by Frankel &
Rose (1997) who argued that, as EMU was a natural extension of the European integration
process, this would boost trade integration and business cycle symmetry. Using data covering
21 industrial countries from 1959 through to 1993 their gravity model based analysis showed
21
Gros & Thygesen, (1998) p292
See Engel, C, & Rogers (1995) "How wide is the border?," International Finance Discussion Papers 498, Board
of Governors of the Federal Reserve System (U.S.).
23 De Grauwe (1998) p54
24 The Economist, Definitions Section, Available at:
http://www.economist.com/research/Economics/alphabetic.cfm?term=assets (accessed 3rd May 2011)
25 Artis, MJ. & Zhang, W. (1995) ‘International Business Cycles and the ERM: Is there a European Business
Cycle?’ International Journal of Finance Economics, Vol 2, p1
22
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that there was ‘a strong positive relationship between the degree of bilateral trade intensity
and the cross country bilateral correlation of business cycle activity’26. With greater
integration and more synchronised cycles, the authors argued, ‘a country is more likely to
satisfy the criteria for entry into a currency union ex post than ex ante’27. Thus with European
Business Cycle symmetry having increased in the lead up to the Euro and with this process
being expected to continue, this would indicate the fading away of the most important
‘exogenous’ source of asymmetric shocks.
Furthermore, in regards to the view, that in the absence of political union, nations budgetary
decisions could by themselves create asymmetric shocks, there were grounds for optimism
that this would not be a big problem. For, the latter half of the 1990s saw a significant fiscal
consolidation and the improvement of fiscal discipline across the soon to be Eurozone
members as they sought to abide by the Maastricht conditions which would allow them to
participate in EMU. This phenomenon was supposedly enhanced by the conclusion of the
Stability and Growth Pact (SGP) in 1997 which was intended to keep deficits below 3% of
GDP and debt levels below 60% of GDP as European policy makers set up a framework to
ensure fiscal discipline.
The rationale behind such a pact was to prevent imprudent members of EMU from imposing
costs on others. For, ‘a country that allows its debt-GDP ratio to increase continuously will
have increasing recourse to the capital markets of the union, thereby driving the union’s
interest rate upwards’28 which therefore increases the burden of the government debts of other
countries. This is a typical case of a moral hazard problem as the resistance to deficit
spending is reduced and the propensity to pursue an inappropriate expansionary fiscal policy
increases.
To contain such a propensity the SGP stipulated that if a nation’s budget deficit exceeded the
3% limit an excessive deficit procedure would be triggered where the delinquent government
would be given a warning and a timeframe in which to correct for this. If this warning was not
adhered to a fine would be imposed. The SGP also contained two clauses which were hoped
to be further safeguards. The ECB was independent from political pressure (Article 108) and
was explicitly forbidden from financing members deficits directly and also a no bailout clause
(Article 103) was established so that national governments alone were in charge of their
budgets and they would be responsible for any slippage. It was argued by the European
Commission at the time that such a framework ‘makes stability orientated monetary policy of
the ECB possible while at the same time providing sufficient flexibility for national budgetary
authorities to accommodate for asymmetric shocks’29.
3.4. Inflation discipline and Commitment Gains from
it:
The Maastricht treaty established the ECB as an institution free from political interference
with price stability as its key goal. Article 105 outlined this in writing by stating ‘it is only
without prejudice to the objective of price stability that the ECB will support the general
economic policies in the community’30. Such a goal was initially defined as ‘a year on year
Frankel JA & Rose, AK. (1997) ’Is EMU More Justifiable Ex Post than Ex Ante?’ European Economic Review,
Volume 41, Issue 3-5, p760
27 Ibid, p760
28 De Grauwe (1998) p191
29 EU Commission (1997) quoted in Gros&Thygesen, p346
30 Maastricht treaty, quoted in Schwarz, P. (2004) The Euro as Politics, Profile Books, London, p38
26
9
HICP (Harmonised Index of Consumer Prices) increase of below 2%’31 but was later clarified
in 2003 to mean an inflation objective below, but close to 2% in the medium term.
Thus, with such a credible commitment to price stability, it was expected that an important
benefit of joining a currency union would be a reduction in inflation rates, particularly for
those nations that had a tradition of poor internal discipline and high inflation. Thus,
according to Alessina & Barro (2002) ‘by joining a monetary union with a credible anchor
country or set of countries, a client country eliminates the inflation bias arising from time
inconsistency in monetary policy’32. In the post-war period the German Bundesbank had built
up a reputation for promoting a low inflation environment and was regarded worldwide as the
model of a successful policy of monetary stability. The ECB was institutionally based on the
Bundesbank and given its credibility, and the fact that low inflation countries such as
Germany were seen as anchors, there were supposedly good grounds to believe the ECB
could deliver its price stability goal.
4. Theoretical Costs of the Euro:
4.1. One size does not fit all:
One of the key arguments against EMU was that regional imbalances and the fact that
different Eurozone countries will have different economic growth rates means that the
European Central Bank would set an interest rate that was not appropriate for all Euro
members. A simple example would be an expansion of demand in one country, say Germany
and a contraction in demand of another, say France, due to non synchronization of business
cycles across the two countries. In such a scenario ‘there is an output decline in France and an
increase in Germany which will most likely lead to additional unemployment in France and a
decline of unemployment in Germany’33. Furthermore, as output is booming in Germany, this
leads to upwards pressure on its price level. Thus, as Hovell (2002) highlights ‘the interest
rates need to rise in order to curtail the excess demand in Germany but fall to restore full
employment in France’34. Practically speaking, The Economist (1998) argued that ‘the ECB
has a very difficult task setting monetary policy’35 due to growth differentials between
member states pointing out that in 1997 ‘Ireland’s economy grew by 10% whereas Germany’s
grew by 2.5% strongly suggesting that Ireland needs higher interest rates than Germany’36.
Linked to this ‘one size does not fit all’ problem was the Walters critique37, named after
Richard Walter, a counsellor to Margaret Thatcher in the 1980s. For, in a unified bond
market, nominal interest rates are equalised and therefore, in practice, real interest rates are
lower when inflation is higher. Therefore with a common monetary policy the effects of this
are more expansionary in countries with high inflation rates and contractionary in countries
31
ECB (1999) Monthly Bulletin, January, p46
Alessina & Barro (2002), quoted in Silva, JMC & Tenreyro, S. ‘Currency Unions in Prospect and Retrospect’
Annual Review of Economics, Vol 2, p63
33 De Grauwe (1998) p6
34 Hovell, RB (2001) ‘The Creation of EMU’ in Artis & Nixson eds. The Economics of the European Union,
Oxford University Press, p248
35 The Economist (1998) ‘Can one size fit all’, Available Online at: http://www.economist.com/node/159074
(accessed 7th May 2011)
36 Ibid
37 See Miller, M & Sutherland, A, (1991) ‘The "Walters Critique" of the EMS--A Case of Inconsistent
Expectations?,’ The Manchester School of Economic & Social Studies, vol. 59(0), pages 23-37
32
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with low rates. As a consequence of this growing divergence can occur with inflation
increasing where it started higher and decreasing where it started lower.
Furthermore, it was expected that countries would differ with their inflation preferences and
that this introduced costs in a monetary union. Indeed on this issue, Martin Feldstein (1997)
was highly sceptical. He argued that the Euro would create a situation of incompatible policy
goals amongst member states between those that favoured reigning in inflation, such as
Germany and those that preferred higher inflation in order to keep the level of unemployment
down. According to Feldstein ‘this general conflict about the governance and character of
monetary policy would be exacerbated whenever a country experienced a decline in aggregate
demand that led to a cyclical increase in unemployment’38. Furthermore, he believed that such
‘conflicts over economic policies and interference with national sovereignty could reinforce
long standing animosities based on history, nationality and religion’39 and he thought that this
could even lead to war on the continent.
Thus, differences in Eurozone economic performance with ‘a one size does not fit all’
problem and different macroeconomic preferences were seen as serious costs in EMU.
However, as is outlined earlier, Euro proponents saw this as an unlikely problem due to the
expected synchronization of business cycles.
4.2. The Euro and asymmetric shocks:
In the lead up to the Euro there was a theoretical presumption that EMU would make
asymmetric shocks less likely due to greater integration and business cycle symmetry.
However, there were others such as Krugman (1991) and De Grauwe (1998) who felt that
EMU could actually become a source of suck shocks. For Krugman40 greater economic
integration leads to greater specialisation and regional concentration which increases the
chance of asymmetric shocks. De Grauwe, meanwhile, focused on the fact that in the absence
of political union, nation states would continue to exercise considerable sovereignty in
various important economic areas. Chiefly, they would continue to have a large degree of
discretion over their spending and tax policies. According to him ‘the fact that countries will
maintain most of their budgetary powers in a future monetary union creates the possibility
that large asymmetric shocks may occur in the union’41. For example, when the authorities of
a country increase taxes on wage income, this only affects labour in that particular country
and this will create disturbances that lead to divergent price and wage developments in that
country but do not effect the others.
Linked to this point about the lack of political union is that, from the Euro’s inception, there
was not a system for fiscal transfers between the member states. Thus, if a member country
would suffer an economic downturn, with a large fall in tax receipts and owing to this the
government would struggle to meet its spending requirements; no system was in place for the
Eurozone as a whole to alleviate such a fiscal crisis. Eichengreen (1997) stressed the failure
of the Maastricht treaty to include extensive provisions regarding fiscal federalism posed
serious problems. For him such problems could be attenuated by US style ‘interregional fiscal
transfers which limits regional unemployment differentials by offsetting a portion of the
decline in regional income and helping to relax the external constraint’42.
