Seminar 3: The costs and benefits of the single currency.


The trilemma associated with governing an open economy in an international market suggests that nation-states can only have two of the following:

  • Full freedom of full capital movements (let’s call it globalisation).
  • Fixed exchange rate (think of it as the price of your currency).
  • Independent monetary policy (think of it as central banking).

A country with full capital mobility and fixed exchange rates loses the capacity to conduct a national monetary policy. This means countries lose an important tool of economic adjustment when confronted with an economic crisis, such as a recession.

This week we are asking whether the Economic and Monetary Union in Europe (EMU) is a radical response to this trilemma? If so, what are the costs and benefits?

In the EMU, nation-states have given up their monetary policy in return for a shared currency, between 19 different nation-states, and the free movement of capital between these countries (but they have not created a banking, capital market or fiscal union), governed by the European Central Bank (ECB) in Frankfurt.

The Costs of EMU

(Summary: loss of currency adjustment, loss of lender of last resort, being compelled into a pro-cyclical fiscal policy).

What are the costs of the European monetary union?

The cost derives from the fact that when a country relinquishes its national currency it loses an instrument of economic policy i.e. it loses the ability to conduct a national monetary policy. In effect, it no longer has a national central bank.

This graph on divergent bond yields sets the scene for the series of crises that afflicted the Euro area since 2008, and an important reminder of what happens when a country loses the ability to conduct it’s own monetary policy in response to a crisis.

The important thing to note is that the increase in the interest rate charged to governments (to borrow money) meant some countries got priced out of international markets, and had to resort to a non-market loan from the IMF/EC/ECB (the Troika).

When national central banks cease to exist, countries cannot use exchange rate adjustments as a policy instrument (devaluations and revaluations are ruled out, and interest rate risks are priced in). They also cannot change the short term interest rate.

Any adjustment must now take place via internal devaluation. What this means is that when confronted with a shock, internal prices (think wages, rents, healthcare, education) must be adjusted downwards, rather than the price of currency.

Let’s assume a monetary union and take two countries, Spain and Germany.

If output (economic growth) declines in Spain and unemployment rises, whilst the opposite occurs in Germany (output increases and unemployment declines), how is it possible to bring both countries back into equilibrium?

  • This decline in output can be caused by either an external shock to aggregate demand, such as a financial crisis, or something as simple as a change in consumer preferences, or a reversal of capital flows from German to Spanish banks.

There are two possibilities in the classical theory of optimal currency areas (OCA): wage/price flexibility and mobility of labour.

First, if wages decline in Spain the aggregate supply curve shifts downwards whereas it shifts upwards in Germany (wage rises). This makes Spanish products more competitive (exports improve) whilst in Germany imports increase (domestic demand improves).

This generates a balanced relationship.

Second, an additional mechanism that will lead to a new equilibrium between these countries involves the mobility of labour. Unemployed workers in Spain will move to Germany where there is excess demand for labour. This leads to a decline in unemployment in Spain, and avoids wage-inflationary pressure in Germany.

In OCA theory, absent these two mechanisms in a monetary union, Spain and Germany will be stuck in a bad equilibrium. It generates a long-term aggregate demand problem.

What would happen in a hard-peg and soft-peg currency regime?

Spain would either devalue the currency or adjust domestic interest rates, whilst directly targeting the real exchange rate to improve cost competitiveness.

The consequence of losing this tool of adjustment can be viewed here.

If wages are rigid, (what economists call “sticky”), and labour mobility is absent, different countries in a monetary union will find it extremely difficult to adjust (and improve price competitiveness) when confronted with an asymmetric shock.

Unemployment will remain high in Spain, and it will be faced with years of deflation, whereas Germany is unlikely to push for a policy that undermines its competitiveness.

Divergence between the two countries grows. Does all of this sound familiar? It should.

The loss of monetary independence leads to the second cost. Member-states, in effect, issue debt in a foreign currency over which they have no control. Financial markets now have the power to force a default on these countries when faced with crisis. Think back to the divergence in bond yields, which started the sovereign debt crisis.

For example, let’s take the case of the UK and Spain.

If UK investors fear a default they will sell their UK government bonds. Interest rates (bond yield) will rise and the price of the pound will drop. Pounds will be sold in the foreign exchange market. Capital will be forced to stay local.

Further, the British government can get the Bank of England to buy bonds. The debt market would stay liquid. British society has a lender of last resort. This acts as a bulwark against financial attack.

The UK can effectively finance debt through money creation. The tradeoff is higher inflation. They can do this because they have a lender of last resort.

In Spain the opposite occurs. If a default risk arises investors will sell their bonds and re-invest them in a safer Euro region, say Germany. Money floods out of the Spanish banking system. The money supply shrinks.

Spain now faces a liquidity crisis. There is no lender of last resort. The Spanish government has no influence over the ECB. Spain is effectively borrowing in a foreign currency. A liquidity problem turns into a solvency problem.

In a monetary union, short-term interest rates converge (i..e cheap credit, the good times of the Euro) but when faced with an asymmetric shock, long-term interest rates on government bonds diverge (bad times of the Euro).

This is what happened from 2008-2011 until Mario Draghi (governor of the ECB) signalled that he would intervene in bond markets if necessary. And he did, the ECB are indirectly buying government debt through the private banking sector.

During the asymmetric shock, GDP and employment declines rapidly in one region (southern Eurozone) whilst it recovers more rapidly elsewhere (northern Eurozone). This reinforces pressure on fiscal policy. Budgets are cut. Taxes are increased.

