Macroeconomic stabilization in the Eurozone (I)

Summary:

-The theory of optimal currency areas is absolutely central to understanding the problems of the Eurozone. Joining a currency area brings benefits but also costs. The aim is to balance these by meeting certain criteria.

-Initially, the eurozone was not an optimal currency area.

-Monetary integration creates virtuous dynamics, but also potentially vicious ones.

-The persistence of the economic crisis can be explained by a major political crisis.

Joining a monetary union is an extremely important decision because the dynamics it unleashes are very powerful. Moreover, the Maastricht compromise, which launched European monetary integration, was considered the direct path to political union, the ultimate goal of the European project.

Most of the economic work on the eurozone as a monetary zone stems from Mundell’s seminal 1961 paper on optimal currency areas (OCAs). The OCA theory emerged as a response to Friedman (1953), who advocated a floating exchange rate system at a time when the world was at the beginning of the Bretton Woods experiment.

Mundell defines an OMA as the optimal geographical (rather than political) area in which internal economic equilibrium (low inflation and full employment) and external equilibrium (a sustainable balance of payments position) could be more easily achieved with a fixed exchange rate regime. Once one (or more) political or legal entities adopt a common currency, the question of its optimality arises.

Cost-benefit analysis of a common currency and asymmetry

The advantages of a common currency are mainly microeconomic and therefore more difficult to quantify: reduced transaction costs, elimination of exchange rate risk, more stable and transparent prices, greater competition, etc. Microeconomic advantages can also arise from the creation of a single market, which can only be achieved through monetary integration.

The disadvantages of a single currency are mainly macroeconomic and stem from the loss of flexibility to absorb asymmetric shocks in order to manage internal and/or external imbalances: (i) the loss of monetary policy autonomy and (ii) the loss of the external nominal adjustment mechanism (changes in relative prices and wages are much easier to achieve through external nominal depreciation than through internal real depreciation). In fact, the only tool available to governments to counter asymmetric shocks is fiscal policy, beyond market mechanisms, of course. The challenge here is therefore to balance the costs and benefits.

The issue of asymmetric shocks is absolutely essential. The problem for a monetary zone is to determine whether asymmetric shocks are present or not and, if so, whether there are stabilization mechanisms in place to deal with them. There are two types of stabilization mechanisms: market mechanisms and institutional instruments (economic policies, macroeconomic framework). They can take two forms: (i) a risk-sharing system to smooth consumption and income after a positive or negative shock, or (ii) promoting the adjustment of relative prices after an economic disruption.

Static analysis of the optimality of the eurozone

The debates on the eurozone that took place in the 1990s focused on two points. The first is not really a debate in itself, as most experts agreed: is the eurozone of the 1990s potentially an optimal currency area? Definitely not. The most skeptical authors were American economists, notably Krugman, but also Bayoumi and Eichengreen, who in several articles in the early 1990s showed that (i) the core and periphery of the future euro area have different economic cycles (i.e., asymmetric supply and demand shocks are very prevalent) and (ii) the time required to adjust to these shocks varies from country to country. By comparing the virtual euro zone with the United States, these authors show that the pupil is still a long way from its master. Consequently, the costs associated with the loss of monetary and exchange rate policy autonomy would outweigh the benefits of monetary integration.

The discussion then focused on the sharing of certain properties by the member states of the future euro area that would reduce the constraints of monetary integration by reducing the impact, occurrence, and duration of asymmetric shocks. These properties stem from the work of Mundell and other authors such as Kenen and McKinnon (among others). These criteria are factor mobility (particularly labor), price flexibility, trade openness, industrial diversification, low inflation differentials, and one or more risk-sharing systems (financial and fiscal integration).

Dynamic analysis of the optimality of the eurozone: the theory of endogeneity

This is the second point of the debate that remains highly controversial: is there a way to dynamically improve the optimality of the eurozone? A whole body of literature on this question has developed since the 1990s. Frankel and Rose’s intuition in 1997 was that the single currency would create virtuous circles, which would increase the optimality of a monetary union over time, thereby improving the « static rating » of member countries: « Countries which join EMU, no matter what their motivation may be, may satisfy OCA properties ex post even if they do not ex ante! ». This is the theory of endogeneity: integration feeds integration.

Adopting a single currency transforms the area into an OMA. For these authors, endogeneity is achieved in particular through trade integration. Monetary integration would promote trade [1], particularly intra-industry trade within the euro area, which would bring the productive structures of each country closer together, thereby reducing asymmetric shocks and increasing the optimality of the area.

In 2006, de Grauwe and Mongelli took stock of the debates on the theory of endogeneity, which had developed beyond the single channel of trade: financial integration, inflation rates, price flexibility, fiscal integration, symmetry of shocks, etc. would evolve dynamically thanks to the euro. It is therefore not a question of looking at a cross-section of the euro area at a given point in time, but also of analyzing the trajectory it is taking. It should be noted that Frankel and Rose’s idea is a concrete application of Lucas’s critique (1976) [2], which had major consequences for economics. How can we imagine what the United States would look like today if it did not have the dollar?

Dynamic analysis of the optimality of the eurozone: the theory of specialization

This debate is not so simple because, while virtuous circles do exist, the adoption of the euro may also create vicious circles. This is what Krugman argued as early as 1993: « The EEC would become less of an OCA with the creation of the euro because of the specialization pattern that would occur. » The dynamic forces that can increase the optimality of a monetary zone can also become harmful.

For example, with regard to trade, Krugman tells us that monetary and financial integration lowers the cost of a current account deficit (in a monetary area in theory, but also often in practice, internal current account balances are outdated concepts: who knows or calculates the current account balance of Florida or Corsica?), encouraging countries to specialize in their comparative advantages: productive structures diverge and asymmetric shocks increase, thereby reducing the optimality of the eurozone. This is also the case in the United States, where states specialize among themselves. Specialization is therefore not negative in itself (economies of scale, economic efficiency, etc.). It is negative if stabilization and adjustment mechanisms do not exist. The adoption of the euro would therefore have effects that would shape the eurozone, as these processes are very powerful, albeit slow.

The crisis is primarily political

Everything is planned, everything is contained in this theory, and yet the member countries of the eurozone and their governments have been making mistakes for 15 years. How, then, can we understand the crisis in the eurozone? The current situation in which the eurozone is trapped is mainly a political problem. The explanation lies in ways of thinking that are deeply rooted within each state.

For example, I accept the redistribution that takes place within my country, even if it is virtually unconditional, unidirectional, and permanent, but for those on the other side of the border, « it’s a different story. » This is a caricature, but it is precisely this identity issue that lies at the root of the existence and persistence of the economic crisis, for which solutions have been clearly identified but are difficult for some to implement as they stand (e.g., a union of budget transfers between states).

If the member countries of the Eurozone decide to allow budget transfers between themselves, the crisis should disappear fairly quickly because the Eurozone as a whole has better economic fundamentals than the United States, the United Kingdom, or Japan. The political limits of European integration seem to have been reached with the crisis, which has acted as a catalyst, while the framework of the Eurozone as designed by Maastricht is not, or is no longer, appropriate. How can we move from EMU 1.0 to EMU 2.0?

This is the question we will attempt to answer in two stages in this series: first, we will identify the problems facing the eurozone, and then we will propose a solution tailored to these findings. We will adopt a systematic approach, analyzing each of the points we have just touched on in more detail.

Notes