the euro

Eco 328

The euro

In 1999, 11 nations in Europe

elected to form a “currency

area”, known as the Euro area,

or Eurozone.

There are19 member countries.

They all use the new notes and

coins bearing the name euro

and the symbol €.

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The euro

• The European Union (EU) is a mainly economic, but

increasingly political, union of countries that is in the process

of extending across the geographical boundaries of Europe.

• The main impetus for the euro project came in 1992 with the

signing of the Treaty on European Union, at Maastricht, in the

Netherlands.

• Under the Maastricht Treaty, the EU initiated a grand project

of Economic and Monetary Union (EMU).

• A major goal of EMU was the establishment of a currency

union in the EU whose monetary affairs would be managed

cooperatively by members through a new European Central

Bank (ECB).3

The Ins and Outs of the Eurozone

Different countries choose to participate in different aspects of

economic and monetary integration

As of 2014, the EU comprised 28 countries (EU-28).

• A country can be in the EU but not in the Eurozone.

• Those who wish to get “in” must first peg their exchange rates

to the euro in a system known as the Exchange Rate

Mechanism (ERM).

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The Ins and Outs of the Eurozone

An optimal currency area

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• In 1961 the economist Robert Mundell wrote a paper

discussing the idea of a currency area, also known as a

currency union or monetary union, in which nations replace

their national monies with a common currency.

• He thought it purely a theoretical exercise, as such a union

would never be politically feasible.

• Half a century later most of Europe uses the same currency.

• Mundell received the Nobel Prize the same year the euro

launched.

EU à la Carte This map

shows the state of

Europe as of 2014,

indicating which

countries are in the

European Union (EU),

which EU members are

in the Eurozone or the

Exchange Rate

Mechanism (ERM),

and future members.

Notes:

EU-Eurozone (18): Austria,

Belgium, Cyprus, Estonia,

Finland, France, Germany,

Greece, Ireland, Italy, Latvia,

Luxembourg, Malta, Netherlands,

Portugal, Slovakia, Slovenia,

Spain

EU-ERM (2): Denmark,

Lithuania.

EU-Other (8): Bulgaria, Croatia,

Czech Republic, Hungary, Poland,

Romania, Sweden, United

Kingdom.

Candidates (5): Iceland,

Macedonia, Montenegro, Serbia,

Turkey.

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Market Integration and Efficiency Benefits

If there is a greater degree of economic integration between the home

region (A) and the other parts of the common currency zone (B), the

volume of transactions between the two and the economic benefits of

adopting a common currency due to lowered transaction costs and

reduced uncertainty will both be larger.

Economic Symmetry and Stability Costs

If a home country and its potential currency union partners are more

economically similar or “symmetric” (they face more symmetric shocks

and fewer asymmetric shocks), then it is less costly for the home

country to join the currency union.

When two regions adopt a common currency, each region will lose its monetary autonomy, and the monetary authorities who have control of the common currency will decide on a common monetary policy and set a common interest rate for all members.

The Theory of Optimum Currency Areas

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Cost and benefit

• As market integration rises, the efficiency benefits of a common

currency increase.

• As symmetry rises, the stability costs of a common currency

decrease.

If the net benefits are negative, the home country would stay out

based on its economic interests. If the net benefits turn positive,

the home country would join based on its economic interests.

Simple Optimum Currency Area Criteria

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• When countries consider forming a currency union, the

economic tests (based on symmetry and integration) set a

higher bar than for judging whether it is optimal to fix.

• Denmark is in the ERM, so the krone is pegged to the euro,

but not in the Eurozone.

• Denmark appears to have ceded monetary autonomy to the

ECB, but transactions between Denmark and the Eurozone

still require a change of currency.

• Denmark has the option to exercise monetary autonomy or

leave the ERM at some future date if they want the flexibility

of a more freely floating exchange rate.

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What’s the Difference Between a Fix and a Currency

Union?

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The greater the symmetry of shocks and the higher the degree of economic integration, the greater the case for pegging the exchange rate. Higher degrees of symmetry and integration, still, may justify even greater monetary commitment, such as a currency union.

• Italy is one of several countries in which rumors of departure

from the Eurozone have surfaced from time to time.

• An Italian exit from the euro would be difficult and costly.

Reintroducing new lira as money would be difficult and all

Italian contracts in euros would be affected by the

“lirification” of the euro.

• Other countries that have tried these kinds of strategies, such

as “pesification” in Argentina and de-dollarization in Liberia,

have resulted in economic crises.

• Exit from a peg is easy, but exit from a common currency is

much more difficult.

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What’s the Difference Between a Fix and a Currency

Union?