Feldstein, M. (1997) ‘EMU and International Conflict’, Foreign Affairs, November/December, Vol 76.
Available Online at: http://www.nber.org/feldstein/fa1197.html (accessed 25th April 2011)
39 Ibid
40 See Krugman, P. (1991) Geography and Trade, Cambridge, Mass: MIT Press
41 De Grauwe (1998) p25
42 Eichengreen, B. (1997) European Monetary Unification, MIT, p48
38
11
4.3. Lack of adjustment mechanism to asymmetric
shocks
As argued in the OCA literature, one of the key determinants of a successful monetary union
was the ability of factors of production, chiefly labour to move in response to an asymmetric
shock that affected one county or number of countries more than others. However, it was
argued that differences in labour market institutions and the historic lack of labour mobility in
the continent would not enable this to happen, introducing significant costs for EMU.
In terms of differences in labour institutions, in the event of a supply shock such as a big oil
price increase De Grauwe (1998) showed that ‘wages and prices in countries may be affected
differently, making it difficult to correct for these differences when the exchange rate is
irrevocably fixed’43. Moreover, it was argued that rigid and protected labour markets in many
European counties constrained labour mobility and Feldstein (1997) contented that ‘although
the legal barriers to labour mobility within the European Union have largely been eliminated,
language and custom impede both temporary and long-term movement within Europe’44.
Thus, whereas in theory if domestic wages and prices are slow to adjust in regions hit by an
economic slump, workers would leave such regions, alleviating unemployment problems
there in practice this development would not happen in the Eurozone leaving the country that
experienced the slump with persistently high unemployment. This was in contrast to the
United States where ‘the American heritage of immigration and national settlement makes
Americans much more willing to move internally than their European counterparts’45.
Some economists did not see this as a major problem at the time. For example,
Gros&Thygesen (1998) argued the theory that different labour institutions and lower mobility
could be a drawback was ‘misplaced’. For, ‘international labour movements in the EU have
now increased to a point where they are of an order of magnitude comparable to international
migration within member countries’46.
Nonetheless, in the lead up to the Euro, citing low labour flexibility in particular, De Grauwe
(1998) wrote that ‘there is now a broad consensus among economists who have tried to
implement the theory empirically, that the EU15 is not an optimal currency area’47. A study
by Bayoumi & Eichengreen (1997) constructed an OCA index for European countries taking
into account a multitude of variables such as nominal exchange rate variability, labour
mobility, trade linkages and output disturbances. They found that Europe was essentially split
between ‘core’ and ‘periphery’ groups. The former including Germany, the Benelux
countries, Austria and Denmark were seen as a group where shocks were highly correlated
and the speed of adjustment relatively fast. This may have been ‘because such countries have
been closely linked to the German economy for many years’48 and these were seen as a group
capable of forming a near optimal currency area. In contrast, another set of countries
including Italy, Spain, Greece, Portugal, Finland and Sweden were seen as a group with little
convergence towards EMU, where shocks were larger, more idiosyncratic and where the
speed of adjustment was lower. This group made the EU15 as a whole not an OCA and
according to Sapir (2009) would have been left ‘out in the cold if the OCA theory criteria had
43
De Grauwe (1998) p16
Feldstein, Martin, (1997), “The political economy of the European Economic and Monetary Union: Political
sources of an economic liability”, NBER Working Paper Series, no. 6150
45 Ibid, p36
46 Gros & Thygesen (1998) p310
47 De Grauwe (1998) p74
48 Bayoumi,T & Eichengreen, B. (1997) ‘Ever closer to heaven? An optimum-currency area index for European
countries’ European Economic Review 41, p766
44
12
been used instead of Maastricht’49. It is important to remember this in light of the current state
of the Eurozone which will be looked at in depth in Section 5 of this paper.
4.4. Loss of devaluation as an instrument of economic
policy:
Lastly, some economists such as Milton Friedman were critical at the prospect of EMU as
this would mean losing the ability to devalue domestic currency, in other words reduce its
value in terms of others. It was argued by Friedman (2000) a devaluation option ‘solves the
co-ordination problem when wages and prices are out of line, sidestepping the unwillingness
of workers to take pay cuts’50 as wages can be sticky on their way down during periods of
economic slumps. A devaluation could thus restore competitiveness and reduce the risk of
persistent unemployment and economic hardship in the time it takes for wages to adjust
downwards. Indeed, looking at this issue De Grauwe (1998) argued that ‘variations in the
exchange rate remain a powerful instrument to help economies to eliminate important
macroeconomic disequilibria and to make the adjustment process less costly in terms of lost
output and employment’51. For him the successful French, Belgian and Danish devaluations
of 1982-3 which helped to re-establish external equilibrium without significant costs in terms
of unemployment illustrate this point. The 1982 devaluation of the Belgian franc by 8.5%, for
example, ‘led to a rapid turnaround in the current account balance of payments and that
country’s recovery in employment proceeded at a pace that was not significantly different
from the rest of the Community after that date’52.
Nonetheless, it was argued by others like Pitchford & Cox (1997) that such devaluations can
‘quickly result in higher inflation, and are of limited usefulness to the external objective
because the higher inflation would quickly eliminate the competitive advantage that the
country would gain initially through devaluation’53. Also, it was presumed that devaluation by
one country would generate a response from others and thus ‘a generalised resurgence of
uncoordinated exchange rate policies throughout the EU, which results in widespread efforts
to improve competitiveness through a weakening of the exchange rate would achieve very
little since the share of trade with the rest of the world in EU GDP is rather low’54.
5. The Euro and the historical record:
In brief, it seems that given the great fanfare to which the Euro was introduced in 1999, it
has failed to bring the expected economic gains whilst has, in fact, been a source of instability
which threatens its very future. Firstly, although there is significant debate on the issue, one
can argue that the Euro has failed to generate the expected trade benefits. Less controversial is
the finding that expected price transparency has not led to greater convergence among
member states. Also, one can contend that some of the theoretical costs, as outlined in section
4, have happened in practice. The ECB’s one size fits all policy plainly failed to fit all,
contributing to unsustainable booms in the periphery. Furthermore, the autonomous budgetary
49
Sapir (2009) p264
Friedman, M. (2000) quoted from “An interview with Milton Friedman. Interviewed by John B. Taylor, May
2000” Macroeconomic Dynamics, 5, 2001, p128
51 De Grauwe (1998) p50
52 Ibid, p33
53 Pitchford, R, & Cox, A. (1997) eds. EMU Explained: Markets and Monetary Union Reuters, London, p132
54 Gros & Thygesen (1998) p232
50
13
decisions some states have taken, despite the Stability and Growth Pact, have also been a
source of instability. Such states now face high debt burdens and competiveness issues that
the single currency makes harder to get out of. In the face of such disappointment, it is little
wonder that the single currency has declined in popularity in recent years.
5.1. Has EMU increased trade?
An expected increase in trade was one of the main theoretical benefits derived from EMU
and indeed it was one of the key gains that countries which joined the Euro hoped for in the
face of a loss of monetary autonomy. Furthermore, the expected trade increase was meant to
deepen the integration process and increase business cycle symmetry as argued by Frankel &
Rose in 1997. To what extent EMU has fermented intra Euro trade is thus a key issue and it is
one that can only be answered empirically.
There have been a number of econometric studies that have attempted to quantify the gains
of the single currency but these took time to come through. For a number of years Andrew
Rose’s study with its 200% estimate was, in the absence of other empirical studies,
highlighted as a key source in the Euro debate. For example in Sweden, in the lead up to their
referendum on the Euro, Rose’s estimate was cited by many of those on the ‘Yes’ campaign.
On the other side of the debate, Bo Malmberg of the ‘No’ campaign provided a rebuttal to
Rose in 2003 by arguing that the reasons that Rose had come up with such a high estimate
was that ‘his research has been heavily focused on trade flows over large geographical
distances between comparatively small nations whose trade flows started at a very low
level’55. EMU however, involved bigger countries who were already fairly well integrated.
In the years since the Euro’s introduction, Rose’s methodology and findings have largely
been discredited. As Baldwin (2008) has noted, Rose’s paper suffered from some weaknesses
key of which were omitted variables that are ‘pro trade and correlated with the currency union
dummy biases the estimate upwards’56 and reverse causality in that ‘big bilateral flows cause
a common currency rather than vice versa so the high estimate reflects the impact of trade on
currency union, not the other way round’57. Finally, his model was mis-specified in that it
compared the actual trade to such a model of what trade should have been in the case of
absent common currency.
By around the 5 year mark since the Euro became an accounting currency, with data having
been accumulated in such a timeframe, studies started to come through that analysed the
effect of the Euro on European trade patterns. The first of which was undertaken by Micco et
al (2003) who adopted the gravity equation framework used by Rose to control for observable
differences between a control group of countries that were not part of the Eurozone and a
treatment group of Eurozone countries. Their results were that the currency had increased
trade among Eurozone members by between 4 and 16%. Subsequent work has attempted to
address methodological weaknesses in these authors’ work, such as the short sample period
(1992 to 2002) and the 1993 break in the trade series.
Indeed, overall there have been over 20 studies looking into the Euro effect on trade.
