Abstract
Index for Illustrations and Tables
List of Abbreviations
Executive Summary
0 Introduction
1 Theory of the Optimum Currency Area
1.1 Mundell on factor mobility
1.2 McKinnon on the degree of openness
1.3 Kenen on product diversification
1.4 Limitations, conflicts and contradictions
1.5 Modern views
2 Cost and benefits of currency unions
2.1 Monetary efficiency
2.2 Economic growth and trade
2.3 International use
2.4 Credibility of monetary policies
2.5 Loss of monetary independence
2.6 Cost and benefits compared
3 The European Economic and Monetary Union as an OCA
3.1 Synchronization of business cycles
3.2 Cross-country insurance mechanisms
3.2.1 Labour mobility
3.2.2 Price and wage flexibility
3.2.3 Integration of financial markets
3.2.4 Fiscal capacity
3.3 Is the EMU an OCA?
4 The EMU and the global economic and financial crisis
4.1 Pre-crisis risk factors
4.2 The crisis
4.3 Post-crisis outlook
4.4 Reform of fiscal and economic governance in the EMU
4.4.1 The Stability and Growth Pact
4.4.2 The European Semester, the Six-Pack and the Two-Pack
4.4.3 The European Stability Mechanism and the Fiscal Compact
4.4.4 The Euro Plus Pact
4.5 The Banking Union
4.6 The need for a cyclical stabilization tool
5 Fiscal capacity with a stabilization function in the EMU
5.1 Risk-sharing mechanisms
5.2 European unemployment insurance
5.3 Cyclical shock insurance for the euro area
6 Evaluation of the European unemployment insurance
6.1 Framework of evaluation criteria
6.2 Stabilization properties
6.2.1 Timely response to cyclical developments
6.2.2 Strictly targeted on short-term asymmetries
6.3 Distribution neutrality
6.4 Moral hazard and incentives
6.4.1 Avoid incapacitation of domestic stabilizers
6.4.2 Support structural reforms
6.4.3 Avoid inefficient implementation of transfers
6.5 Political feasibility
6.5.1 Fit with national and European institutions
6.5.2 Transparency
7 Summary and conclusion
Bibliography
The member states of the euro area have delegated the framing of monetary policy to a European Central Bank, while fiscal policy remains in responsibility of the national governments. In a monetary union, counter-cyclical fiscal policy can deliver only limited help to minimize the loss of monetary policy for adjustment to idiosyncratic shocks. As fiscal capacity at EMU level could transfer a significant part of the cyclical aspects of fiscal policy to the supranational level and help the euro area members to focus their fiscal policy on structural balances.
A variety of such risk-sharing mechanisms have been suggested in the academic literature. This Master’s Thesis evaluates the concept of euro area wide unemployment insurance, in comparison with cyclical transfers between the Eurozone members based on their business cycle position. The European unemployment insurance scheme surpasses other concepts with regards to the criteria distributional neutrality and transparency, both of which are essential in order to gain support of European policymakers and voters.
Abstract
Die Mitgliedstaaten der Eurozone haben die Gestaltung einer gemeinsamen Geldpolitik an eine Europäische Zentralbank übertragen, während die Fiskalpolitik in die Verantwortung der nationalen Regierungen erhalten blieb. In einer Währungsunion kann eine antizyklische Fiskalpolitik nur in begrenztem Umfang zur Abfederung asymmetrischer Schocks dienen. Allerdings könnte ein fiskaler Transfermechanismus auf Ebene der Europäischen Währungsunion ein erheblicher Teil der zyklischen Aspekte der Finanzpolitik auf die supranationale Ebene transferieren und so den Mitgliedern des Euroraums ermöglichen, ihre Fiskalpolitik auf strukturelle Gesichtspunkte zu konzentrieren.
In der akademischen Literatur wurde eine Vielzahl solcher Mechanismen vorgeschlagen. Diese Masterarbeit bewertet das Konzept einer Arbeitslosenversicherung für die Eurozone im Vergleich zu zyklischen Risikoversicherungsmechanismen. Die Europäische Arbeitslosenversicherung übertrifft alternative Konzepte in Bezug auf die Charakteristika Verteilungsneutralität und Transparenz. Beide sind wesentliche Kriterien um öffentliche Unterstützung für dieses Konzept sicherzustellen.
Figure 1: Cost-benefit representation of the OCA criteria
Figure 2: Unemployment in 1999 and 2012, US and Eurozone
Figure 3: Employment dynamics of Massachusetts
Figure 4: Symmetry and labour market flexibility in monetary unions
Figure 5: Evolution of public debt ratios between 1982 and 2011
Figure 6: Current account balances of selected Eurozone members
Figure 7: Relative unit labour cost, EMU 1999 to 2011 (average 1970-2010 = 100)
Figure 8: Ten-year yields on sovereign bonds, January 1993 to February 2012
Figure 9: Yields on 10-year sovereign bonds, October 2009 to June 2012
Figure 10: 10-year yield spreads over German bonds in Q4 2011
Figure 11: Changes introduced by the Six Pack
Figure 12: Changes introduced by the Two Pack
Figure 13: Overview of empirical studies
Figure 14: Calculation of individual transfers
Figure 15: Unemployment rates by duration in selected EMU countries, 2007 and 2013
Figure 16: Evolution of Commission estimates for Greek output gap in percent of GDP
Figure 17: Evaluation of different risk-sharing mechanisms (Source: own table)
illustration not visible in this excerpt
In contrast to most existing monetary unions, the member states of the euro area have delegated the framing of monetary policy to a European Central Bank, while fiscal policy remains almost entirely in responsibility of national governments, under a set of rules set in the Maastricht Treaty and the Stability and Growth Pact.