Other Optimum Currency Area Criteria

Labor Market Integration

• In the event of an asymmetric shock, labor market integration

provides an alternative adjustment mechanism through

migration.

Fiscal Transfers

• A third adjustment channel is available if fiscal policy is not

independent but built on top of a federal political structure

with fiscal mechanisms that permit interstate transfers—

known as fiscal federalism.

• If Home suffers a negative shock, fiscal transfers from Foreign

allow more expansionary fiscal policy in Home.

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Several other criteria can make a currency union more attractive, even for given levels of market

integration. Factors that lower costs or raise benefits will shift the OCA line down and to the left,

expanding the OCA zone.

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We can use comparative analysis to see if Europe performs as well

as or better than the United States on each of the OCA criteria,

which would lend indirect support to the economic logic of the

euro.

Goods Market Integration As intra-EU trade flows rise further,

the EU’s internal market will become more integrated, but on this

test Europe is probably behind the United States.

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Optimum Currency Areas: Europe Versus the United States

OCA Criteria for

the Eurozone

and the United

States

Most economists

believe that the

United States is

much more

likely to satisfy

the OCA criteria

than the EU is.

Why?

Data in panel (a)

show that

interregional

trade in the

United States

rises to levels

much higher

than those seen

among EU

countries.

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We can use comparative analysis to see if Europe performs as well

as or better than the United States on each of the OCA criteria,

which would lend indirect support to the economic logic of the

euro.

Symmetry of Shocks Most EU countries compare quite

favorably with the U.S. states on this test. There is no strong

consensus that EU countries are more exposed to local shocks

than the regions of the United States.

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Data in panel (b)

show that U.S.

and EU shocks

are comparably

symmetric.

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Labor Mobility

• Labor in Europe is much less mobile between states than it is in

the United States. The flow of people between regions is also

larger in the United States than in the EU.

• Labor markets in Europe are less flexible, and differences in

unemployment across EU regions tend to be larger and more

persistent than across the United States.

• The labor market adjustment mechanism is weaker in Europe.

On this test, Europe is far behind the United States.

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Data in panel (c) show

that U.S. labor markets

are very integrated

compared with those of

the EU.

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Fiscal Transfers

• Stabilizing transfers, whereby substantial taxing and spending

authority are given to the central authority, exist in the United

States but not in the EU.

© 2014 Worth Publishers

International Economics, 3e | Feenstra/Taylor20


Data in panel (d)

show that interstate

fiscal stabilizers are

large in the United

States, but

essentially

nonexistent in the

EZ.

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• On the OCA criteria, the EU falls short of the United States as a

successful optimum currency area.

• Goods market integration is weaker, fiscal transfers are

negligible, and labor mobility is low. At best, economic shocks

in the EU are fairly symmetric, but this gives only limited

support for a currency union given the other shortcomings.

• On balance, economists tend to believe that the EU, and the

current Eurozone within it, were not an optimum currency area

in the 1990s and that nothing much has happened yet to alter

that judgment.

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The eurozone is not an OCA

The US seems to fit all the characteristics for an OCA, but not the eurozone

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Monetary Policy and Nominal Anchoring

• If Home suffers from chronic high inflation that results from

an inflation bias of Home policy, the more politically

independent common central bank of the currency union could

resist political pressures to use expansionary monetary policy

for short-term gains.

• Italy, Greece, and Portugal are Eurozone members that

historically have been subject to high inflation.

• High-inflation countries are more likely to want to join the

currency union, the larger are the monetary policy gains of this

sort.

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Political Objectives

• Forming a currency union has value for political, security,

strategic, or other reasons.

• Political benefits can be represented by the OCA line shifting.

• In this scenario, for countries between OCA1 and OCA2, there

are economic costs to forming a currency union, but these are

outweighed by the political benefits.

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• With the devastation of World War II, many feared that dire economic

conditions would undermine the legitimacy of European capitalism, with

the neighboring Soviet bloc all too eager to spread its alternative

Communist model.

• The Marshall Plan, from 1947 to 1951 poured billions of dollars of aid

into Western Europe to help rebuild the economic infrastructure.

• A series of ever tighter binding treaties ensued in the following decades

which brought Europe closer together and saw many more countries

come into the fold. The EU now has 28 member states (many ex-

Soviet), 19 of which are in the Eurozone.

• Even if it did not make perfect economic sense, proponents still

reasoned along two lines

• An OCA could be self-fulfilling. Sign the treaties and print the

money, and the member states will become integrated.

• The political considerations outweigh the economic costs.

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Politics of the euro

the euro

Economy & Finance