Although it is not a worthwhile exercise to examine each study individually, the general
finding according to De Grauwe (2009) is that the Euro has increased trade somewhat as it
Malmberg, B. (2003) ‘The yes-campaign has misinterpreted its trade guru’ Available Online at:
http://faculty.haas.berkeley.edu/arose/MalmbergE.htm (accessed 20th April 2011)
56 Baldwin, R. et al (2008) ‘Study on the impact of the Euro on Trade and Foreign Direct Investment’ European
Economy. Economic Papers. 321. May 2008. Brussels, p18
57 Ibid, p18
55
14
‘has lowered fixed and variable costs of exporting firms’58 but this increase is by far less than
the one that had been estimated by Rose in 2000. The estimates for a positive Euro effect
range from 2% in Baldwin (2006) to more than 70% in Gil-Pareja et al (2008) and the
differences in the studies largely depend on the length of the Euro period, what countries are
in the control group, the effect becomes greater by including developing countries, and on
how the gravity model is specified. In a survey on this topic, Flam (2009) has argued that the
period with the Euro should be as long as possible and this makes him focus on three studies,
concluding that ‘trade between Euro countries is higher by 10 to 30% and trade between Euro
and non countries by half as much between 2002 and 2006 due to the Euro’59.
However, many of the higher estimate studies methodology can be questioned. One of the
chief criticisms is that they have not taken into account sufficiently the effect of the single
market. As Baldwin & Taglioni (2008) have argued ‘ it is not sufficient, as some studies do,
to control for the Single Market with a time invariant dummy to capture any higher level of
trade between countries participating in the Single Market. Instead, one must control for
increasing effects of the Single Market over time’60.
Furthermore, the most recent econometric study on this issue by Silva & Tenreyo (2010) has
found little evidence of a ‘Euro effect’ on trade flows. Their analysis uses a ‘differences in
differences’ approach which is based on the comparison between trade flows for the periods
before and after the Euro was introduced for two groups of countries, those that joined the
Euro during the observation period and those that didn’t. The former is the ‘treatment group’
while the latter is the ‘control group’. In this way, their methodology is similar to that used by
Micco et al (2003) but these authors take into account limitations of that work. For example
they include a ‘Euro 12 dummy equal to 1 for the pairs for which both countries are part of
the Euro 12 group’ as this ‘controls for possible unobservable systematic differences in
characteristics between pairs of members of the Euro 12 and other pairs’61. The authors also
have the benefit of being able to examine a larger time period and to this end use a data set
from the International Monetary Fund’s Trade Statistics that runs from 1993 to 2007.
In short, the authors find that for the Euro 12 dummy, named Currency Union (CU) and the
main regressor of interest ‘the low t-statistics62 for the coefficient of CU, coupled with the
variability of its estimates across the different samples, strongly suggest that the effect of the
Euro on trade is negligible’63. This is largely because before the Euro was created, trade
between the Euro 12 was already intensive and comparatively stronger than between
comparable countries, even those that were part of the EU. Therefore when one controls for
this econometrically ‘there is little evidence that the creation of Euro has had an effect on
trade’64 on a general level.
Nonetheless, one can argue that although the Euro’s effect may well have been negligible in
terms of overall trade in the Eurozone, the single currency’s effects in such a regard have
differed from country to country. In a recent analysis, (Hogrefe, Jung & Kohler, 2010) have
examined Euro induced trade affects in a disaggregate manner across member countries and
chiefly, the role of currency misalignment in this process. Their methodology augments a
58
De Grauwe, P. (2009) Economics of Monetary Union, Oxford Uni Press, Oxford, p69
Flam, H. (2009) The Impact of the Euro and International Trade and Investment: A Survey of the Theoretical
and Empirical Evidence, Swedish Institute for European Policy Studies, Stockholm, p7
60 Baldwin & Taglioni (2008), quoted in Ibid, p30
61 Silva, JMC & Tenreyro, S (2010) ‘Currency Unions in Prospect and Retrospect’ Annual Review of Economics,
Vol 2, p59
62 The ‘t’ statistic is found by dividing the coefficient by its standard error. This statistic is a measure of the
likelihood that the actual value of the coefficient is not zero. The larger the absolute value of t, the less likely that
the actual value of the coefficient could be zero. In this case the low t statistics mean that the actual value of the
CU coefficient is more likely to be zero.
63 Silva, JMC & Tenreyro, S (2010) p60
64 Ibid, p61
59
15
traditional gravity model to incorporate nominal exchange rates, which serves as a guidance
for modelling implicit currency misalignment when analysing the effect of monetary unions.
Furthermore, they included a nominal cost divergence term in their regressions and interacted
this with a dummy indicating Euro membership. It was argued that this was an appropriate
way to ‘test the key hypothesis that cost divergence has different implications for trade
between Euro area member countries, compared to countries that enjoy independent
currencies and the option of nominal exchange rate adjustment’65. Their results confirm such
a hypothesis in that comparing the average levels of bilateral misalignments since the start of
EMU, a disaggregate view shows large country heterogeneity. For example Germany and
Austria register a trade effect above 5% whereas for the Iberian countries and Netherlands a
negative effect is found for their bilateral level exports. Thus, the authors conclude ‘the true
impact of entering the currency union creates trade gains for some, but not for all countries.
For others, the opposite holds true’66.
Therefore Andrew Rose’s estimates of a tripling of Euro trade have been proven to be way
out of line and his methodology is now largely discredited. It did however lay the groundwork
on which future economic historians would evaluate the effect of the single currency on trade.
There have been over 20 of such studies in the last decade and most have found a positive
benefit of Euro membership in this regard. However, the studies that have higher estimates
often do not take into account fully the effect of the single market over time and the most
recent analysis by Silva & Tenreyo (2010) has found no evidence for an overall Euro induced
increase in Eurozone trade. Furthermore, another recent study by Hogrefe, Jung & Kohler
(2010) has shown large country differentials in terms of the Euro’s effect and that some have
seen their exports increase due to the Euro whilst for others, the opposite has been found.
Therefore, one can argue that thus far the role of trade in monetary integration has not gone
according to expectations. Trade has undoubtedly increased significantly in the years since
the Euro was introduced both as an accounting and cash currency. However, the role of the
Euro in such an increase is still a matter of controversy. Also such increased trade flows have
not seemingly increased price convergence which is to what we now turn.
5.2. Has EMU brought price transparency?
Another of the main economic arguments behind the introduction of the Euro was that it
would lead to greater price transparency which would benefit consumers and therefore
increase their welfare. According to the current European Commission website (2011) ‘this is
because increased price transparency has the effect of increasing competition between shops
and suppliers, keeping downward pressure on prices in the Euro area’67. However, how much
of this price transparency promise has been born out by the historical empirical evidence?
The current spate of empirical evidence on this issue shows us that this ‘price transparency’
promise has not happened in practice. One of the first papers to look at this issue was by
Engel & Rogers (2004) who used city price data from the Economist Intelligence Unit City
Data. Their sample was based on 139 goods (including 101 tradable goods) from 25 cities in
17 European countries and overall found price dispersion to have narrowed from 1993 to
2003 but that most of this change occurred between 1990 and 1994 mainly due to a
convergence in tradable price levels as a result of increased tax harmonisation and income
dispersion. The introduction of the Euro, however, did not seem to have increased
Hogrefe, J, Jung, B & Kohler, W (2010) ‘Readdressing the trade effect of the Euro: Allowing for currency
misalignment’ ZEW Discussion Paper No. 10-023, April 2010, p26
66 Ibid, p24
67 European Commission website ‘Consumer Benefits’. Available Online at:
http://ec.Europa.eu/economy_finance/Euro/why/consumer/index_en.htm (accessed 7th May 2011)
65
16
convergence as there was actually an increase in price dispersion post 1998. However, the
authors themselves acknowledged that the observed time period may have been too short to
measure the Euro’s real effects.
Nonetheless, subsequent studies observing a longer post EMU period have found similar
results. Wolszczak Derlacz (2006), with data up to 2005 analysed data on both the aggregate
and disaggregate level, the former done by computing a price index by dividing the
‘purchasing power parity’ by the nominal exchange rate of the national currency to the Euro
whereas the latter was examined by using data from the Economist Intelligence Unit (EIU).
The author tested both levels for sigma convergence, shown as the standard deviation of the
relative price levels across countries at a given point in time and beta convergence, the
negative relation between the average growth rate of prices (inflation) and the initial price
level. She found some evidence of beta convergence among prices but as Sturm et al (2009)
have argued ‘whereas beta convergence only implies that countries with initially low price
levels grow faster, sigma convergence implies that the countries’ prices converge to the same
level and thus beta convergence is the weaker concept’68. Wolszczak-Derlacz found no
evidence of sigma convergence in her results, key of which for the disaggregate level is
shown in the diagram below:
Figure 1: Evolution of price dispersion in the Eurozone, 1990–2005. Source: WolszczakDerlacz (2006)
0,45
mean standard deviation
0,4
0,35
0,3
0,25
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
Also, with observations up to 2006 and using the EIU data set, Cuaresma et al (2007) tested
for sigma convergence among 160 products in 27 European cities by comparing a ‘Eurozone
group’ with that of a control group of developed European countries not part of the Eurozone.
Their findings show that ‘according to the plotted series from 1990 to 2006, price dispersion
decreased mostly during the early 1990s and remained flat afterward’69. EMU had no
observed effect on this and in 2006 prices showed substantial differences across cities going
beyond levels explained by factors such as taxation, for example ‘in 2006, one kilogram of
apples cost EUR 2.68 in the German city of Mannheim but EUR 0.85 in Vienna’70.