According to the theory of Optimum Currency Areas, the stability of a monetary union depends on its capacity to cope with idiosyncratic shocks through automatic adjustment mechanisms, such as the flexibility of wages and prices, labour mobility across the union and the integration of capital markets. However, evidence suggests that these mechanisms are weak compared to most other currency unions and moreover, that the diverse cultural and political environment of the euro area impedes their “endogenous” development.
Lacking sufficiently developed automatic stabilizers, counter-cyclical fiscal policy could minimize the loss of the monetary policy channel for adjustment of asymmetric shocks. However, the entry into a monetary union fundamentally changes the capacity of governments to finance their budget deficits. Governments have to issue debt in a common currency outside their direct control and in addition, lack a national central bank as lender of last resort. This phenomenon makes currency unions more vulnerable to changing market sentiments. As a result, the member states of a monetary unions face issues, which are typical for emerging economies, where the inability to engage in Keynesian fiscal policies to absorb asymmetric shocks tends to produce more pronounced booms and busts.
The recent financial crisis exposed the fragile nature of the Eurozone, as well as weaknesses of the Union’s governance framework and crisis resolution mechanisms. As a consequence, the EU tightened its system of economic and fiscal governance in several incremental steps and furthermore introduced additional financial backstops.
As a supplement to the reformed governance framework, the European Commission proposed the implementation of a central fiscal capacity for the euro area in her "blueprint for a deep and genuine economic and monetary union” in November 2012. Since the Commission’s "blueprint”, a variety of risk-sharing mechanisms have been suggested in the academic literature. Dullien (2008, 2013), for example, proposed a common short-term unemployment insurance scheme as a joint stabilization mechanism for the Eurozone, a concept, which also found continuous support on the part of the European Commission.
This Master’s Thesis evaluates Dullien’s euro area wide unemployment insurance scheme in comparison with the concept of cyclical transfers between the Eurozone members based on the relative output gap as a measure for business cycle position.
The assessment of the above concepts requires a framework of relevant criteria as a basis, most of which tie with the requirements for a common fiscal capacity as detailed in the “blueprint” of the Commission, namely, stabilization properties, distribution properties, moral hazard and incentives and political feasibility.
The results can be summarized as follows:
Both mechanisms score high on stabilization and can be expected to deliver timely and sufficiently targeted responses to cyclical developments. However, federal unemployment benefits can be expected to crowd-out domestic spending and release financial resources, which bight be spent in a suboptimal way by national governments.
The European unemployment insurance scheme is clearly superior in terms of its distributional properties. While this mechanism allows for adjustment of country-specific contribution rates in order to offset sustained surpluses or deficits, distributional neutrality of schemes based on the relative output gap still remains to be verified.
Compared to EMU-wide unemployment benefits, cyclical transfers earmarked to national payroll taxes suggest better performance with regards to the avoidance of moral hazard.
Both schemes would seamlessly merge into the framework of national and European institutions and mechanisms.
In contrast to risk-sharing schemes based on the complex and non-observable output gap metric, the European unemployment insurance scores high on transparency.
In light of the current political environment, characterized by increasing levels of Euroscepticism, strong performance in distributional neutrality and transparency seems to be essential for a common fiscal capacity mechanism to find sufficient support among European policymakers and voters.
Only the concept of euro area wide unemployment insurance satisfies these essential requirements to the full extent.
The 2008 financial crisis, sparked by the US subprime mortgage crisis, brought the global financial system to the brink of a catastrophe. In addition to plunging the global economy into the most severe recession since the Second World War, the crisis also challenged the existence of the European Union’s (EU) single currency, the euro, and the EU as a whole. The subsequent sovereign debt crisis in Europe raised doubts over the Union's institutional and procedural framework, and it ability to safeguard the proper functioning of the Economic and Monetary Union (EMU).
In contrast to most existing monetary unions, the member states of the euro area have delegated the framing of monetary policy to a European Central Bank, while fiscal policy remains almost entirely in responsibility of national governments, under a set of rules set in the Maastricht Treaty and the Stability and Growth Pact.
Lacking independent monetary policy, the stability of a monetary union depends on its capacity to deal with idiosyncratic shocks through automatic adjustment mechanisms. According to the theory of Optimum Currency Areas (OCA), these mechanisms include, first and foremost, flexibility of wages and prices, as well as mobility of labour across the member states, and integration of capital markets. However, evidence suggests that the diverse cultural and political environment of the Eurozone compromises the working of these mechanisms. In the absence of sufficiently developed automatic stabilizers, counter-cyclical fiscal policy could minimize the loss of the monetary policy channel for adjustment of asymmetric shocks.
