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VOL. 11, NO. 2 • APRIL 2016 DALLASFED

Economic Letter

Consequences of the : Monetary Union, Economic Disunion?

by Enrique Martínez-García and Valerie Grossman }

ABSTRACT: Forming a ineteen countries in the flexibility, and labor mobility across bor- monetary union brings the have adopted ders lessen the costs associated with a the euro since 1999, surrender- monetary union and make it more likely benefits of a shared N ing independence over their for a currency area to be optimal for its but also—as the experience with the expectation members. It also suggests that deepening of the euro area shows in that commercial and political ties would cross-border capital flows or enactment the years following the global deepen. of policies to redistribute fiscal benefits A monetary union can lower transac- among union members can provide a financial crisis—significant tion costs and increase price transpar- degree of risk sharing and ease the bur- costs associated with the ency and competition, creating and den of a monetary union. loss of monetary policy financial opportunities. Countries reap The theory was put to a test when 11 independence and exchange these benefits based on their ability to European Union member states debuted exploit them. Similarly, the loss of mon- the euro in 1999: , , rate flexibility. etary policy independence affects some , , , Ireland, , countries much more than others. , , and Experience suggests that the euro area . joined in 2001, followed is far from the “optimal currency area” by in 2007, and in economists envisioned in the 1960s and 2008, in 2009, in 2011, that its advocates foresaw. Among the in 2014 and in 2015 reasons: diverging business cycles across (Chart 1). member countries, wage (and price) With such a varied group of countries, rigidities and limited mobility of labor a situation can arise in which aggregate and capital between euro economies. demand in one of them, say Spain, weak- ens at the same time that it strengthens in Case for Monetary Union another country, say Germany. Absent a The theory of optimal currency areas, currency union, such divergence could be developed in the early 1960s, outlines addressed by pursuing relatively expan- when the benefits of a shared currency sive monetary policy (lowering the policy outweigh the costs associated with the rate, for example) in Spain while tighten- loss of monetary policy independence ing monetary policy (raising the rate) in and exchange-rate flexibility.1 Germany. The idea behind the theory is that However, when the two countries are similar business cycles, price and wage bound by a shared currency and common Economic Letter

Similarly, a monetary union can Chart The European Union and the Euro Area in 2015 reduce the cost of adjusting to diverging 1 demand among countries through risk sharing with members. Such sharing can occur through capital markets (stock and Euro area bond markets) and cross-country fiscal Other members of the European Union transfers, such as unemployment insur- ance. The benefits of a common monetary policy diminish as risk-sharing mecha- nisms weaken.

Euro’s Benefits The perceived benefits of the euro stem from expanding trade, lowering transaction costs and facilitating cross- border flows of labor, capital and informa- tion. During the euro’s first eight years, a remarkable degree of nominal conver- gence occurred, most evident in interest rates on . Euro backers cited the compression of long-term inter- Chart est rates among member countries as Euro-Area Long-Term Borrowing Costs Converge Before 2008 indicative of the success of the monetary 2 (10-year government bond yields) union (Chart 2). Percent Monetary policy autonomy prior to 30 the euro led to differences among coun- Jan. 1, 1999: Euro launched tries that were reflected in long-term 25 spreads. After adopting Jan. 1, 2001: the euro, countries such as Spain could 20 Greece joins borrow at essentially the same rates as Germany. Spreads above Germany’s 15 relatively safe borrowing cost re-emerged in 2008 with the global financial crisis 10 in spite of a shared monetary policy because of heightened country risks. 5 Dissimilarities across Europe grew, under- scoring the costs that come with sacrific- 0 ’80 ’85 ’90 ’95 ’00 ’05 ’10 ’15 ing monetary policy independence. Greece Ireland Finland Portugal Belgium Luxembourg Monetary Union Limitations Spain France Netherlands Italy Austria Germany Before the euro, Spain and Germany

