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The Eurozone: Piecemeal Approach to an Optimum Currency Area

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The Eurozone: Piecemeal Approach to an Optimum Currency Area A Service of Leibniz-Informationszentrum econstor Wirtschaft Leibniz Information Centre Make Your Publications Visible. zbw for Economics Handler, Heinz Working Paper The Eurozone: Piecemeal Approach to an Optimum Currency Area WIFO Working Papers, No. 446 Provided in Cooperation with: Austrian Institute of Economic Research (WIFO), Vienna Suggested Citation: Handler, Heinz (2013) : The Eurozone: Piecemeal Approach to an Optimum Currency Area, WIFO Working Papers, No. 446, Austrian Institute of Economic Research (WIFO), Vienna This Version is available at: http://hdl.handle.net/10419/128970 Standard-Nutzungsbedingungen: Terms of use: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Documents in EconStor may be saved and copied for your Zwecken und zum Privatgebrauch gespeichert und kopiert werden. personal and scholarly purposes. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle You are not to copy documents for public or commercial Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich purposes, to exhibit the documents publicly, to make them machen, vertreiben oder anderweitig nutzen. publicly available on the internet, or to distribute or otherwise use the documents in public. Sofern die Verfasser die Dokumente unter Open-Content-Lizenzen (insbesondere CC-Lizenzen) zur Verfügung gestellt haben sollten, If the documents have been made available under an Open gelten abweichend von diesen Nutzungsbedingungen die in der dort Content Licence (especially Creative Commons Licences), you genannten Lizenz gewährten Nutzungsrechte. may exercise further usage rights as specified in the indicated licence. www.econstor.eu ÖSTERREICHISCHES INSTITUT FÜR WIRTSCHAFTSFORSCHUNG WORKING PAPERS The Eurozone: Piecemeal Approach to an Optimum Currency Area Heinz Handler 446/2013 The Eurozone: Piecemeal Approach to an Optimum Currency Area Heinz Handler WIFO Working Papers, No. 446 February 2013 Abstract Soon after the establishment of the Eurozone it became obvious that the structural differences between member countries would not abate, as expected, but rather gradually widen. Although part of the problem can be attributed to the enlargement process, it also relates to asymmetric effects of the common currency and to diverging economic policies. This paper discusses the literature which associates the economic characteristics of EMU with arguments of the optimum currency area (OCA) theory and asks for missing capstones that would meliorate EMU to eventually resemble an OCA. As potential candidates for such building blocks, some sort of fiscal union and lender of last resort may qualify, drawing on the experiences of other currency unions and federal states. The financial and debt crisis has revealed that the endogenous forces within a currency union may be too slow to absorb the shocks originating from the crisis. For a currency union to survive in such a situation it is all the more important that the OCA criteria are met and/or that complementary institutions are in place. However, as actual developments in the Eurozone reveal, the political process of approaching an OCA is piecemeal rather than comprehensive and prompt. E-mail address: [email protected] 2013/035/W/0 © 2013 Österreichisches Institut für Wirtschaftsforschung Medieninhaber (Verleger), Hersteller: Österreichisches Institut für Wirtschaftsforschung • 1030 Wien, Arsenal, Objekt 20 • Tel. (43 1) 798 26 01-0 • Fax (43 1) 798 93 86 • http://www.wifo.ac.at/ • Verlags- und Herstellungsort: Wien Die Working Papers geben nicht notwendigerweise die Meinung des WIFO wieder Kostenloser Download: http://www.wifo.ac.at/wwa/pubid/46402 1 The Eurozone: Piecemeal Approach to an Optimum Currency Area Heinz Handler (WIFO, Vienna University of Technology) Abstract Soon after the establishment of the Eurozone it became obvious that the structural differences between member states would not abate, as expected, but rather gradually widen. Although part of the problem can be attributed to the enlargement process, it also relates to asymmetric effects of the common currency and to diverging economic policies. This paper discusses the literature which associates the economic characteristics of EMU with arguments of the optimum currency area (OCA) theory and asks for missing capstones that would meliorate EMU to eventually resemble an OCA. As potential candidates for such building blocks, some sort of fiscal union and lender of last resort may qualify, drawing on the experiences of other currency unions and federal states. The financial and debt crisis has revealed that the endogenous forces within a currency union may be too slow to absorb the shocks originating from the crisis. For a currency union to survive in such a situation it is all the more important that the OCA criteria are met and/or that complementary institutions are in place. However, as actual developments in the Eurozone reveal, the political process of approaching an OCA is piecemeal rather than comprehensive and prompt. Keywords: Eurozone, endogenous optimum currency areas, national and multinational currency unions JEL classification: E42, E65, F33, F36, F42, F55 Contact: [email protected] Homepage: http://heinz.handler.wifo.ac.at This study is part of a project (“Possible Futures of the Eurozone”) funded by the “Jubiläumsfonds der Oesterreichischen Nationalbank” (Project No. 14261). 