Being forced into an internal devaluation is the third cost of monetary union. Pro-cyclical fiscal policy deepens the monetary asymmetry.

In a monetary union this asymmetry in fiscal responses to an asymmetric shock could be avoided with a budgetary union and the issuance of a common Euro bond (much like the fiscal equalization among the German Länder, or the US Federal States).

This provides an insurance and a protection mechanism for its members. The EU budget amounts to only 1.1% of EU GDP whereas national budgets typically absorb 40-50% of GDP. Social welfare and public services remain at the national level.

Finally, the cost of monetary union is also related to differences in labour market and legal institutions.

Some countries market-oriented labour markets (Ireland), other countries have collective bargaining oriented labour markets (Italy).

These legal-institutional differences also apply to mortgage markets, banking, taxation and corporate finance, to name but a few. We will discuss these differences in more detail in our seminar on European varieties of capitalism.

So, the costs of EMU are primarily related to how countries respond to an economic recession: a) the loss of currency adjustment to deal with competitiveness problems, b) the loss of a lender of last resort, which acts as a bulwark against financial markets, c) being forced into an internal devaluation, which leads to pro-cyclical fiscal policy, d) being stuck in a monetary union with divergent legal-institutions to deal with markets.

Note, the EU and the troika are fully aware of these. Hence, their preference for, a) a supranational capital markets union, b) empowering the ECB to stabilise financial markets, c) liberalisation of labour and product markets. In short, EU policymakers want to “complete the monetary union”. Why is this not happening?

What are the benefits of a monetary union?

While the costs of monetary union are usually associated with macroeconomic outcomes, the benefits are usually associated with microeconomic outcomes.

These benefits are primarily associated with the direct and indirect effects of eliminating transactions costs (for free trade in capital) and ensuring price transparency.

Removing exchange rate risk facilities economic growth. It provides stable money.

According to the neoclassical model of technological change, a monetary union will expand and improve free trade. A single currency complements economies of scale.

Monetary union also spurs financial and capital market integration. This generates welfare gains. Markets are less uncertain about the future revenue of firms.

All of these benefits are reflected in a famous EC Commission report on ‘One Market, One Money‘ (1990), which provided the ideational basis for the EMU.

The role of economic ideas: Keynesians versus Monetarists 

Comparing the costs and benefits of monetary union is not just a technical exercise. When comparing costs and benefits it makes a huge difference as to what “model’ we use, and what assumptions we make. These are related to ideas.

Monetarists and Keynesians look at the political and economic world in very different ways. This is fundamentally related to different ideas about how economies operate.

For monetarists, national monetary tools are ineffective instruments to correct asymmetric shocks. Losing monetary sovereignty makes no difference.

Monetarists operate from the micro-foundations of classical political economy, which assumes price and wage flexibility (and if these are not flexible then policymakers ought to make them so i.e. liberalisation of markets, including collective bargaining).

Keynesians on the other hand see the world as full of rigidities (wages and prices are not flexible). National monetary policies and the exchange rate are powerful instruments in absorbing shocks. Losing sovereignty makes a big difference.

In trying to assess the cost-benefits of a monetary union what matters most is the extent of wage and price rigidities.

This leads to a division between economists operating from abstract-theoretical models (i.e. that assume by definition lower wages = more employment) and political economists operating from case-based empirical studies (i.e. that show there is no relationship between wage cuts and employment).

In the Euro area all labour market policies are focused on supply-side reforms. The monetarist argument dominates.

The monetary union has also exposed governability problems associated with democratic legitimacy. Governments have less capacity to shape the course of their domestic economies yet are accountable for it’s performance.

In world of free capital flows successful economic management has become much harder. Nation-states are weaker.

Unlike monetary policy (Europeanized)  fiscal and incomes policies (nationalized) are politicized policy instruments. The EU now affects all three.

For Fritz Scharpf in trying to maintain output legitimacy governments may undermine input legitimacy.

In conclusion, monetary union benefits some and imposes a cost on others. There are winners and losers.

In the absence of a federal union some countries such as the Benelux, Germany, and other export-oriented economies benefit. But can this be said for countries such as Italy, Greece, Portugal and possibly Spain?

To get a sense of these differences, lets examine the divergence in macroeconomic policies post-EMU.

Fritz Scharpf suggests that monetary union created the conditions for a sequence of three crises from 2008-2010. Banking crisis – credit squeeze – sovereign debt crisis.

Some consider the design of EMU to blame for the problems afflicting the Euro. Others blame the inability of southern European governments to impose tough structural reforms. Discuss.

What next for an incomplete monetary union?

Assuming that countries are not likely to leave a monetary union (even if they suffer years of one-sided deflation and austerity), is it possible to imagine a political-fiscal union emerging as a complement to monetary union?

This is a political question that requires giving up more national sovereignty and brings us back to the initial trilemma.

The European Monetary Union was a radical political response to the global economic trilemma: capital mobility combined with complete abandonment of national monetary sovereignty.

Member-states of the EMU have accepted deep economic integration. The choice is then between national politics (less integration) and shared policies (more integration).

If member-states accept more integration (which seems to be the case, for example, on banking union) then the choice is more democratic or technocratic decision-making (ECB, EU Commission).

Public opinion favors accountability so the choice is what type of policymaking governments should institute.

To complete the monetary union governments need to go down either the intergovernmental or federal route. EMU is stuck somewhere in the middle.

German voters don’t want a budgetary union, or a common Eurobond, and Irish voters don’t want tax harmonization.

Europe is stuck in a bad equilibrium.


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