Sturm, J.E. et al (2009) ‘The Euro and prices: changeover-related inflation and price convergence in the Euro
area’, European Economy. Economic Papers. 381. June 2009 (Brussels) p179
69 Cuaresma, JC et al (2007) ‘Price Level Convergence in Europe: Did the Introduction of the Euro Matter?’
Austrian Central Bank, Monetary Policy and the Economy: Issue 1 (April) p105
70 Ibid, p105. Note that this assumes that this is the same or very similar type and quality of apple
68
17
Another more recent key survey by (Sturm et al, 2009), important as it has been published
by the European Commission, uses Eurostat data for 224 product groups. The authors
disaggregate the data by looking at three dimensions, that of the country aggregate, time and
aggregation of product groups. They argue that their findings show that ‘for the aggregation
over all products, we find no evidence for convergence due to the Euro cash changeover’71.
Although they find sigma and beta convergence for some product groups and categories in
EMU countries as opposed to not in non EU countries such as in ‘recreation and culture’ and
for single product groups such as ‘jewellery, clock and watches’, these are exceptions to the
rule.
Reasons put forward for this observed lack of price convergence are diverse. Cuaresma et al
(2007) posit that ‘most product market integration took place in the early 1990s, so that no
second convergence was to be expected’72. However, as aforementioned the ECB in 2002 had
indeed expected price convergence to increase in the aftermath of the introduction of the Euro
and one can doubt that consumer market integration was saturated by the introduction of the
Euro given the wide price differentials observed in the studies. Other factors pointed to
include information barriers between local and foreign consumers hampering competition
between producers and distributors. Differences in the development of distribution costs in
the Eurozone was highlighted as a major reason of washing machine divergence in a survey
by the Deutsche Bundesbank (2009) as ‘the price level was highest in those countries where
labour costs have risen most sharply since the launch of EMU and conversely a very low
price level prevails in those countries where the growth in unit labour costs remained small’73.
Linguistic differences have also been highlighted by Bris & Micola (2008) who have argued
that ‘cities in which similar languages are spoken tend to have more similar prices than those
in which very different languages are spoken’74. Therefore, such factors together may have
outweighed the possible price transparency effects of EMU as a common currency.
Therefore, there are a number of reasons why price transparency has not occurred in the
Eurozone and these were always going to be difficult barriers to overcome. Nonetheless, the
fact remains that such transparency was sold in the 1990s to European electorates and indeed
continues to be highlighted as an economic gain from EMU. The evidence shows that such a
gain has not materialised.
5. 3. ECBs Inflation performance and ‘One size does
not fit all’:
The ECB’s inflation performance since the inception of the Euro has been of considerable
debate. On one side, some have argued that it has been a resounding success. The ECB
website itself unsurprisingly argues that its policies have ‘established an environment of price
stability in the Euro area, exerting a moderating influence on price and wage-setting’75.
Furthermore, Harry Flam (2009) has argued that ‘the inflation record of the Eurozone is
outstanding and it is a great achievement for a new central bank to have established a strong
low inflation reputation in such short a time span’76. Looking at the aggregate level of
71
Sturm, JE et al (2009) p180
Cuaresma, JC et al (2007) p111
73 Deutsche Bundesbank (2009) ‘Price convergence in the Euro area’ Monthly Report, March 2009, p45
74 Bris, A & Micola, A.R. (2008) ‘Separated by a common currency? Evidence from the Euro changeover’
Department of Economics and Business, Universitat Pompeu Fabra, Economic Working Paper No. 1086, p37
75 ECB website (2011) ‘Benefits of the Euro’ Available Online at :
http://www.ecb.int/ecb/educational/facts/euint/html/ei_007.en.html (accessed 5th May 2011)
76 Flam, H eds. (2009) EMU at ten: Should, Denmark, Sweden and the UK Join? SNS Economic Policy Group
Report, Stockholm, p19
72
18
inflation of the Eurozone as a whole, it might well look as if the ECB’s monetary policy was
indeed a great success. For, according to Julian Callow (2010), European economist at
Barclay’s Capital, the average yearly Eurozone inflation rate has been 1.96%77 since the start
of EMU, firmly in line with the ECB’s ‘below or close to’ 2% objective.
Furthermore, Otmar Issing (2010), who was on the Executive Board of the European Central
Bank between 1998 and 2006 has argued that ‘business cycle synchronisation has increased
since the 1990’s and is currently at a high level and thus from the business cycle perspective,
the ECB’s single monetary policy poses no major problems’78. However, this argument seems
hard to substantiate given the large inflation and growth differentials between Euro member
states in the years of the Euro’s existence. For, although to meet the Maastricht conditions,
Eurozone countries narrowed their inflation rate differentials in the years leading up to the
Euro, Silva & Tenreyo (2010) have shown that ‘after the launching of the Euro inflation rate
differentials increased with Germany at the lower bound of the inflation range and Ireland at
the upper bound’79. Although differences in productivity growth and catch-up effects were
pointed to as reasons not to worry about such inflation differences, in hindsight it appears that
the ECB’s monetary policy was far from optimal for all Euro member states.
Indeed looking at the past few years, there is an undeniable argument, supported by Baldwin
& Gros (2010) that ‘the one size monetary policy plainly failed to fit all’80. Although different
monetary policy preferences have, as yet not been the source of the kind of international
conflict that Feldstein predicted in 1997, differing economic outcomes have been a source of
concern in the Euro’s brief history due to the ‘one size does not fit all’ problem. For, the old
deutschmark bloc (Germany, France, Austria, Netherlands, Belgium and Luxembourg) tended
to experience lower than average growth and inflation and could have done with more
expansionary monetary policy whereas the reverse was true for the European Periphery. The
so called PIGS (Portugal, Ireland, Greece and Spain) countries boomed and this was
accompanied by prices and wages that rose much more than average. As De Grauwe (2009)
has shown, ‘inflation differentials between the lowest and highest inflation countries regularly
exceeded 3%’81 and furthermore between 2000 and 2007 ‘the cumulative excess inflation was
10 percentage points for Ireland and 8 points for Greece and Spain’82. Such inflation
differentials can clearly be seen in Figure 2 on the following page83 with France, Germany
and Austria (Group A) regularly having inflation rates below the Eurozone average whilst the
PIGS (Group B) having much higher rates than such an average. If these states were to have
had control of their own currency, it is hard to argue that their central banks would not have
run a tighter monetary policy.
Callow, J. (2010), Figure taken from ‘Eurozone inflation undershoots ECB target’ Financial Times 5th January
2010, Available Online at: http://www.ft.com/intl/cms/s/0/44d97fba-f9eb-11de-adb400144feab49a.html#axzz1NZ0mCNnu (accessed 25th May 2011)
78 Issing, O. (2010) The Birth of the Euro, Cambridge University Press, p208
79 Silva, JMC & Tenreyro, S (2010) p63
80 Baldwin, R. & Gros, D (2010) ‘The Euro in Crisis – What to do?’ In Baldwin, R, Gros, D & Laeven, L. eds
(2010) Completing the Eurozone Rescue: What More Needs to Be Done? Centre for Economic Policy Research
(CEPR), London, p4
81 De Grauwe (2009) p194
82 Ibid, p4
83 Figures from Eurostat (2011) ‘Annual Inflation rate database’, Available Online at
http://epp.eurostat.ec.europa.eu/tgm/table.do?tab=table&language=en&pcode=tsieb060&tableSelection=1&footno
tes=yes&labeling=labels&plugin=1 (accessed 2nd August 2011)
77
19
Figure 2: Inflation differentials in the Eurozone, Source: Eurostat (2011)
Absolute inflation deviation from
Eurozone average for Group A
-2
-2
-3
-3
-4
-4
Germany
France
Austria
Portugal
Ireland
Greece
Spain
Related to this is that one can indeed see symptoms of the so called ‘Walters critique’ in the
housing price booms of the European periphery. For, as the critique goes ‘uneven inflation
rates with a uniform policy interest rate can produce real interest rate differences that prompt
divergent trends’84. As Kevin O’Rouke (2011) has argued when Ireland joined EMU
‘overnight interest rates were cut from roughly 7% to 3%’85 and with high inflation rates, real
interest rates were low in that country and for the other booming periphery nations. To give
an example De Grauwe (2009) shows that with average inflation of 3.3% during 1999-2008
and the long term nominal interest rate of 4.8%, Ireland had a real interest rate of 1.5%
whereas Germany had a real interest rate of 3.3% over the same time period86. Thus, the
negative real interest rate Ireland and others on the periphery experienced encouraged
borrowing fuelled investment in assets such as housing whilst Germany’s relatively high real
interest rates had the opposite effect. The result of this was that between 1997 and 2008
‘house prices more than doubled in Spain, and more than tripled in Ireland. In contrast,
German house prices barely moved’87. This can be seen in the Figure 388 on the next page:
84
Ibid, p6
O’Rourke, KH (2011) ‘Ireland in crisis: a European problem that requires a European solution’, Interview by
Viv Davies. Available Online at: http://www.voxeu.org/index.php?q=node/6017 (accessed 26th April 2011)
86 Figures from De Grauwe (2009) p197
87 De Grauwe (2009) p198
88 Figures from The Economist (2008) ’Global House Prices: Popping Sounds’ Available Online at:
http://www.economist.com/node/12725898?story_id=E1_TNSNVRJR (accessed 22nd May 2011)
85
20
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
-1
1998
2010
2009
2008
2007
-1
2006
0
2005
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2004
1
2003
1
2002
2
2001
2
2000
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1999
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1998
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1997
Absolute inflation deviation from
Eurozone average for Group B
Figure 3: House price indices (% change over 1997-2008) Source: The Economist, Dec 06
2008
250
200
150
100
50
0
Germany
Italy
Netherlands
Belgium
Spain
Ireland
An insight into this issue can be seen concerning the Taylor rule, named after the US
economist John Taylor. In brief, ‘this rule describes how the central bank reacts (by adjusting
its policy interest rate) to changes in the deviation of the actual rate of inflation from target,
and the divergence of output from its long term potential (the output gap)’89. The rule was
designed to give central banks recommendations at how to set short-term interest rates as
economic conditions change and also to achieve both their short-run goal for stabilizing the
economy and long-run goal for inflation. Although not without its critics, the Taylor rule ‘is
conceptually of great interest to central banks as it can provide indications as to the current
stance of monetary policy and to that extent act as a kind of guide’90.
