Conventional wisdom views the benefits and costs from monetary unions as straightforward. The costs are macroeconomic– reduced influence over stabilisation policy – while the gains are microeconomic – improved economic efficiency. This is the perspective taken by most comments on the Eurozone’s recent travails (see Krugman 2010). The reality is more varied. The benefits and costs from sharing a single currency vary over time as well as by country.
The Eurozone is part of a broader process of economic, financial, and institutional integration that started in 1958. All along, national economies have adjusted to changing institutional frameworks and their market structures have been transformed. This half-century process has resulted in EU countries that are highly interdependent, particularly Eurozone members.
This column introduces a CEPR Policy Insight which argues that the benefits of a monetary union develop gradually over time and require policymakers to seize opportunities and perseverance in the face of adversity.
Diverse microeconomic benefits
Money is more useful when it is used over a wider area – as a unit of account, medium of exchange, standard for deferred payments, and store of value. The larger the international circulation of the euro, the higher is its usefulness. Inside the Eurozone, nominal exchange rate uncertainty has disappeared, leading to savings in transaction and hedging costs. There is by now solid empirical evidence that intra-Eurozone trade in goods and services has already risen by 5-10% on average (Baldwin et al. 2008), and this without trade diversion; there has been no “fortress Europe” effect. Higher cross-border mergers and acquisitions have led to restructuring of capital within the same sector of activity – thereby raising efficiency.
A related benefit is the euro’s “vehicle currency” role in international trade. This lowers the cost of international transactions for Eurozone residents on the trade and finance sides. International policy co-operation is also simplified.
The launch of the euro has also brought a significant deepening of financial integration, albeit unevenly across financial market segments. So, while we see more portfolio diversification, cross-border banking integration has advanced only slowly. Looking ahead, financial integration is likely to rise further with declining cost of equity capital and bond financing. Yet below the surface financial integration and sophistication also came with some negative externalities. Last, we might have expected greater price transparency across the Eurozone discouraging over time price discrimination and decreasing market segmentation.
Benefits of improved macroeconomic stability
The ECB is highly credible, and inflation in most Eurozone countries has never been so low. Moreover, inflation expectation has remained well anchored since the launch of the euro, and even during the ongoing financial crisis. This has been instrumental in securing the lowest interest rates on a two-, five-, ten- or even fifty-year basis. For many Eurozone countries this represents a significant benefit; lowering public debt servicing, and supporting investment and growth. Price stability has also supported overall macroeconomic stability. Over the last decade average per capita growth in the Eurozone and the US were very similar. Moreover, average GDP growth rates of high performing Eurozone countries were even higher than most adjacent non-Eurozone EU countries.
Macroeconomic stability is being supported by increasing opportunities for financial based risk sharing in the Eurozone. How? Increasingly integrated financial markets and diversified portfolios are reducing the extent to which households and firms saving and spending decisions are dependent on domestic economic and financial developments.
The Eurozone has shown resilience to external developments and shocks. In fact, more resilience than most of its individual member countries ever exhibited before the launch of the euro. But greater resilience does not imply insulation. Recent financial events have shown that investors and rating agencies differentiate between sovereign borrowers. This puts a prize on securing the highest level of fiscal governance and unassailable fiscal sustainability.
On the downside, there are microeconomic costs. A one-off cost resulted from the switching to a new currency. This included administrative, legal and hardware costs such as re-denominating contracts and adapting vending machines.
Costs from decreased control over macroeconomic stabilisation
Eurozone governments no longer have direct control over monetary or exchange rate policy. Some Eurozone countries exhibiting higher nominal price and wage rigidities than the Eurozone average, might incur in higher frictional unemployment (until such rigidities are reduced through structural reforms). All things being equal, this may eventually lead to more pronounced short-term output and employment fluctuations in countries with less flexible labour and product markets. Moreover, these national governments also lose the option of “gradually defaulting” through unanticipated inflation – but this is no panacea.