Recent experience suggests, though, that despite of the union-wide fiscal governance system, most euro-zone countries failed to implement counter-cyclical fiscal policies in times of favorable economic conditions. Moreover, classic Keynesian fiscal policies on the part of the individual member states seem an insufficient tool to combat output shocks in a currency union. Joining a monetary union fundamentally changes the capacity of governments to finance their budget deficits. Governments have to issue their debt in a common currency, which is functionally equivalent to a foreign currency in the sense that they don’t control its supply. Therefore, in extreme cases, financial markets can force a severe liquidity crisis or even default upon the members of a monetary union (“self-fulfilling solvency crisis”).
As a consequence, after the acute impacts of the 2008 crisis had subsided, the EU substantially tightened its system of economic and fiscal governance, and introduced financial backstops like the European Stability Mechanism (ESM) and the Banking Union, aimed at preventing the spread of future shocks across its member states.
In addition, a renewed debate has emerged on how to move fiscal stabilization policies to the European level, culminating in the European Commission’s "blueprint for a deep and genuine economic and monetary union” in November 2012, which proposed the implementation of a central fiscal capacity for the euro area. Such a risk-sharing mechanism would transfer a significant part of the cyclical aspects of fiscal policy to the supranational level and help the member states to focus their fiscal policy on structural balances.
Since the Commission’s “blueprint”, a variety of risk sharing mechanisms have been suggested in the academic literature, for instance the expansion of the Union’s budget, or the implementation of a cyclical insurance scheme at EMU level, which would manage in- and outflows directly linked to the business cycle position of the individual member states. Dullien (2008, 2013) proposed a common short-term unemployment insurance scheme as a joint stabilization mechanism for the Eurozone, a concept, which also found continuous support on the part of the European Commission.
This Master’s Thesis evaluates Dullien’s euro area wide unemployment insurance scheme in comparison with an alternative EMU-wide risk-sharing concept, which appears in the academic literature in a considerable number of variants: a cyclical transfer mechanism based on the relative output gap as a measure for business cycle position.
The Thesis is structured as follows: Chapter 2 summarizes the academic literature related to the theory of the OCA, as well as the respective views on cost and benefits related to membership in a monetary union. Chapter 3 tries to answer the question whether the EMU holds the main characteristics of an OCA as defined in the vast literature on currency areas. Furthermore, it will be analyzed whether “endogenous” developments brought the European monetary union closer to an OCA. Chapter 4 then examines the impacts of the 2008 economic and financial crisis on the European economies, the weaknesses the crisis exposed, and the subsequent reform of the European governance framework in order to address those shortcomings. Chapter 5 provides an overview of the various risk-sharing mechanisms proposed in the academic literature, with a strong focus on the Dullien’s European unemployment insurance scheme and the concept of EMU-wide cyclical shock insurance as detailed by Enderlein et al (2013).
In chapter 6, a framework of evaluation criteria is establishment as a basis to assess the above risk-sharing concepts. These criteria are applied in order to analyze the strengths and shortcomings of both concepts. A summary and conclusion is then presented in Chapter 7.
The theory of Optimum Currency Areas (OCA) has its early origins in a series of papers, which questioned the Bretton-Woods system of monetary management under which fixed, but adjustable, exchange rates prevailed. However, most authors, which participated in that debate about the benefits and trade-offs of different exchange rate regimes disregarded the specific characteristics of real-world economies and made their cases equally applicable to economies of any kind.[1]
In 1960s, Mundell (1961), McKinnon (1963), and Kenen (1969) laid the foundations of the theory of OCAs in three highly influential papers, showing that the specific characteristics of an economy should determine its exchange rate regime. The authors identified the properties, which individual economies within a single currency area should possess and laid out the cost and benefits resulting from the use of a common currency. Subsequent authors criticized and refined the contributions of Mundell, McKinnon and Kenen, adding to their framework of characteristics and providing more detailed assessments of the benefits and costs of currency union.
Nevertheless, the theory of OCAs remained inconsistent and fragile and as a result, academic interest in this field of research faded in the early 1970s. New developments in economic research, as well as the experience of the European monetary union led to a revival of the OCA theory almost 20 years later.
Mundell (1961) shared the arguments of preceding authors, which questioned the Bretton-Woods system and argued in favor of flexible exchange rate regimes as means to achieve the goal of economic stability. However, in contrast to those authors, he challenged whether individual countries are the appropriate units to take full advantage of the benefits of flexible exchange rates. Mundell proposed three criteria to determine the geographic area, in which economic stability, characterized by low inflation, full employment and a sustainable balance-of-payments position, can be achieved without the need to fall back on nominal exchange-rate adjustments:
Firstly, he identified internal factor mobility, particularly internal labor mobility as the main trait of an OCA, since the geographic mobility of the labor force would mitigate imbalances resulting from asymmetric shocks and therefore reduce the need for nominal exchange-rate adjustments.
Secondly, lacking sufficient labor mobility, the flexibility of wages across an OCA would have similar stabilizing effects.
Thirdly, in the absence of a mobile workforce and a certain degree of price flexibility, Mundell argued for flexibility of nominal exchange rates and individual monetary policy as the appropriate means to facilitate economic stability.
