The paper is remarkable in two ways. First, it describes how basically all leading U.S. economists mentioned in the paper were very critical on the introduction of the euro. Applying the standard theory of ‘optimal currency areas’, they came to the conclusion that the euro is a very bad idea and that an economic disaster would only be a matter of time. However, the European authors of the paper, just as many European politicians at the time, are surprised by the American scepticism, even though it is based on rigorous economic analysis.
Second, the timing of the paper is abysmally bad. It was published in 2009, just before the shit hit the fen, so to speak. Shortly after, the Eurozone plunged into an economic contraction similar in magnitude to the Great Depression of the 1930s, making the pessimistic forecasts of the U.S. economists come true.
Robert Mundell was one of the first economists who analysed which factors are the most important in determining the optimum economic area for a single currency. His paper ‘A theory of Optimum Currency Areas’ was so influential and original that he was awarded the Nobel Prize in economics. Most of the theory on optimum currency areas is based on Mundell’s ideas, which were then further elaborated by other influential economists.
In what follows, I will briefly summarize the most important criteria, which determine whether it is optimal for a region to share a currency and adopt a common monetary policy.
1) The degree of factor mobility
Mundell identified that an optimal currency area requires a high degree of factor mobility. This ensures that factors production, i.e. capital and labor, are moving to the region where their marginal productivity is highest. Factor mobility is thus crucial for an efficient allocation of resources within the currency area.
It turns out that labor mobility within the Eurozone is significantly lower than within the U.S. This is obviously due to large cultural differences, different languages, and other barriers (many of them institutional), which prevent people from moving to another country within the Eurozone and look for work elsewhere when faced with poor job opportunities at home.
In comparison, the economic costs associated with moving from one state to another are much lower in the U.S. For that reason, the difference in unemployment rates in between most states is relatively small: As of August 2014, Georgia has the highest unemployment rate with 8.1% while North Dakota has the lowest with 2.8%.
This difference of about 5 percentage points, however, is quite insignificant compared to what one can observe nowadays within the Eurozone: Germany and Austria have an unemployment rate of about 4.9% while in Spain and Greece unemployment is at 24.5% and 27.2%, respectively.
While in the U.S. labor moves from high-unemployment to low-unemployment states, thus leading effectively to a quasi-equalization of unemployment rates across states, low labor mobility within the Eurozone prevents this adjustment mechanism from happening.
Similarly, a high degree of capital mobility within a currency union is necessary so that capital can be allocated to the region where its marginal productivity is highest. In comparison to labor, capital is very mobile within the Eurozone. Unfortunately, instead of leading to an efficient allocation of resources, capital flows from the North to South created enormous housing bubbles in the European periphery, thus exacerbating boom and bust cycles within the currency area.
One can thus conclude that labor flows within the Eurozone were largely insufficient to create an efficient allocation of labor from taking place while capital flows were directed to unproductive activities, i.e. an overproduction of housing in the South. This misallocation of resources created the aforementioned bubble and thus led to an amplification of the business cycle.
2. The symmetry of economic shocks
Another factor that determines whether several countries make up an optimal currency area is the symmetry of economic shocks. Basically, both supply shocks (e.g. higher commodity prices) and demand shocks (e.g. a reduction in consumer spending) should be highly symmetric so that the business cycle across countries is synchronized. The synchronization of boom and bust cycles throughout a currency area is crucial since monetary policy has to respond to these shocks.
It is fairly obvious that the Eurozone does not fulfill this criterion. Using a standard Taylor rule, it is easy to see that monetary policy by the ECB was already inappropriate for most countries before the crisis. The nominal interest rate set in Frankfurt was too high for Germany, which suffered from low growth rates and elevated unemployment in the early 2000s after the Dot-Com bubble. Conversely, monetary policy was too loose for the European periphery. Low interest rates led to an economic boom creating large housing bubbles in countries like Ireland and Spain.
The Eurozone is far too diverse and economic shocks across member countries are highly asymmetric, which means that the stance of monetary policy is likely to be inappropriate for at least some of the member countries at any point in time.
3. Fiscal policy coordination and fiscal transfers
The smooth functioning of a currency union also relies on the amount of fiscal transfers from one region to the other. Paul Krugman points out that the housing bubble in Florida and the ensuing fall in home prices was roughly as bad as the one in Spain (http://krugman.blogs.nytimes.com/2012/06/02/florida-versus-spain/?_php=true&_&_r=0).
Nevertheless, unemployment in Florida leveled out at about 11.4% in the midst of 2010 and declined subsequently while unemployment in Spain exceeded 26% in 2012. This large difference can be attributed to fiscal transfers and automatic stabilizers. Unemployment benefits, food stamps and health care benefits are all programs that are paid by the federal government. Krugman’s quick and dirty estimation reveals that Florida received annual transfers from the federal government roughly equal to 4% of state GDP in 2010, which led to a significant cushioning of the recession. The absence of ‘federal’ transfers within the Eurozone (because there is no federal state) meant that the economic downturn in Southern European countries was much larger in comparison to the most affected states in the U.S. (such as Florida or California).