A single monetary policy requires common fiscal restraints as is the case with the Stability and Growth Pact. The aim is to avert unsustainable national fiscal policies. Such restraints are relatively more binding for countries with relatively higher public debt and a proclivity to run higher budget deficits. The importance of sound fiscal policies cannot be overemphasised. Eurozone countries need to keep room for manoeuvre for their automatic stabilisers that are extremely powerful stabilisation tools. An often debated issue is that the EU, and therefore the Eurozone, lacks a supranational risk sharing arrangement akin to the US Federal budget. The latter might partly absorb any temporary asymmetric shocks. This cost is somewhat mitigated by the increasing financial based risk sharing, albeit from a low level.
The initial years of Eurozone have shown how there can be significant gains and losses in competitiveness even in a relatively short time-period. How was that possible? What we have learned is that even modest, but persistent, inflation differentials can erode, or strengthen, relative competitiveness. In other words, real exchange rates did change since the launch of the euro. Within certain boundaries this may not be problematic, but over long stretches of time this is not desirable. Conventionally the burden of adjusting would fall more on the deficit countries and for them the inability to devalue prevents an escape route often used in the past. This may be perceived as a significant cost, yet this too is no panacea.
Costs from adverse external effects
An old issue is the loss of direct control of part of national foreign exchange reserves and other assets that are transferred to the newly established supranational central bank. This cost is mitigated by the fact that joint reserves may have a proportionally higher bearing. From the standpoint of fiscally disciplined countries with stable legacy currencies, there are adverse effects if other members run sizeable and uncontrollable budget deficits, and accumulate unsustainable debts. Again the remedy lies in strengthening fiscal governance.
There is a broad range of benefits and costs in sharing a currency. Contrary to conventional wisdom, the macroeconomic costs of losing influence over macroeconomic stabilisation by relinquishing direct control over monetary policy and the exchange rate are more contained than previously feared. Moreover, the euro has spurred macroeconomic stability and financial integration. The latter will increasingly foster financial-based risk sharing. There is also evidence of a wide range of microeconomic gains in terms of improved microeconomic efficiency, and of broadly positive external effects.
An underlying temporary asymmetry is not receiving enough attention. Some costs are incurred at the start of monetary unification, such as the changeover cost and the investment to set up a sound institutional framework. Instead, some benefits accrue gradually as the new currency gains acceptance, its circulation widens, as economic and financial integration deepen, and as economic governance consolidates. In other words, time plays an important role.
Despite evidence of further integration over the last decades, Eurozone countries are still quite heterogeneous and are likely to remain so for the foreseeable future. It is unlikely that differences in legal systems, financial structures, and various other domestic characteristics, institutions, and preferences will rapidly fade out. Is that a problem? Various commentators have argued that heterogeneity should not be overstated. Moreover, financial based risk sharing will increasingly contribute to smoothing asymmetric shocks.
We have also learned that the costs of slow dynamic adjustment are far above all other costs. It is also still poorly researched and poorly explained to the general public. In essence, this is a cost from not undertaking structural reforms and liberalisations. For many countries, reforms were postponed for too long and would have been even more complex to undertake without the euro: i.e., assuming that peer-pressure and market discipline help. In other words, opportunities should be seized.
Recent events are showing that what has been achieved by the EMU cannot be taken for granted, but needs instead to be nurtured. The EMU needs new economic governance with broad ownership and an assessment of how systemic risks have now changed and are still changing. In particular, fiscal governance must be revisited in various ways. Hence, perseverance also plays an important role for the success of the EMU.
Disclaimer: This column reflects the author’s personal views and he is solely responsible for its content. He is grateful to Lars Jonung and Charles Wyplosz for comments.
Mongelli, Francesco Paolo (2010), 'Some observations on "political" in EMU', CEPR Policy Insight No. 47.
Baldwin, Richard, Virginia DiNino, Lionel Fontagné, Roberto A De Santis, and Daria Taglioni (2008), “Study of the Impact of the Euro on Trade and Foreign Direct Investment”, European Economy, Economic Papers, Brussels, 321. May.
Krugman, Paul (2010), “Anatomy of a Euromess”, The New York Times, blog, 9 February.