McKinnon (1963) added the degree of openness to Mundell’s set of criteria, which he defined as the ratio of tradable goods to non-tradable goods. He examined how the effects of a shock will change the relative price of tradable and non-tradable goods in an economy, claiming that the general price index of a relatively open economy will respond much more strongly than the general price index of a relatively closed economy. McKinnon argued “if we move across the spectrum from closed to open economies, flexible exchange rates become both less effective as a control device for external balance and more damaging to internal price level stability.”[2] Consequently, export oriented countries with a high ratio of tradables to non-tradables should employ fiscal policy rather than flexible exchange rates to cure economic imbalances and therefore will draw benefits from forming or joining currency areas.
Also the size of an OCA plays a critical role according to McKinnon, as the prices of tradables (both imports and exports) will vary with fluctuating exchange rates. Consequently, for a small and export oriented country, the nominal exchange rate will be an unsuccessful means to affect trade terms and hence to restore external balance. As a result, only in case “the area under consideration is sufficiently large so that the body of non-tradable goods is large, then pegging the value of the domestic currency to this body of non-tradable goods is sufficient to give money liquidity value in the eyes of inhabitants of the area in question”.[3]
Kenen (1969) proposed the diversification of production as an additional characteristic for OCAs, since a well-diversified economy will be more resilient against changes in demand for its export products. Positive and negative impacts on exports will to some degree offset each other, which, in comparison to less diversified economies, will decrease the likelihood and impact of asymmetric shocks and ease their negative effects. Thus, a country with a low degree of product diversification needs flexible exchange rates to cushion the impacts of external shocks, while a highly diversified economy may find it beneficial to form or join a currency area.
Furthermore, Kenen argued that similar production structures among the countries sharing a common currency might reduce the incidence of shocks, which impact the countries in an asymmetric way.
Kenen also advanced the idea that fiscal integration should be a criterion to judge optimality for participation in a single currency area. He claimed that a high level of fiscal integration between two areas increases the ability to mitigate the effects of asymmetric shocks through fiscal transfers from low unemployment regions to high unemployment regions.
Dellas and Tavlas (2009) summarize the classical arguments as follows:[4]
Degree of factor mobility, as well as wage and price flexibility (Mundell)
Occurrence of asymmetric shocks (Mundell)
Degree of openness (McKinnon)
Size of an economy (McKinnon)
Level of fiscal integration (Kenen)
Level of sectorial diversification (Kenen)
Similarity of economic structures (Kenen)
Throughout the 1960s, the above contributions received thorough peer reviews and triggered a broad and controversial discussion among the scientific community.[5]
However, the framework of criteria remained internally inconsistent and fragile and can, under certain conditions, produce inconsistent and contradictory results.
For instance, Dellas and Tavlas (2009) claim “the openness characteristic suggests that small economies should adopt pegged rates since small economies are likely to be relatively open. Such economies, however, are also apt to be relatively undiversified, making them better candidates for flexible rates according to the diversification criterion.” Moreover, Mundell, McKinnon and Kenen built their framework of criteria in an environment shaped by the Bretton Woods System of exchange rates and limited international capital flows. The authors analyzed their claims, using a simple model of the world economy comprised of two countries, assuming a permanent trade-off between inflation and unemployment (Phillips curve) that could be exploited by the fiscal authorities to fine-tune the economy. Their assumptions might have led the authors to overlook several factors, which considerably complicate the choice of an exchange-rate regime.[6]
However, Mundell’s basic argument survived despite these valid criticisms, with particularly factor mobility being today understood as a key criterion defining an OCA.[7]
While Mundell, McKinnon and Kenen focused on specific characteristics, which depend on the state of a specific economy, in the 1970s, the discussion moved toward criteria related to macroeconomic policy tradeoffs. These include differences in targeted rates of inflation and unemployment, the degree of general policy integration, and the variability of real exchange rates.[8]
Some authors went even further, arguing that economic criteria were of minor concern in the assessment of OCAs, as opposed to the long-term political commitment on the part of the respective governments.[9]
In light of the various limitations, conflicts, contradictions inherent in the OCA framework, academic interest in this theory faded in the mid 1970s. However, substantial new developments in international macroeconomics, as well as the experience of the European monetary union led to a revival of the OCA theory.[10]
The earlier literature was based on the assumption of an exploitable long-run Phillips curve, with the implication that delegating monetary policy to a central monetary authority imposes high cost on an economy. However, as confidence in a permanent inflation-unemployment trade-off had gradually eroded, the modern literature on OCAs shifted away from examining the characteristics of economies toward credibility aspects of alternative exchange-rate regimes.
Alesina and Barro (2002) even view the elimination of the inflation-bias problem of discretionary monetary policy, which results from incentives for governments to over-stimulate their economies and to monetize budget deficits and debt, as major benefit of currency unions.[11]
Other authors emphasize that, particularly for countries with histories of high inflation, joining a monetary union with a centralized monetary authority can act as a credible commitment to low inflation, which will alter inflation expectations and consequently reduce the cost of accomplishing a low-inflation equilibrium. Thus, the loss of national monetary policy, which the early authors viewed as major cost of monetary unification, turns into a benefit in the modern literature.[12]
While the early authors focused their work on aspects that qualify an economy to join a monetary union, Frankel and Rose (1996) initiated a stream of literature that investigated how the characteristics of economies change after having adopted a common currency: They argue that “a naive examination of historical data gives a misleading picture of a country’s suitability for entry into a currency union, since the OCA criteria are endogenous. Entry into a currency union may raise international trade linkages […] and more importantly, tighter international trade ties can be expected to affect the nature of national business cycles.” Though Frankel and Rose acknowledge the ambiguous nature of reduced trade barriers, which could either help dampen business cycles across a currency union, but also “result in increased industrial specialization by country and therefore more asynchronous business cycles resulting from industry-specific shocks”, the empirics they presented suggests that historically, increased trade integration has resulted in a higher degree of business cycle synchronization.[13]
As most empirical studies on cost and benefits of joining a currency union have been based on the experience gained from the European monetary union, the respective contributions will be discussed below the context of the Eurozone.