An analysis by Taylor himself shows how loose monetary policy contributed to the housing
boom in the periphery Euro countries. Figure 491 shows the change in housing investment
among Eurozone members 2001-06, related to the sum of the differences between the interest
rate target implied by the Taylor rule and the actual policy rate. It shows, unsurprisingly, that
it was the periphery booming countries with the largest deviations from the Taylor rule that
had the biggest change in housing investment as a share of GDP.
89
Issing,O (2010) p89
Ibid, p90
91 Taylor, J. (2009), Getting Off Track, Hoover Institution Press, Stanford, California, p9
90
21
Figure 4: Housing Investment versus Deviations from the Taylor Rule in Europe during
2001–6, Source: Taylor,J. (2009)
Thus with the PIGS countries facing a looser monetary policy than was needed, these
countries, according to Ubide (2010) ‘should have been running fiscal surpluses of the order
of 5-6% of GDP to offset the negative real interest rate its borrowers enjoyed’92. However,
political pressure to increase welfare and infrastructure spending made this politically
impossible and instead such countries ran a looser than optimal fiscal policy. It can be argued
that this has been a source of asymmetric shocks within the monetary union.
5.4. The Euro, asymmetric shocks and divergences:
One can argue that the Euro has actually increased asymmetric shocks and actually created
asymmetric divergences in competitiveness. Although Krugman’s 1991 argument that greater
integration would lead to greater economic specialisation and subsequently more asymmetric
shocks is hard to substantiate, member’s budgetary decisions have indeed been the source of
suck shocks. Despite the Stability and Growth pact, Euro states had a high amount of
discretion over what fiscal policy measures they could undertake and the argument that this
could be a source of asymmetric shocks seems to have been born out in the years since the
Euro’s introduction. For, in essence the Pact failed to achieve what it set out to do. As The
Economist (2009) notes ‘the emphasis on the costs to others of fiscal indiscipline meant that
Ubide, A ‘The European bicycle must accelerate’ In Baldwin, R, Gros, D & Laeven, L. eds (2010) Completing
the Eurozone Rescue: What More Needs to Be Done? Centre for Economic Policy Research (CEPR), London, p45
92
22
countries were careful to behave no worse than their peers, rather than being prudent on their
own behalf’93. Thus, with electorates that wanted to reap the benefits of the good times, public
finances often added to rather than subtracted from demand pressures and ‘fiscal policy often
worked against the monetary sort rather than complementing it, as the pact intended’94.
The PIGS countries in particular had tax revenues and subsequent spending requirements
that were heavily reliant on transaction based taxes in the booming property sector that
negative real interest rates had played a key role in bringing about. Moreover, in the booming
period capital gains tax receipts were also high during a period of large-scale property price
increases. As a result of the windfall revenues that had come from such tax receipts ‘Ministers
had been able to insist that their fiscal policies were sound because they fitted in with the
pact’s narrow guidelines’95 and therefore underlying fiscal weakness was masked.
Indeed, as Baldwin & Gros (2010) have noted ‘the failure of deficit discipline meant that
almost half the Eurozone nations entered the crisis period of 2008 onwards with high debt
ratios, many well above the Maastricht limit’96. Thus, when the global financial crisis hit in
September 2008, several countries were already in weak budgetary positions but found
themselves in a situation where they had to take on more debt. Firstly, the property market
bubbles burst. As Krugman (2011) has shown ‘in 2007, construction accounted for roughly
13% of total employment in the PIGS countries, so when the building booms came to a
screeching halt, employment crashed’97. This precipitated a recession with automatic
stabilisers in the form of unemployment benefits and other social spending at a time when tax
receipts were falling with a downfall in property market related taxes.
This inevitably led to faster public debt accumulation which was further worsened by the
bailout of overleveraged banks and their toxic assets which turned private into public debt.
This was particularly the seed of Ireland’s crisis. Baldwin & Gros (2010) have argued ‘if the
fiscal discipline elements of the Eurozone’s policy framework had worked better prior to the
crisis, low national debt ratios would have provided the room to absorb this sort of additional
pressure’98. However, such a framework plainly failed to ensure that member states would
have such room and as a result many have had to take on huge budget deficits in recent years
as shown by Figure 5 on the following page99. Such external debt problems would not have
been evident if the Eurozone had a fiscal union in that income would have automatically been
transferred from stronger countries such as Germany to weaker members. However as
Krugman (2011) has demonstrated ‘Europe isn’t fiscally integrated; German taxpayers don’t
automatically pick up part of the tab for Greek pensions or Irish bank bailouts’100. Fiscal
transfers between member states are very small and ‘the EU wide budget is 1.06% of the
combined EU GDP compared to the US federal budget of over 20% of GDP’101. In the
absence of such fiscal transfers, struggling to pay for such deficits and at risk of insolvency
some countries have had to agree to EU and IMF sponsored bailouts, Greece was the first to
accept this in May 2010 followed by Ireland in November of that year and now Portugal, all
agreeing to large austerity measures in an attempt to bring their public finances back in line.
The Economist (2009) ‘A special report on the Euro area: Holding together’, Print edition June 11th 2009.
Available Online at: http://www.economist.com/node/13767371?story_id=13767371 (accessed 10th March 2011)
94 Ibid
95 Ibid
96 Baldwin, R. & Gros, D (2010) p13
97 Krugman, P (2011) ‘Can Europe be saved?,’ New York Times, January 12th 2011. Available Online at:
http://www.nytimes.com/2011/01/16/magazine/16Europe-t.html (accessed 6th March 2011)
98 Baldwin, R. & Gros, D (2010) p11
99 Figures from AMECO but diagram taken from Jungen, K. ‘How vulnerable is Italy’, Available Online at:
http://www.roubini.com/affiliate/google-news/40869daed0ec7c06fffdf5356d9daae5f69db104/analysis/143257.php
(accessed 15th May 2011)
100 Krugman, P (2011) ‘Can Europe be saved?,’ New York Times, January 12th 2011. Available Online at:
http://www.nytimes.com/2011/01/16/magazine/16Europe-t.html (accessed 6th March 2011)
101 Rusek (2008) p137
93
23
Figure 5: Primary Deficit (% of GDP), Source: AMECO
The Competitiveness Issue:
Furthermore, one can contend that the Euro has also produced asymmetric trends, most
clearly in competitiveness that has threatened the cohesion of EMU. The PIGS countries
experienced high economic growth in the period following the Euro’s introduction this
produced what De Grauwe (2010) calls ‘animal spirits’ as ‘the optimism prevailing in
peripheral countries led to booms in economic activities which in turn triggered wage and
price increases in these countries’102. This occurred at a time when Germany followed a tight
policy of wage moderation. Thus, a few years of booming activity brought prices and wage
costs of some countries, namely the PIGS, out of line with the Eurozone and they have seen a
large loss of competitiveness relative to Germany. This can be seen in Figure 6 below103 that
shows the evolution of the relative unit labour costs in the Eurozone since 1999 but selects the
average over the period 1970-2010. Using 1999 as the base year exaggerates divergence as it
assumes 1999 was a year when Eurozone countries were in equilibrium, which was not the
case. Although the divergence is less pronounced than when 1999 is selected, one can clearly
see the upward divergence from the PIGS countries.
Figure 6: Relative unit labour costs in Eurozone (average 1970-2010 = 100) Source De
Grauwe (2010)
102
De Grauwe, P (2010) The Financial Crisis and the Future of the Eurozone, Bruges European Economic Policy
Briefings No 21, p6
103 Ibid, p6
24
Thus, it can be demonstrated as Rusek argued in 2008 that ‘the large and growing
divergences in the internal competiveness are equivalent to an increased frequency and
duration of asymmetric shocks’104. This lack of competitiveness played a big role in
contributing to significant current account deterioration for the PIGS countries whereas
others, namely Germany and Austria saw a large improvement.
5.5. Lack of adjustment mechanism to asymmetric
shocks:
One can argue that the lack of labour mobility in the Eurozone countries have worsened the
crisis. In this regard Krugman (2011) draws a comparison between Nevada, which is a state in
a country, the US, that does have high labour mobility and Spain in the EU. He argues that
‘Nevada’s unemployment problem will be greatly alleviated over the next few years by outmigration, so that even if the lost jobs don’t come back, there will be fewer workers chasing
the jobs that remain’. Thus, he argues, due to the American labour market flexibility and the
communality of labour market institutions across US states, ‘emigration will bring Nevada’s
unemployment rate back in line with the US within a few years’. This is in stark contrast to a
country like Spain, whose economy has higher unemployment, at 20%, much higher than the
EU average. However, although in theory European workers have the legal right to move
freely to look for jobs, in practice this does not happen due to institutional, cultural and
linguistic barriers. Unemployment thus remains persistently high in Spain and the increased
social welfare payments that country has to spend worsen its fiscal situation.