NOTE: Shaded areas show euro-area recessions, according to the Center for Research. pursued different economic policies tai- SOURCES: European ; Center for Economic Policy Research. lored to their own domestic conditions. Such behavior emerged with the 1992 recession. monetary policy, that’s not possible, creat- Looking at the U.S. in 1992, econo- Spain faced relatively weak aggregate ing a need for other mechanisms to share mists Olivier Blanchard and Lawrence demand and rapidly rising unemploy- risks and absorb shocks. Without recourse Katz examined the response to rising ment during the recession. Spanish to a nominal devalution, the unemployment.2 The states share a cur- policymakers chose to provide monetary real (-adjusted) value of the mon- rency (the dollar) and a monetary policy. accommodation, devaluing the peseta etary union’s currency can still decline In a well-functioning monetary union twice to stimulate economic activity and when wages and prices fall within an such as the U.S., adjustment often occurs boost demand (Chart 3). Germany, deal- area—an adjustment known as an internal through the movement of unemployed ing with a fiscal expansion arising from devaluation. Reduced costs of production workers to states with better opportuni- unification of West and , in one country will allow it to gain market ties and, to a lesser extent, through lower continued to pursue the tighter monetary share for its and boost economic wages (internal devaluation), the econo- policy stance it had taken since 1989. activity through external trade. mists argued. The two countries could pursue differ-

2 Economic Letter • Federal Reserve Bank of Dallas • April 2016 Economic Letter ing monetary policies because each had Chart its own currency. Exchange Rates Become Fixed with Euro Adoption When Spain and Germany adopted the 3 euro in 1999, they lost their ability to con- Deutsche mark/peseta duct monetary policy independently and to use the exchange rate as a policy instru- 0.028 Spain joins Euro European adoption 0.026 ment. The set Union monetary policy beginning in 1999 based 0.024 on the economic conditions of the larger 0.022 monetary union rather than in response to the particular needs of Spain or Germany. 0.020 The costs of a single currency with a 0.018 one-size-fits-all monetary policy became 0.016 Devaluations apparent during the 2008–09 recession, 0.014 when domestic economic conditions deteriorated abruptly and began to sig- 0.012 nificantly differ among euro-area nations, 0.010 including Spain and Germany (Chart 4). ’80 ’85 ’90 ’95 ’00 ’05 ’10 ’15 Germany was hit harder than Spain NOTES: Shaded areas show euro-area recessions, according to the Center for Economic Policy Research. The Deutsche mark was Germany’s currency and the peseta was Spain’s before the introduction of the euro. during the downturn but consistently SOURCES: Federal Reserve Board; Center for Economic Policy Research. outperformed the euro area during the recovery. Spain, meanwhile, significantly underperformed. The stance of monetary Chart Euro-Area Conditions Diverge After 2008–09 Global Recession policy became too restrictive for Spain, which suffered a severe economic contrac- 4 (Cumulative growth of real GDP since 2008) tion and high unemployment. Spain could Percent no longer unilaterally employ the tools it 8 formerly used to combat a slowdown and Spain 6 boost exports—lower interest rates and Euro area exchange rate devaluation. 4 Germany A weak recovery took hold in the euro area in 2009–12—but with significant dif- 2 ferences across countries. The 2010–12 sovereign debt crisis that was particularly 0 pronounced in the so-called periphery –2 countries, which included Spain, accentu- 3 ated the problem. The recovery firmed –4 up and became broad based as public finances improved during 2012–15. –6 2008–09 2009–12 2012–15 Labor Markets SOURCES: European Commission; authors’ calculations. Spain’s struggles and those of the other countries in the euro-area periphery since 2008 have raised questions about the Table costs of a common currency. The ability Spain’s Costly Change Since 2008: to undertake an internal devaluation has 1 Lower Labor Costs, Higher Out-Migration proven to be limited because European Spain Euro area Germany labor markets remain quite rigid and sub- ject to national wage setting. In such an 2009–12 2012–15 2009–12 2012–15 2009–12 2012–15 environment, wages and prices within a Real unit labor costs (%) –5.64 –1.53 –0.97 –0.56 –0.54 –0.05 country adjust slowly to changing econom- Unemployment rate (diff). 6.90 –2.50 1.80 –0.40 –2.20 –0.60 ic conditions. Although Spain regained Working-age population (%) –0.79 –2.28 –0.09 –0.25 0.37 1.64 some external competitiveness primarily Government debt over GDP (diff.) 32.71 15.25 12.97 2.19 7.21 –8.06 by lowering its labor costs, unemployment rose sharply—6.9 percentage points during NOTES: The table shows percent changes for the periods 2009–12 and 2012–15 in real unit labor costs and the working-age population. It also includes the difference in percentage points of the unemployment rate and the government debt over gross domestic 2009–12 on top of a 6.6 percentage-point product for both periods. rise during 2008–09 (Table 1). SOURCES: European Commission; authors’ calculations.