The most obvious benefit of monetary union is the elimination of expenses, which are directly related to the exchange of one currency into another. The EU Commission estimated the respective financial gain between ¼ and ½ percent of the EU’s GDP (mostly offset via lower bank revenues, though). Furthermore, the adoption of a common currency also leads to more price transparency, thereby increasing competition, which in turn should facilitate the convergence of prices across the currency union. However, De Grauwe (2012) emphasizes evidence that the monetary union had little effect on the regional dispersion of consumer price across the euro area.[14]
The elimination of exchange rate risks through a common currency is generally viewed as beneficial, as the increase in predictability should enhance welfare in a world populated by risk-averse individuals. However, this argument is discussed controversially in the literature and might not apply under any circumstance. For example, exporting can be viewed as an option whose value, according to option theory, increases with the variability of the underlying asset. Consequently, exchange rate uncertainty would pose a value on the exporter. However, De Grauwe (2012) argues that the fat-tailed distribution of freely floating exchange rates may impose substantial bankruptcy risks on exporters, offsetting the gain from the option value. Furthermore, extreme changes of free-floating exchange rate can trigger major macroeconomic disturbances, rather than posing a tool to combat asymmetric shocks. Therefore their elimination would increase public welfare.[15]
During the run up to the euro introduction, the Commission argued that the elimination of exchange rate risk will step up economic growth across the Eurozone. Lower overall systemic risk would reduce the discount rate implied in business transactions, which would boost capital investment and lift the Eurozone economies on a higher growth path. However, there is limited evidence that the common currency has accelerated growth in the Eurozone as a whole. Only the periphery counties of the European Economic and Monetary Union (EMU) show an acceleration of growth as predicted by the Commission. In this context, De Grauwe (2012) argues that the euro did not reduce the systemic risk in the EMU core countries, as exchange rate uncertainty might have been replaced by other risks specific to the working of a monetary union.[16]
The fact that a shared currency will likely gain additional weight in international monetary relations may create additional benefits for the members of a monetary union: The increasing use of the currency outside the political territory of the monetary union will yield seigniorage income for the union’s national bank. While there are no data available for the EMU, seigniorage profits for the US Federal Reserve are estimated between 0.3 and 0.5 percent of GDP. Furthermore, the shared currency may find increasing acceptance as an international reserve currency, which would benefit the liquidity of sovereign debt issued by the monetary union’s governments. According to the European Central Bank, in 2010 the euro represented about 27 percent of all currency reserves held by central banks, compared to 60 percent for the US dollar. Finally, a benefit difficult to quantify, the international acceptance of a shared currency might also boost financial markets within the monetary union.[17]
The almost irreversible nature of a currency union also increases the credibility of traditional high-inflation members to adopt low-inflation policies in the future. Following from the Barro-Gordon model, unexpected inflation affects the short-term unemployment rate of an economy. A higher than expected inflation rate will lower the unemployment rate in the short-term, and vice versa. This relation creates an incentive for a government to manipulate expectations about future inflation rates for the sake of short-term benefits in employment. However, the economic agents will adjust their forecasts accordingly, which ultimately leads to a suboptimal equilibrium where inflation and unemployment exceed their natural levels, triggering respective losses in welfare. This cycle can only be broken by the government establishing confidence in its commitment to low inflation, which is difficult to achieve. In contrast to a mere commitment, joining a currency union with a centralized monetary policy swiftly re-establishes the agent’s trust. Therefore, monetary union can pose significant benefits to countries with a historically high inflation.[18]
According to Mundell’s theory of OCAs, the main cost of joining a monetary union lies in the loss of national monetary independence, which affects its member’s ability to deal with asymmetric shocks by way of individual monetary and exchange rate policies. However, the effectiveness of monetary policy to combat permanent asymmetric shocks has been challenged by several authors.
De Grauwe (2014) claims that the impact of currency devaluation on a country’s price level tends to dissipate over time.[19]
The devaluation will initially lower the relative prices of the country’s exports, and in this way restore competitiveness. However, the devaluation will simultaneously increase the relative prices of imports, which will put upward pressure on domestic wages, washing out the effects of the currency devaluation over time. The extent to which this will happen increases with the openness of an economy, potentially dampened by the willingness of the domestic workforce to accept a decline in purchasing power. In an open economy with rigid wages, currency devaluation will be ineffective to combat permanent asymmetric shocks and the cost of joining a monetary union will be low. On the other hand, also in a monetary union, a decline in real wages is needed to restore the initial output level after a permanent idiosyncratic shock. In contrast to the above, the reduction of real wages requires here a drop in nominal wages. Obviously, this is more difficult to achieve, as the workforce will typically resist a cut in nominal wages more violently than an increase in nominal wages below the rate of inflation. However, while national monetary policy might be ineffective in combatting permanent demand shocks, it is considered a useful tool to stabilize temporary business cycle dynamics, where wage flexibility cannot be invoked to solve the problem. A member of a monetary union is left with fiscal policies to mitigate the impacts of temporary boom and bust dynamics on its residents, which might pose the risk of amplifying the shock, liquidity crisis or even default.