5.6. Loss of devaluation and the debt issue:
In a single currency it is harder to become more competitive and repay debts and this poses a
big problem for the heavily indebted countries of the Eurozone. For, in a monetary union, it is
evidently not possible to gain competiveness and correct current account imbalances by
currency depreciation. Thus, ‘the only way is to reduce costs, relative to countries inside and
outside the currency area through what economists call internal devaluation’105. This
effectively involves a deflation strategy with declining prices and wages and is the current
strategy of the countries that have accepted EU and IMF sponsored bailouts. Greece’s
austerity measures, for example, involve a freeze on all public sector pay with cuts for some
and also the scrapping of bonuses and job losses for public sector contract workers. In this
case, the government hoped at the time of the bailout that such measures would cut Greece’s
public deficit from the current level of 13.6% to less than 3% by 2014106.
The problem with such a strategy is that it can create a vicious circle as The Economist,
(2010) notes ‘the more wages and prices fall, the bigger debt burdens become in real
terms’107. For, if highly indebted economies continue to have negative GDP growth, there is
less income for them to service such debts. Indeed, Irving Fisher pointed out almost 80 years
ago, the collision between deflating incomes and unchanged debt can greatly worsen
Rusek, A. (2008) ‘Euro: the engine of integration or the seed of dissolution?’ Agricultural economics –Czech,
Vol. 54, No. 4, p143
105 The Economist (2010) ‘All pain, no gain?’ Print edition December 9th 2010, Available Online at:
http://www.economist.com/node/17673268 (accessed 9th March 2011)
106 Figures from BBC (2011) ‘Greece’s austerity measures’, Available Online at
http://www.bbc.co.uk/news/10099143 (accessed 15th May 2011)
107 The Economist (2010)
104
25
economic downturns. This is currently most seen in Greece. That country has continued to
experience a recession and tax revenues have proved disappointing. It has missed its deficit
reduction targets and as The Economist (2011) notes ‘Greek government debt at the end of
last year was close to 145% of GDP and the deficit for 2010 was a colossal 10.5% of GDP,
well above the original target of 8.1%’108. It looks likely that government will have to force
through even greater austerity measures to free up the new spate of IMF/EU aid from the
bailout package.
Related to this debt problem is the fact that EMU members lose their capacity to issue debt
in a currency over which they have full control and this creates vulnerability. As De Grauwe
(2011) notes ‘as a result, a loss of confidence of investors can in a self fulfilling way drive the
country into default which is not so for countries capable of issuing debt in their own
currency’. He shows this mechanism by drawing a distinction between the UK and Spain in a
situation where investors start to have doubts about such nation’s insolvency. For the UK
such investors would sell their UK government bonds and would have pounds to sell in the
foreign exchange market. Therefore, the price of the pound would drop until somebody would
buy these pounds and therefore ‘the UK money stock would remain unchanged’109. Moreover,
the Bank of England can always provide liquidity to the state to avoid default. In contrast, for
Spain ‘the investors who have acquired Euros are likely to decide to invest these Euros
elsewhere and as a result the Euros leave the Spanish banking system’110. Thus the money
supply in Spain shrinks and the government experiences a liquidity crisis. The Bank of Spain
cannot buy government debt and although the ECB can provide liquidity ‘if investors think
that the Spanish government might reach this end point, they’ll sell Spanish bonds in a way
that turns fear into reality’111.
Thus, this mechanism helps explain why, despite the fact that Spain’s debt and deficit are
significantly lower than UK ones, The Spanish government pays roughly 200 points more on
its 10 year bonds than the UK government (shown below112). This scenario evidently does not
help that county’s debt problems.
Figure 7. 10-year government bond rates Spain and UK, Source: De Grauwe (2011)
The Economist (2011) ‘Europe’s debt saga’ Print edition May 14th 2011, p77
De Grauwe P. (2011) ‘The governance of a Fragile Eurozone’, Centre for European Policy Studies, Working
Document, No 346, p4
110 Ibid, p5
111 Ibid, p5
112 De Grauwe, P. (2011) ’ Managing a fragile Eurozone’, Available Online at:
http://www.voxeu.org/index.php?q=node/6484 (accessed 16th May 2011)
108
109
26
This situation has inevitably led many to bemoan the lack of having one’s own currency and
the devaluation policy option that one has with this. O’Rourke has recently argued in regards
to Ireland ‘I think the major lesson of history is that it would be really, really helpful if we
could have a devaluation and in the absence of this with major budget deficits, that’s a major,
major problem for us right now’113. For that country, as Krugman (2011) has noted in the
current crisis ‘it took Ireland two years of severe unemployment to achieve about a 5%
reduction in average wages but in 1993 a devaluation of the Irish punt brought an instant 10%
reduction in Irish wages measured in German currency’114.
As aforementioned though, the loss of competitive devaluations was actually seen as an
advantage of EMU as these were seen to be inflationary at least to some extent. Indeed,
Beetsma & Giuliodori (2010) have recently argued that ‘it seems likely that EMU has
prevented one or more rounds of competitive devaluations that in the longer run would have
merely produced higher inflation and that could have undermined co-operation among EU
countries in other areas’115. However, one can contend that increased inflation in the face of a
devaluation that has initially helped restore competitiveness and alleviated debt problems may
be much more preferable than the vicious circle of bigger real debt which greatly increases
the chance of default and insolvency. As De Grauwe (2011) notes ‘the whole adjustment
process involving currency depreciation is likely to boost output and inflation, thereby
improving the solvency of the sovereign’116.
5.7. Unpopularity of the single currency:
Public Sentiment is an important factor to take into account in viewing the EMU. For, as
aforementioned the European integration movement has been driven by political and security
considerations whereas economic considerations have sometimes taken a backseat. EMU was
seen as the biggest achievement of such a movement and it was hoped my many to be another
step to greater political unification. The backing of member states population’s is vital in any
such process. However, one can reasonably argue that the Euro has had some surprising
unintended political consequences.
For, the Euro has had a striking loss of public approval in the wake of the financial crisis and
subsequent debt problems that many states are experiencing. This declined support has been
found by many recent polls but a recent survey by Transatlantic Trends (2010) which polled
1,000 people in each country with possible 3% sampling error, illustrates such a point
fittingly. It found that when respondents of Euro member states were asked if the Euro was a
good or bad thing, views were mostly negative. For ‘ with few exceptions, the majorities in
the Eurozone countries in the survey said the Euro has been a bad thing for their economy,
including the two economic powerhouses of Europe, France (60%) and Germany (53%), but
also Spain (53%) and Portugal (52%)’117. Indeed, only the Dutch (52%) and the Slovaks
(64%)118 had clear majorities saying the single currency had been good for their country. This
is a stark contrast to opinions at the time of the Euro’s introduction in 2002 when an average
O’Rourke, KH (2011) ‘Ireland in crisis: a European problem that requires a European solution’, Interview by
Viv Davies. Available Online at: http://www.voxeu.org/index.php?q=node/6017 (accessed 26th April 2011)
114 Krugman, P (2011) ‘Can Europe be saved?,’ New York Times, January 12th 2011. Available Online at:
http://www.nytimes.com/2011/01/16/magazine/16Europe-t.html (accessed 6th March 2011)
115 Beetsma, R. & Giuliodori, M. (2010) ‘The Macroeconomic Costs and Benefits of the EMU and Other Monetary
Unions’ Journal of Economic Literature 48 p614
116 DeGrauwe P (2011) The governance of a Fragile Eurozone, April 2011, p14
117 Transatlantic Trends (2010) ‘Key Findings’ Available Online in pdf format at:
http://trends.gmfus.org/doc/2010_English_Key.pdf, p12 (accessed 10th May 2011)
118 Ibid, p12
113
27
of 59% of member state citizens considered the Euro ‘advantageous overall’ in a Euro
barometer survey119.
Reasons for this unpopularity are widespread. Mongelli & Wyplosz (2009) have argued that
much of it stems from the ECB’s lack of transparency and the fact that it does not publish
board meetings minutes has resulted in ‘the impression of a disconnect between policy
decisions and their justification’120. However, it seems far fetched that the publishing of ECB
minutes would make the single currency popular. More likely reasons are that Eurozone
citizens have responded to the lack of tangible benefits from the currency, particularly in the
face of the pre-Euro hype. Moreover, some suspect the Euro has not helped their nations
relatively weak economic performance in recent years and some blame the Euro for playing a
negative role in the financial crisis with the lack of devaluation policy making debt repayment
harder as aforementioned. Nonetheless, whatever the reasons, as Caselli (2009) has argued
‘disappointment with the Euro has fed into political opposition to further steps towards
European integration, including political unification’121. Such disappointment has even led to
new calls for the abandonment of the whole EMU project.
6. The Future of EMU:
6.1. The Breakup of the Euro Area?
The possibility of a Euro member withdrawing from EMU is not a new concept but has not
been taken seriously for most of the Euro’s short history. However, in light of the current
financial difficulties that the PIGS countries are experiencing, this spectre has gained new
poignancy and no longer seems like the nonsensical prospect it seemed only a few years ago.
Indeed on May 7th 2011 the Euro fell by 1% against the dollar following an article in the
German Magazine ‘Der Spiegel’ that reported that a Euro minister meeting was going to take
place about Greece readopting its own currency122, reflecting investor worries of this
happening.