2 1. Introduction Triggered by the global financial and economic crisis, which in 2007 originated in the United States, structural and institutional weaknesses within the European Economic and Monetary Union (EMU or Eurozone) have become obvious which in previous "normal" times had remained hidden. Already in the run-up phase to the EMU there was a considerable debate as to whether this union of heterogeneous states could reap the benefits of an "optimum currency area" (OCA). Sceptic voices (such as Krugman, 1993, or Eichengreen, 1998) were countered by the argument that "EMU entry per se, for whatever reasons, may provide a substantial impetus for trade expansion; this in turn may result in more highly correlated business cycles" (Frankel – Rose, 1998). Thus, it was expected that an "endogenous currency area", i.e. a gradual convergence of economic structures after commencement of the monetary union, would be self-validating and ensuring the viability of the monetary union. Soon after the establishment of the Eurozone it became obvious, however, that the structural differences between member states would not abate, but over the years become even larger. This is partly due to the enlargement process, which has integrated more and more peripheral countries into the euro zone (Peters, 2006). In terms of relative unit labour costs, the gap which existed in 1999 has increased up to 2008 by another 25%. In 2009, the economic crisis reduced the spread between the country with lowest relative costs (Germany) and the one with highest relative costs (Ireland) to some 20% (De Grauwe, 2010a). A similar picture is revealed by other structural indicators. This paper discusses the literature which relates the OCA arguments to the characteristics of EMU and asks for missing capstones that would meliorate EMU to eventually resemble an OCA. As potential candidates for such building blocks, some sort of fiscal union and lender of last resort may qualify, drawing on the experiences of other currency unions and federal states. The financial and debt crisis provides a unique possibility to reconsider the necessity and sufficiency conditions for presumptive members of a monetary union and evaluate the possibility of a long-lasting stable relationship between them. The following Chapter 2 discusses the literature on theoretical arguments and empirical evaluations of the traditional and endogenous optimum currency area models. Chapter 3 confronts the general results with the situation in the European Monetary Union (EMU). An attempt is made to delineate the factors which preclude EMU from being an OCA, and to reason about the consequences for the sustainability of EMU. Experiences from the fate of previous and existing other currency unions, national and multinational ones, are presented in Chapter 4. The concluding Chapter 5 summarises the results. 2. Traditional and endogenous optimum currency areas Within Europe the debate on the creation of a monetary union was not motivated by the choice between a fixed versus a floating exchange rate system which is the focal point of the OCA theory. The (political) question rather was whether the German dominance in monetary affairs should be continued and even extended, or be substituted by a jointly organised monetary system (see Archer, 2002). The link to the OCA theory was emphasised by US economists, such as Bayoumi 3 – Eichengreen (1996): “Like it or not, the theory of optimum currency areas remains the workhorse for analyses of European monetary unification. Indeed, many economists do not like it very much.” This quote remains valid until today, and a number of advances in the theory and its empirical applications make it look a rather modern tool for analysing the macroeconomics of fixed exchange rates. However, some others, including Goodhart (1995) and Bordo – Jonung (1999), maintain that the predictive power of the OCA theory concerning the evolution of a monetary union is rather weak. Mongelli (2002) has subdivided the development of the OCA theory into four phases: • the “pioneering phase” from the early 1960s to the early 1970s which established the OCA theory
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