In addition, De Grauwe (2014) argues that the classical OCA theory lacks one basic aspect, namely, that the entry into a monetary union fundamentally changes the ability of governments to finance budget deficits. While in a stand-alone currency regime a country can request its national central bank to act as a lender of last resort, the members of a monetary union issue their debt in a currency they don’t control. The common currency can play a stabilizing role in the event of a temporary shock, increasing the liquidity of sovereign debt, particularly for small economies. However, in case a country faces a deep and persistent shock, automatic stabilizers might lead to unsustainable levels of public debt, and investors might lose confidence in the country’s solvency. Consequently, distrust of investors will drive up long-term interest rates, requiring the government to implement severe austerity measures, which will amplify the asymmetric shock, inflict severe hardship on its residents, dampen GDP growth, and in turn further deepen the distrust. Thus, financial markets can push a member of a monetary union into a bad equilibrium, which, in extreme cases, can result in severe liquidity crisis or even default (“self-fulfilling solvency crisis”). In other words, while capital markets in a monetary union typically play a stabilizing role, the loss of monetary independence can also increase the vulnerability of its members to the distrust of investors.[20]
Moreover, as banks typically hold a significant proportion of government bonds, a sovereign debt crisis might spill over into the banking sector, with strong externalities posed also on other members of the currency union.
Although the various contributions concerning currency unions are “intuitively appealing and well understood”, Santos Silva and Tenreyro (2010) argue that the theory of OCAs ”lacks a unifying framework to weigh the various gains and losses of forming a currency union.”[21]
Krugman et al (2012) propose the following graph in order to represent benefits and cost related to the OCA criteria:[22]
illustration not visible in this excerpt
Figure 1: Cost-benefit representation of the OCA criteria
According to the authors, a country joining a currency union will experience a monetary efficiency gain, the size of which will increase with the degree of economic integration. The horizontal axis of Figure 1 measures the extent to which a particular country is economically integrated into the product and factor markets of a fixed exchange rate area. The vertical axis measures the monetary efficiency gain, which the country will experience from joining this area. The upward-sloping GG schedule shows this relation.
A country joining an exchange rate area will also experience an economic stability loss, related to the fact that it forgoes the ability to use independent monetary policy and exchange rate for stabilizing output and employment. Like the monetary efficiency gain, the economic stability loss depends on the country’s economic integration with its currency partners. However, the stability loss declines with increasing degree of economic integration (downward-sloping LL1 schedule). In a highly integrated currency area, a fall in aggregate demand will likely impact all member economies to some extent. As a consequence, the common currency will depreciate against outside currencies and act as automatic stabilizer, which will dampen the effects of the slump in demand on unemployment. Moreover, in highly integrated economies, a sizable proportion of the consumption baskets will be imported and therefore reduce the benefits of independent monetary policies. The intersection between the GG schedule and the LL1 schedule indicates the minimum degree of economic integration, which would justify a country joining the exchange rate area. For lower degrees of integration, the stability loss measured by LL1 would outweigh the gain in monetary efficiency measured by GG, whereas at any level of integration above O1, the decision to join will yield positive net economic benefits.
Also the stability of a country’s integration into a fixed exchange rate area will affect its willingness to join. For example, Krugman et al claim that an increase in the magnitude and frequency of shifts in the demand for the country’s exports will push the LL1 schedule upward to LL2 and consequently increase the minimum level of integration required to O1. Thus, other things equal, increased variability in a country’s exports diminishes the payoff of joining a currency area.
Overall, strength of Krugman’s graph lies in the fact that it allows the user to include any additional, also non-economic aspect into the schedules. Furthermore, the shape and position of the cost schedule can be adjusted depending one the user’s view about the effectiveness of national monetary policies as a tool to mitigate asymmetric shocks. Consequently, from a monetarist’s viewpoint the cost curve would be close to the origin, whereas from a Keynesian perspective, rigidities would make national monetary policies powerful tools in combating idiosyncratic shocks.[23]
The European Economic and Monetary Union (EMU) is a unique form of a monetary union with no historical precedence, more integrated than past agreements of fixed exchange rates, but still far from de facto any other monetary union. The EMU member states delegate monetary policy to a common monetary authority, while fiscal policy remains in responsibility of national governments, even though subject to a common fiscal and economic governance framework set by the Maastricht Treaty and the Stability and Growth Pact. Since the introduction of the common currency, twenty years ago, the question whether the Eurozone members form an OCA has been the subject of a heated debate among economists and policymakers.
According to the OCA framework, the costs of a common monetary policy are low, in case the shocks impacting the economies of a fixed currency area are highly correlated. In this case, the optimal monetary policy response for each individual economy would be similar anyway, so a “one-size-fits-all” monetary policy comes at a fairly low cost. However, in case business cycles diverge considerably, the common monetary policy will be suboptimal from the perspective of the individual economies. A country facing an idiosyncratic economic downturn would prefer a more expansionary monetary policy, stimulating its economy by depressing real wages through inflation or a devaluation of its currency, and vice versa.