For, in the absence of the devaluation economic policy tool, with high debt burdens and
struggling to restore competitiveness some have argued that the PIGS countries may find ‘an
exit from the Eurozone the only realistic option for recovery’123. For a country may be
tempted to exit the single currency in order to devalue and to bring its wages closer in line
with workers productivity and also to boost its exports to address its current account
imbalance. In such a scenario ‘a government could simply pass a law saying that the wages of
public workers, welfare cheques and government debts would henceforth be paid in a new
currency, converted at an official fixed rate’124 and other financial dealings such as mortgages,
stock prices and bank loans amongst others would have to be redenominated into this new
currency. Moreover, as Rodrik notes ‘a breakup of the Eurozone may not doom it forever as
119
Eurobaromter Survey (2002) quoted from Mackowiak, B, Mongelli, FP, Noblet, G & Smets, F. (eds.) (2009)
The Euro at ten: lessons and challenges. European Central Bank, Frankfurt am Main, Germany, p43
120 Mongelli, F.P. & Wyplosz, C. (2009) ‘The Euro at ten – unfulfilled threats and unexpected challenges’ in Ibid,
p42
121 Caselli, F. (2009) Comment on "The Euro at ten: unfulfilled threats and unexpected challenges". In Ibid, p64
122 BBC (2011), ‘Euro falls on rumours Greece is to quit the Eurozone’ Available Online at:
http://www.bbc.co.uk/news/business-13317770 (accessed 8th May 2011)
123 Rodrik, D. (2010) ‘Thinking the Unthinkable in Europe’ Available Online at: http://www.projectsyndicate.org/commentary/rodrik51/English (accessed 10th April 2011)
124 The Economist (2010) ‘Breaking up the Euro area: How to resign from the club’ Print edition Dec 2nd 2010,
Available Online at: http://www.economist.com/node/17629757 (accessed 2nd March 2011)
28
countries can rejoin, and do so credibly, when fiscal, regulatory and political prerequisites are
in place’125. However, how realistic is such a breakup?
In truth, despite investor worries to the contrary, it seems very unlikely that an ‘irreversible’
currency union such as the Euro will breakup predominantly due to the huge technical, legal
and political hurdles and factors any country thinking about leaving would experience.
Firstly, Eichengreen (2007) has argued in an influential article on this subject that the
technical difficulties are very large as ‘computers will have to be reprogrammed, vending
machines modified and notes and coins will have to be positioned around the country’126. It
took 3 years in physical preparation for the Euro and importantly such a period was
accompanied by little reason to expect change in exchange rates. This would not be true for
the new currency which would invite large-scale and destabilising currency speculation.
Furthermore, households and firms, uncertain as to the strength of the new currency would
shift their deposits to other Euro area banks and ‘in the worst case a system wide bank run
could follow’127. In response to this the government would impose capital controls,
suspending operation of the bond market and also likely introduce limits on bank
withdrawals. As The Economist (2010) notes this would ‘strangle commerce and leavers may
be cut off from foreign finance, perhaps for years, further starving their economies of
funds’128.
Also, one must take into account legal and political factors. Contracts would be changed into
the new currency and this would likely generate legal challenges that may invalidate such a
redenomination. As Eichengreen contends ‘cases involving suits against the leaver’s debtors
in the courts of other European countries and in the European Court of Justice could be
messy’129. In the political domain, it seems unlikely that a country leaving EMU would be
allowed to simply rejoin at a later date as Rodrik argued. For, such a country would be viewed
as having unilaterally disregarded its commitments to Europe as a whole. With other
European countries resentful at the artificial devaluation that would ensue, ‘a country that
reintroduced its national currency at levels that stepped down its labour costs by 20% might
be required to pay a 20% compensatory duty when exporting to other members of the EU’130
and it would lose the privileges of the single market. Also, it would not be welcome in future
discussions regarding EU policy priorities ‘insofar as member states value their participation
in these political discussions, they would incur significant costs’131.
Lastly, one must remember that the EMU project, whatever, its economic results, has been
one of the most visible and championed achievements of the whole European integration
movement. Allowing any member to leave would risk that country becoming a pariah,
exporting pain to its neighbours which could ‘detonate a chain reaction that would threaten
the fabric of the single market and the EU itself’132. Thus, it seems very unlikely that the
European ‘core’ countries of France and Germany amongst others, which have invested much
in the integration movement in recent decades, would risk such a possibility.
125
Rodrik, D. (2010)
Eichengreen, B. (2007) ‘The Breakup of the Euro Area’, National Bureau of Economic Research Working
Paper No. 13393, p17
127 Ibid, p17
128 The Economist (2010) ‘The future of the Euro: Don’t do it’, Print edition Dec 2nd 2010, Available Online at:
http://www.economist.com/node/17629661 (accessed 2nd March 2011)
129 Eichengreen, B. (2007) p20
130 Ibid, p11
131 Ibid, p35
132 The Economist (2010) ‘The future of the Euro: Don’t do it’
126
29
6.2. Redressing Eurozone fragility
Thus, the costs of a Euro breakup would be hugely disruptive and look unlikely at present.
Nonetheless, despite EMU’s inherent flaws over its lifetime and unpopularity, there are
numerous positive steps that European policy makers could take which would improve the
running of the single currency in the future. Indeed the ongoing Eurozone crisis and fragility
can be seen as a unique opportunity to do just this.
Firstly, economists have long argued that the Euro would work much more efficiently if
Euro states moved towards political union much like the United States. De Grauwe (2011) has
argued that a fiscal union transferring resources to countries hit by economic shocks and the
creation of a common fiscal authority that can issue debt would ‘protect member states from
being forced into default by financial markets and protects monetary union from centrifugal
forces that financial markets can exert on the union’133. One can argue that this would be one
of the best ways of preventing future Euro crises as resources would naturally go from
stronger members to weaker ones, greatly alleviating their debt concerns. However, one only
needs to look at the current state of EU budget negotiations to see that there is little desire to
go in this direction with most major European players such as France and Germany wanting a
freeze in the EU budget until 2020. Any type of fiscal union within Europe looks politically
impossible any time soon.
Nonetheless, some saw the May 2010 European Financial Stability Facility (EFSF), a €440
billion “stabilisation fund” for Euro-zone countries that have trouble financing their debts, as
a step in the right direction. However, as De Grauwe (2010) points out ‘it fails short of an
automatic insurance mechanism mainly because it is a network of bilateral loan agreements,
making it possible for individual countries to pull out in the future’134. Attempts to create a
more permanent fund have taken place. The recent Eurozone summit of March 24-25th 2011,
saw EU leaders agree on such a permanent European Stability Mechanism (ESM) which
boosts the lending capacity of its precursor, the EFSF to 600bn Euros. However, a decision of
how to pay for such a fund was delayed as The Economist (2011) notes because ‘German
Chancellor Merkel refused to put up money her finance minister had pledged’135. Moreover,
when the ESM is launched in 2013, at present, ‘countries that apply for financing from it will
be subjected to a tough budgetary austerity program as a condition for obtaining finance’136.
This will mean pro cyclical budgetary policies that could make a recession worse. Thus, a
financial support mechanism is indeed something that could help but a more integrated,
efficient EMU but the conditions attached to the ESM according to De Grauwe (2011) have
‘transformed it into an institution that is unlikely to produce more stability in the
Eurozone’137. These conditions should be revised before the ESM is launched.
Along with a more permanent insurance mechanism, there are other reforms in the
institutional field that would strengthen the single currency. As has been argued, the Stability
and Growth pact has plainly failed to provide the fiscal stability that it was supposed to
achieve and was a weak barrier against the fiscal profligacy of the PIGS countries. Thus, as
Wyplosz (2010) has argued ‘restoring fiscal discipline requires Europe to tackle this political
De Grauwe (2011) ‘The governance of a Fragile Eurozone’ p16
De Grauwe, P. (2010) ‘How to embed the Eurozone in a political union’ In Baldwin, R, Gros, D & Laeven, L.
eds (2010) Completing the Eurozone Rescue: What More Needs to Be Done? Centre for Economic Policy
Research (CEPR), London, p31
135 The Economist (2011) ‘The Eurozone's periphery: They're bust. Admit it’, Print edition March 31st 2011,
Available Online at: http://www.economist.com/node/18485985 (accessed 7th April 2011)
136 De Grauwe (2011) ‘The governance of a Fragile Eurozone’ p20
137 Ibid, p21
133
134
30
failure head on by adopting institutions that bind the budgetary process’138. Although there are
many suggestions on how to do this, the establishment of national fiscal councils has gained
widespread academic approval of late. Lane (2010) has argued that ‘an independent fiscal
council can help identify the stabilisation risks facing the economy, estimate the appropriate
cyclical position for the annual budget and estimate the optimal future path of fiscal balances
that will ensure fiscal sustainability’139. It works by having formal fiscal rules that specify the
medium term path for the structural fiscal balance whilst allowing flexibility in the presence
of a large macroeconomic shock. A current example of such a system is evident in Sweden
today, which Fatas & Mihov (2010) have argued shows ‘how an independent body can allow
for flexibility in times when there is a clear trade off between sustainability and
stabilisation’140. Although it may be too early to judge the Swedish example an unequivocal
success, Calmfors & Wren Lewis (2011) have contended that it has played a significant
positive contribution to that country’s strong fiscal position. For example ‘the council’s call to
the political parties in the 2010 parliamentary election campaign to avoid committing to
measures that would permanently worsen the budget balance received widespread media
attention and likely strengthened fiscal discipline’141.