Aside from fiscal transfers, the institutional setup of the Eurozone requires the national states to use countercyclical fiscal policy as a stabilization tool. That is because monetary policy will be often inappropriate (either too loose or too tight) for many member countries. In the case of a boom, a government should thus reduce its expenditures to cool off the economy while in the case of an economic slump it must increase its expenditures. Unfortunately, exactly the opposite occurred. Governments usually spent too much in good times while unnecessarily engaging in harsh austerity in recent years. Pro-cyclical fiscal policy thus exacerbated the boom and bust cycle in the Eurozone. Instead of smoothening the business cycle, governments were thus largely responsible for amplifying it!
4. Lender of last resort for government and banks
The recent crisis also made it abundantly clear that Central Banks have to assume their role as lender of last resort, both for the banking sector as well as for the government. This role is obviously necessary for the financial industry. The business model of banks is to borrow short (banking deposits) and to lend long (credit to consumers and firms). This so-called maturity mismatch can get even healthy banks in trouble. In normal times, banks are protected by the law of large numbers. Usually, only a fraction of bank customers decide to withdraw some cash at any given day while at the same time other customers will increase their deposits. During a crisis, however, it frequently happens that a large number of people suddenly decide to withdraw cash out of fear that their bank might fail. In that case, even healthy banks can easily get into trouble because they only have a certain amount of capital at hand.
Governments usually have several tools at their disposal to prevent this kind of self-fulfilling prophecy from happening. Deposit insurance, for example, eliminates or at least reduces the incentive for bank customers to withdraw their money in times of crisis. Similarly, the Central Bank can always inject money into the banking system if required.
However, it turns out that the Central Bank’s role as lender of last resort is also crucial for the backing of government debt. The Eurozone crisis painfully revealed that there is a fundamental difference between countries that can borrow in their own currency (e.g. the U.S., the UK, Japan, etc.) and countries that cannot (e.g. Spain, Portugal, etc.).
Governments that can print their own currency can never run out of cash, which makes them fundamentally different from Eurozone countries. Spain’s government, for example, clearly can run out of cash and might be forced to default on its debt obligations. In that respect, Eurozone countries are more similar to U.S. states like Florida or California.
For that reason, American or Japanese government debt was regarded as much safer than debt issued by Eurozone countries. While the U.S., the UK, and Japan were able to borrow at record-low costs during the crisis despite having very high debt levels, the bond markets quickly turned against some of the Eurozone countries even though their economic fundamentals were roughly comparable at that time.
The crucial difference was that the ECB did not assume its role as lender of last resort. Of course once it did, it led to a significant improvement for the member countries, which were suffering from the speculation in the bond markets. In 2012 at the peak of the Eurozone crisis, Draghi’s announced that the ECB would do whatever it takes to save the currency area. In the months that followed his speech, bond yields of the so-called PIIGS countries (Protugal, Spain, Ireland, Italy, Greece) normalized very quickly without that the ECB was forced to buy a single bond. This supports the theory that bond yields at that time really did not accurately reflect economic fundamentals. Instead, speculation in the bond market followed a self-fulfilling prophecy, which was put to an end once the ECB de facto assumed its role as lender of last resort.
Using the four criteria mentioned above, it becomes obvious that the Eurozone really does not represent an optimal currency area. Labor mobility is minimal in between countries, economic shocks are highly asymmetric across the currency area, fiscal transfers and fiscal coordination between member countries is largely absent. Last but not least, the ECB has only very reluctantly assumed its role as lender of last resort, and this far too late after as a lot of economic damage was already inflicted.
Briefly after the introduction of the euro, Mundell thought that the common currency would be a success story. This is insofar surprising as his own criteria suggest that the Eurozone does not represent an optimal currency area.
The advent of the euro has demonstrated to one and all how successful a well planned fixed exchange rate zone can be. After the 11 currencies of the zone were locked to the euro and to each other, even before the euro has been issued as a paper currency or a coin, speculative capital movements between the lira and the mark, the franc and the peseta, and all the other currencies became a thing of the past. It ended uncertainty over exchange rates and destabilizing capital movements. The 11 countries of the euro zone are now getting a better monetary policy than they ever had before. The creation of the euro zone therefore suggests a viable approach to the formation of other currency areas when prospective members can agree on a common inflation rate and a coordinated monetary policy.
My considered opinion has long been that the loss outweighs the gain (from joining the euro). The potential members of the EMU do not have sufficiently flexible wages and prices, or sufficiently mobile workers, or a sufficiently effective fiscal compensatory mechanism, to serve as a satisfactory substitute for flexible exchange rates. The likely result is that the euro will exacerbate political tensions by converting divergent shocks that could have been readily accommodated by exchange rate changes into divisive political issues.
Bracket added to quote for clarity.
…for seven long years since the signing of the Maastricht Treaty started Europe on the road to that unified currency, critics have warned that the plan was an invitation to disaster. Indeed, the standard scenario for an EMU collapse has been discussed so many times that it sometimes seems to long term eurobuffs like myself as if it had already happened...
With the outbreak of the Eurozone crisis, it should have become clear that these American economists were right all along. But instead of following their advice on how to mitigate the economic crisis, European policy makers mostly did exactly the opposite of what economists recommended. The consequence is that the Eurozone member countries are now performing worse than during the Great Depression in the 1930s, a remarkable accomplishment!!!