De Haan et al (2008) surveyed the vast amount of studies, which examine the correlation of cyclical indicators over time in the countries in the Eurozone. However, the academic literature has not yet reached consensus on whether business cycles have converged since the introduction of the euro, or whether, as Krugman argues, economies of scale and scope have triggered further regional concentration of industries across the Eurozone countries. In case the latter applies, region-specific shocks would supplant sector-specific shocks, thereby increasing the likelihood of idiosyncratic business cycles. The various authors also tend to disagree on the factors (ranging from trade relations to financial relations and fiscal policy), which may affect business cycle synchronization.[24]
Overall, De Haan et al conclude, that the evidence on business cycle synchronization across the Eurozone is mixed and highly depends on the periods analyzed, with trade intensity explaining at least a fraction of the business cycle correlations, while the evidence for other factors is mixed.[25]
Baldwin (2006) analyses the empirical literature on the trade effects of the euro and finds a vast disparity of results, from over 200% increase in trade reported by early authors, to negligible or even negative trade effects.[26] Baldwin recaps that the euro’s effects on trade within the Eurozone seem to be modest (with 9% being he authors best estimate) and materialized immediately after the introduction of the common currency. However, rather than diverting international trade into the Eurozone, the euro also created incremental trade with non-Eurozone nations (approximately 7% according to Baldwin), which may be a result of the liberalization of product markets accompanying the adoption of the euro. Particularly the liberalization of previously protected sectors might have boosted exports within the Eurozone and beyond.[27]
De Grauwe (2014) counters Krugman’s argument on regional concentration, claiming that economic integration may not necessary trigger increasing regional concentration. Economies of scale seem to matter more for industrial activities than for services. Consequently, in light of the rising relative importance of services (more than 70% of GDP in many EU countries in 2012), further economic integration will not necessarily lead to increased asymmetries in the Eurozone. The author quotes evidence, which shows that the trend of regional concentration in the US has already started to revert in the late 1990, suggesting that the European Monetary Union (EMU) might not incur regional concentration of economic activities to the same extent as the US.[28]
In summary, the evidence suggests that the euro has moderately increased trade flows between EMU members (although the size of this effect is still uncertain), which in turn led to business cycles converging across the Eurozone.
The central insight of OCA theory is that a high degree of asymmetry in business cycles makes the members of a currency union experience large adjustment cost as a result of asymmetric shocks. The following chapter discusses cross-country insurance mechanisms, which can reduce the destabilizing effects of these shocks.
Mundell (1961) highlighted the importance of labor mobility for the assessment of costs of participation in a currency union. The costs of a common monetary policy depend on the ability of an economy to dampen the effects of an adverse idiosyncratic shock on employment through a decrease in relative labor cost. A country, which floats its exchange rate, has the option to devaluate its currency in order to decrease relative wages and restore employment. However, in an environment of fixed exchange rates, a decrease in relative labor cost requires nominal wages to drop, which often proves difficult from a political perspective. Alternatively, the mobility of a country’s workforce across national borders can bring about a similar effect and therefore help to restore full employment.
As a rough estimate of labour mobility within the Eurozone, Pasimeni (2013) shows that the average percentage of foreign-born residents in the countries of the Eurozone has increased from 10.98% in 2009 to 11.53% in 2012.[29]
However, the levels of migration between the states that comprise the United States (US) are still two times higher than those between the members of the European Union. In the US, regional differences in unemployment tend to be offset by a reduction of the labour force via outwards migration, whereas European economies typically face more severe changes in labour participation, resulting in substantial and permanent differences in unemployment rates among the member states of the Eurozone.[30]
Pasimeni (2013) illustrated this fact by plotting the unemployment rates of US states and Eurozone regions at two distinct points in time (see Figure 2):[31]
illustration not visible in this excerpt
Figure 2: Unemployment in 1999 and 2012, US and Eurozone
Whereas the differences in unemployment rates between 1999 and 2012 seem almost randomly distributed in the US (ρ=0.382), the same data plotted for Eurozone regions show considerable correlation (ρ=0.727), indicating that unemployment in the Eurozone is a localized phenomenon with limited mitigation from labour mobility.
Krugman (2012) illustrated this mechanism using the minicomputer boom that the US state of Massachusetts experienced between the mid 1980s and 1990s as an example:[32]
Massachusetts was hit by a severe economic downturn at the beginning of the 1990s, caused by the sudden shift of global consumer demand from minicomputers to PCs. Figure 3 shows the unemployment rate of Massachusetts as a percentage of total US employment, as well as the unemployment rates for both the state and the entire country.
illustration not visible in this excerpt
Figure 3: Employment dynamics of Massachusetts
The shock in the early nineties pushed the state’s unemployment rate above the national average. Five years later, Massachusetts had fully recovered and unemployment trended again well below the average US rate. However, Figure 2 shows that by 1996, the state’s share in total US employment had not returned to its pre-crisis level, which indicates that part of the workforce had migrated out of the state in the course of the crisis.