A joint issue of Eurobonds which would mean participating countries becoming jointly
liable for the debt they have issued together is another step in strengthening EMU and as De
Grauwe (2011) argues, it would be ‘an important mechanism of internalizing the externalities
of the Eurozone’142. Nonetheless, such a proposal has met considerable opposition due to a
number of problems. For, it creates problems of moral hazard where an incentive is created
for countries to rely on this implicit insurance and to issue too much debt. Also, some
countries in stronger budgetary positions such as Germany will be reluctant to pay potentially
higher interest on their debt that a Eurobond involving countries with poorer credit ratings
would bring. Therefore, such a Eurobond system must be designed ‘as such to eliminate the
moral hazard risk and must produce sufficient attractiveness for the countries with favourable
credit ratings’143. One way of doing this might be to charge fees on such bonds relative to
their fiscal positions so that those with higher debt levels would face a higher fee and vice
versa. In any case, a successful Eurobond would create a large new bond market with a lot of
liquidity and would be ‘a collective defence system against the vagaries of euphoria and fears
that regularly grip financial markets, leading to centrifugal forces in a monetary union’144
Furthermore, labour mobility between Euro member states is still weak compared to other
currency unions such as that of the United States. Reform in this area has been near non
existent in the period since the Euro’s introduction. Nonetheless, one can argue, along OCA
theory, that reforms increasing the degree of flexibility of labour markets regarding real
wages and labour mobility ,although difficult to implement, are necessary to turn the
Eurozone into a better functioning monetary union. As Eichengreen (2007) has noted
‘regulations to ensure that French ski resorts extend equality of treatment to instructors
trained in other European countries and more generally removing residual barriers to the
mutual recognition of technical credentials, the portability of pensions and the receipt of
social services in the new labour market will relieve the pressure on countries with depressed
labour markets’145. For such measures should better address such countries unemployment
problems as workers can more easily more around the Eurozone, creating new job
Wyplosz, C. (2010) ‘The Eurozone’s levitation’ In Baldwin, R, Gros, D & Laeven, L. eds, p 35
Lane, PR. ‘Rethinking national fiscal policies in Europe’ In Baldwin, R, Gros, D & Laeven, L. eds, p61
140 Fatás, A, & Mihov,I. (2010) ‘Fiscal policy at a crossroads: The need for constrained discretion’ In Baldwin, R,
Gros, D & Laeven, L. eds, p71
141 Calmfors, L and S Wren-Lewis (2011), “What Should Fiscal Councils Do?”, CESifo Working Paper No. 3382,
p45
142 De Grauwe P. (2011) ‘The governance of a Fragile Eurozone’, p21
143 Ibid, p22
144 De Grauwe, P. (2011) ’ Managing a fragile Eurozone’, Available Online at:
http://www.voxeu.org/index.php?q=node/6484 (accessed 16th May 2011)
145 Eichengreen, B. (2007) p27
138
139
31
possibilities in those countries. However, up to now there has been little suggestion that
European politicians are prepared to move in this direction as such measures are indeed
politically divisive domestically.
Lastly, as has been mentioned the PIGS countries current strategy of internal devaluation
risks a downward spiral where it becomes harder to repay their large debt and this will only
get harder with the ECB’s recent decision to increase interest rates. Thus according to Daniel
Rodrik (2010) ‘the need for debt restructuring is an unavoidable reality’146 for Greece in
particular as such debts must be reduced for the austerity measures that such countries are
currently undertaking to not doom them to years of stagflation. Eichengreen (2010) has
recently made a similar argument and has laid out a reasonable plan. He argues that
governments ‘should offer a menu of new bonds worth some fraction of their existing
obligations so that bondholders have a choice between par bonds with a face value equal to
their existing bonds but a longer maturity and lower interest rate and discount bonds with a
shorter maturity and higher interest rate but a face value that is a fraction of existing bond’s
face value’147. For such a measure to succeed the IMF and German government should
guarantee that such bonds are adequately collaterised and banks that suffer losses as a result
of such restructurings must have their balance sheets reinforced. European level co-operation
and political will from Germany, in particular, is needed which must ‘convince their
constituents that using public money to provide sweeteners for debt restructuring is essential
to the internal devaluation strategy that they insist their neighbours follow’148.
Of course practically speaking a restructuring will mean large losses for bondholders of the
restructured nation’s government debt and would indeed cause losses of tens of billions of
dollars at Europe's commercial banks. However, in the Greek case, that country is on an
unsustainable path facing its third straight year of recession and rising government debt.
Restructuring debt is thus necessary but unfortunately such a scenario looks bleak at present
for as The Economist (2011) has noted ‘Europe’s leaders won’t hear of debt reduction now,
but insist that any country requiring help from 2013 may then need to have its debt
restructured and that new official lending will take priority over bondholders’149. The result of
this is that the aforementioned debt ‘downward spiral’ gets worse for the PIGS countries in
the meantime and ‘the risk that investors could face a haircut in two years time keeps yields
high today, which in turn blights the rescue plans’150. As the Barrons newspaper (2011)
recently put it ‘the choice for Greece's bondholders, as we see it, is to accept 50 cents on the
Euro now -- or 30 cents or worse down the road’151.
Rodrik, D. (2010) ‘Thinking the Unthinkable in Europe’, Available Online at: http://www.projectsyndicate.org/commentary/rodrik51/English (accessed 10th April 2011)
147 Eichengreen, B. (2010) ‘Europe’s Inevitable Haircut’, Available Online at: http://www.projectsyndicate.org/commentary/eichengreen25/English (accessed 10th April 2011)
148 Ibid
149 The Economist (2011) ‘The Eurozone's periphery: They're bust. Admit it’, Print edition March 31 st 2011,
Available Online at: http://www.economist.com/node/18485985 (accessed 7th April 2011)
150 Ibid
151 Racenelli, VJ (2011) ‘How to Fix Greece’ Barrons, Available Online:
http://Online.barrons.com/article/SB50001424053111903548904576343340195494116.html?mod=TWM_pastedit
ion_1 (accessed 28th May 2011)
146
32
7. Conclusion:
Thus, this paper has attempted to analyse the Euro single currency by comparing the
theoretical benefits and costs which were highlighted in the lead up to the advent of EMU
(Economic & Monetary Union) with what has actually happened in practice. It has been
argued that, in short, the evidence shows that many of the benefits have failed to come about
whereas, in contrast, many of the costs have.
The Euro was meant to increase trade through the elimination of transaction costs and the
elimination of exchange rate risk and also to increase price convergence through expected
price transparency and the law of one price. The evidence has shown that neither has
happened. The prediction by Andy Rose that monetary union could increase trade for
participant members by up to 200% now looks ridiculous and is discredited. Moreover,
studies that have found the Euro to have had a substantial effect on trade have methodological
problems amongst them that they do not take into account the effect of the European single
market over time. Also, although the evidence shows that there was price convergence before
the Euro’s inception, there has been no significant narrowing of price differentials over the
Euro’s short history.
It was also hoped that the Euro would through greater trade integration promote business
cycle symmetry make asymmetric shocks less likely. Furthermore, by anchoring themselves
to a credible institution such as the ECB and low historic inflation countries, previously
inflationary countries and indeed the whole of the Eurozone would be able to benefit from a
low inflationary environment. Some have argued that looking at the ECB’s overall record, it
has indeed succeeded, by large, in promoting such an environment.
However, taking a disaggregate look paints a different picture. For, the Euro has actually
experienced a period of business cycle asymmetry and a classic ‘one size does not fit all’
problem in the conduct of its monetary policy. For, the overheating economies of the
periphery, namely the PIGS, could have done with a stricter monetary policy whereas the
sluggish economies of France and Germany could have done with a looser one. With a looser
than optimal interest rate, the PIGS countries experienced an asset price fuelled boom. This
may not have been such a problem if such countries had pursued sensible fiscal policy.
However, one can argue that the Eurozone member’s profligate policies have, in themselves,
been a source of asymmetric shocks. For, still abiding by the Eurozone’s fiscal rules, these
countries engaged on a public spending spree with much revenue coming from taxes related
to the asset price boom. When this bubble burst, these countries debts soared and they had to
rely on EU and IMF sponsored bailouts. Moreover, with the lack of the devaluation policy
tool and unable to issue debt in their own national currencies, these countries will find it
harder to repay such debt and restore competitiveness. Years of deflationary pain await.
Given this, it is little wonder that the Euro has experienced a stark decline in popularity in
recent years.
Thus, with the Eurozone in such dire straights, some have argued that a country may be
tempted to leave EMU and devalue. However, this paper has argued that such a prospect is
unlikely due to the huge technical and legal barriers that a country would have to overcome.
Instead of focusing on this unlikely prospect, it is thus better to focus on ways that will make
EMU more stable in the future. This paper has argued that a fiscal union would be the most
optimal way of doing this but that it looks politically impossible anytime soon. Nonetheless
there are positive steps that can be taken. A more permanent insurance mechanism,
independent fiscal councils to ensure budgetary discipline and the joint issuing of Eurobonds
have all been highlighted. A new focus on making labour markets more flexible would also
help solve the adjustment problem as pointed to in the OCA literature. Finally, the ECB
33
should allow Greece and possibly other PIGS countries in the future to restructure their debt
as with negative economic growth and with high debt burdens the crisis is likely to get worse
rather than better for that country in particular in the near future. Nonetheless, with the entire
‘Euro’ project so unpopular and with domestic concerns, it is as yet unclear whether
politicians will take some of the aforementioned steps which would make the Eurozone
function more optimally. As Wolfgang Münchau has recently written ‘a breakup of the Euro
is unlikely, but another outcome – a perpetually malfunctioning and divided monetary union
seems increasingly on the horizon’152.
Münchau, W. (2011) ‘Original sin: The seeds of the Euro crisis are as old as the Euro itself’ Foreign Policy,
Available Online at: http://www.foreignpolicy.com/articles/2011/04/07/original_sin (accessed 10th April 2011)
152
34
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