Economic Letter • Federal Reserve Bank of Dallas • April 2016 3 Economic Letter

Economists Blanchard and Katz, who remains relatively small (less than 2 per- Economic Review, no. 53, vol. 4, 1963, pp. 717–25. A questioned the costs of the European cent of its total gross domestic product). related examination of the euro can be found in “The Euro monetary union prior to its debut, pointed To cushion the effects of the 2008–09 and the Dollar in the Crisis and Beyond,” by Enrique out that labor mobility can be an even recession, national governments pursued Martínez-García and Janet Koech, Federal Reserve Bank of more important channel than internal expansive domestic fiscal policies that Dallas, and Monetary Policy Institute Annual devaluation to confront diverging - entailed accumulating substantial debt. Report, 2010. For more in-depth analysis, see Economics nomic conditions within a monetary The added obligations partly contributed of Monetary Union, Tenth Edition, by Paul De Grauwe, New union. to deteriorating conditions during the York: Oxford University Press, 1992, reissued 2014. Unlike movement between U.S. states, 2010–12 sovereign debt crisis.5 2 See “Regional Evolutions,” by Olivier J. Blanchard and labor mobility across European coun- Lawrence F. Katz, Brookings Papers on Economic Activity, tries—and sometimes within nations— Euro’s Future vol. 23, no. 1, 1992, pp. 1–76. was and remains limited. Structural European monetary union proved 3 Greece, Ireland, Portugal and Cyprus were bailed out by barriers (cultural, linguistic) continue costly following the 2008 recession the European Commission and the International Monetary to restrict labor mobility. The severity of because of limited wage and price flex- Fund, with additional support from the European Central the recession in Spain, among other fac- ibility and a lack of cross-border labor Bank, as a result of the 2010–12 sovereign debt crisis. tors, reduced the size of the working-age mobility. Moreover, the absence of a Spain received aid in 2012–13 for bank recapitalization. population, particularly during 2012–15, continues to confound the 4 See “Completing Europe’s Economic and Monetary as Table 1 shows. If workers cannot leave monetary union along with inadequately Union,” by Jean-Claude Juncker, in cooperation with Donald the country for opportunities elsewhere, developed private risk-sharing mecha- Tusk, Jeroen Dijsselbloem, Mario Draghi and Martin Schulz, they might become discouraged and drop nisms through deeper cross-border capi- European Commission, 2015. out of the workforce. Table 1 indicates that tal mobility. 5 In theory, the efficiency of a common redistributive policy labor force adjustment has occurred very The euro’s creation owes much to in the context of depends on the slowly and only after unemployment rates Europe’s desire to heal the wounds of amount of common benefits to be adopted. (See “A Single exceeded 20 percent after 2010. World War II and reassert itself on the Welfare Benefit Level for Europe? Efficiency Implications world stage. To the extent that European of Policy Harmonization in a Federal System,” by Jason Risk-Sharing Mechanisms countries remain committed to making L. Saving, Southern Economic Journal, no. 70, vol. 1, While significant progress has been the euro work, they will need to pursue 2003, pp. 184–94.) Furthermore, maintaining stable prices made toward developing a , policies to remove barriers and facilitate at home within a monetary union depends not solely on many obstacles to cross-border capital the cross-border movement of labor and domestic but also on the fiscal policies of other mobility remain—legal, regulatory and capital. governments with which a country shares a common cur- . In a 2015 report on accomplishing rency. (See “Control of the Public Debt: A Requirement for the economic and monetary union, the Martínez-García is a senior research Price Stability?” by Michael Woodford, National Bureau of European Commission endorsed comple- economist and advisor and Grossman is Economic Research, NBER Working Paper no. 5684, 1996; tion of a banking union and a new capital- a senior research analyst in the Research The Debt Burden and Its Consequences for Monetary Policy, markets union initiative.4 Department at the Federal Reserve Bank by Guillermo A. Calvo and Mervyn A. King, eds., New York: The same report cites movement of Dallas. St. Martin’s Press, 1998, pp. 117–54; and “The Precarious toward fiscal union as another important Fiscal Foundations of EMU,” by Christopher A. Sims, De long-term goal for Europe. However, Notes Economist, vol. 147, no. 4, 1999, pp. 415–36.) financial transfers across countries 1 See “A Theory of Optimum Currency Areas,” American haven’t played a significant role simply Economic Review, vol. 51, no. 4, 1961, pp. 657–65; “Op- because the European Union’s budget timum Currency Areas,” by Ronald I. McKinnon, American

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