Consequences of the Euro: Monetary Union, Economic Disunion?
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VOL. 11, NO. 2 • APRIL 2016 DALLASFED Economic Letter Consequences of the Euro: 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 European Union 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 currency N ing independence over their for a currency area to be optimal for its but also—as the experience monetary policy 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 trade 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: Austria, Belgium, rate flexibility. etary policy independence affects some Finland, France, Germany, Ireland, Italy, countries much more than others. Luxembourg, Netherlands, Portugal and Experience suggests that the euro area Spain. Greece joined in 2001, followed is far from the “optimal currency area” by Slovenia in 2007, Cyprus and Malta in economists envisioned in the 1960s and 2008, Slovakia in 2009, Estonia in 2011, that its advocates foresaw. Among the Latvia in 2014 and Lithuania 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 government debt. 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 interest rate 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 Economic Policy Research. pursued different economic policies tai- SOURCES: European Central Bank; 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 exchange rate devalution, the unemployment.2 The states share a cur- policymakers chose to provide monetary real (inflation-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 East Germany, 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 exports 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 European Central Bank 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.