Recent analysis shows that geographical mobility of the European workforce increased by more than 50% between 2005 and 2012. Dheret et al (2013) attribute this development mainly to the 2004 and 2007 enlargements of the European Union and the 2008 financial and economic crises. The addition of new members boosted migration of workers mainly along two distinct corridors (from the EU8 to Germany, Ireland and the UK and from the EU2 to Italy and Spain). In addition, the 2008 crisis deeply impacted mobility trends and gave rise to new migration patterns, with net migration flows decreasing substantially at the first onset of the crisis, followed by a general increase in geographical mobility from 2010 onwards. In this period, divergences in labour market performance across the European Union intensified, giving rise to a new migration corridor, from the southern European countries, which faced record-high unemployment levels, to Germany as a core destination.[33]
Ahearne et al (2009) examined the influence of the 2008 crisis on labour mobility within the EU. The authors found that cyclical macroeconomic variables have considerable power to explain migration flows within the Union. In a case study on Ireland, they showed that migrants acted as a labour market buffer during the 2008 crisis, which absorbed a disproportional share of the labour market adjustment. In other words, migrants to some extent shielded the native Irish workforce from fluctuations of the business cycle.[34]
Van Beers et al (2014) recently investigated how interregional migration contributed to the restoration of employment after asymmetric shocks hitting the US and the Eurozone between 1986 and 2012. They found that the gap between the US and the Eurozone has decreased in recent years due to an increase in internal labour mobility, but in part also resulting from the fact that migration flows from outside the Eurozone increasingly respond to changing economic conditions.[35]
Overall, the literature provides strong evidence that labour mobility has increased across the Eurozone in recent years. It’s not clear, however, what proportion of this phenomenon can be considered an “endogenous” development of the European monetary union and what proportion needs to be attributed to the 2008 crisis. Nevertheless, the effects of labour migration across Europe currently seem well below the US, and moreover too weak to mitigate the persistent localized unemployment prevalent in the Eurozone.
The relevance of price and wage flexibility in the OCA framework relates to its ability to moderate the effects of adverse asymmetric shocks on employment, acting as an alternative or complementary adjustment mechanism to labour mobility.
Price and wage flexibility in the Eurozone has been discussed controversially in the academic literature. Various authors observed prices and wages in the Eurozone to be either stickier or more flexible than in the US, with substantially different results depending on the industrial sector investigated, and with wages generally more rigid than prices.[36]
For example, Alesina et al (2008) investigated whether the adoption of the euro sparked the deregulation of product and labor markets. While the authors found strong evidence that joining the European currency union accelerated structural reforms in product markets, they present a more complex situation for labor markets, claiming that the adoption of the euro did not significantly affect primary labour markets across the Eurozone. However, in several countries, Alesina et al observed the emergence of secondary labour markets with temporary and much more flexible contracts. Furthermore, the authors find that the run up to the euro has been accompanied by significant wage moderation, although this development has decelerated after the adoption of the Euro in most countries.[37]
Also a study recently commissioned by European Central Bank observed only limited wage adjustment across the euro area, even during the 2008 crisis, which seems to result from multiannual wage contracts that are common across most euro area countries. However, as a consequence of fiscal consolidation in some Eurozone countries, public sector wages have adjusted faster than private sector wages.[38]
[...]
[1] cf Horvath 2003: 10
[2] McKinnon 1963: 719
[3] McKinnon 1963: 722
[4] cf Dellas/Tavlas 2009: 19
[5] See for a detailed review Horvath 2003: 12-16
[6] Dellas/Tavlas 2009: 20-21
[7] cf Horvath 2003: 14
[8] cf Horvath 2003: 17
[9] cf Horvath 2003: 18 The author discusses the respective contributions of Ingram 1969, Mintz 1970 and Machlup 1977 in detail.
[10] cf Dellas/Tavlas 2009: 26
[11] cf Alesina/Barro 2002: 435
[12] cf Dellas/Tavlas 2009: 27
[13] cf Frankel/Rose 1996: 2
[14] cf De Grauwe 2014: 56-57
[15] cf De Grauwe 2014: 59
[16] cf De Grauwe 2014: 64
[17] cf De Grauwe 2014: 67
[18] cf De Grauwe 2014: 45-46
[19] cf De Grauwe 2014: 35
[20] cf De Grauwe 2014: 7
[21] Santos Silva/Tenreyro 2010: 54
[22] Krugman et al 2012: 572
[23] cf De Grauwe 2014: 70
[24] cf De Haan et al 2008: 234-235
[25] cf De Haan et al 2008: 266
[26] cf Baldwin 2006: 11-33
[27] cf Baldwin 2006: 87
[28] cf De Grauwe 2014: 27
[29] cf Pasimeni 2013: 4
[30] cf Van Beers et al 2014: 16
[31] cf Pasimeni 2013: 5
[32] cf Krugman 2012: n.p. Please note that the share of Massachusetts in total US employment never recovered to the level before the crisis.
[33] cf Dheret et al 2013: 5-10 EU 8: Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Slovakia and Slovenia EU2: Romania and Bulgaria
[34] cf Ahearne et al 2009: 40
[35] cf Van Beers et al 2014: 25
[36] cf Pasimeni 2013: 6-8
[37] cf Alesina et al 2008: 3
[38] cf ECB 2012: 8
