Euro Land and Optimal Currency Areas - A Valentine’s Day Massacre

In A2 macro when we teach the economics of a single currency, it is not long before the idea of an optimal currency area makes an appearance. The crisis facing Greece and a number of other Euro Zone countries has laid bare the structural flaws in the monetary union project. Euroland is a long way from being an optimal currency zone.

For a currency union to operate with lower underlying risks a number of sturdy pillars are needed

1/ Member countries need to have a sufficient amount of structural economic convergence. For example they need to have broadly similar trade patterns, share similar business cycles, underlying trend growth rates and housing market structures. The reality is that the rules created for countries wanting to adopt the Euro did not give sufficient weight to these factors. Instead monetary guidelines were used such as convergence in nominal interest rates, consumer price inflation and fiscal deficits.

2/ Participating countries need to respond in a similar / symmetrical way to external economic shocks (such as commodity price changes) and also policy changes. Locking your country into a currency union means accepting a single policy interest rate (in this case set by the ECB) so a country needs to be able to live permanently with a policy rate set for the monetary union as a whole rather than one tailor-made for an individual nation. Most students are familiar with this “one size fits all” dilemma - the problem is that the impact of rate changes does vary from country to country. Instead of helping to stabilise an economy, if countries react in an asymmetrical manner to an interest rate change, this can make European monetary policy destabilizing—it will be either too stimulative or too tight, but not quite right!

3/ If a nation is inside a currency union it needs sufficient labour market flexibility to absorb unexpected economic events. We judge flexibility in many different ways including geographical and occupation mobility of the workforce, and the flexibility of pay and employment in different industries

4/ Fourthly (and this factor is not to be under-estimated) an optimal monetary union needs some sort of fiscal union so that tax transfers could be made to regions or countries hit by “asymmetric economic shocks”. Even in the United Kingdom (whose regions have a currency union - sterling) there are deep-seated and persistent differences in regional economic performance that have hugely important social consequences. An activist and effective regional strategy is as important today as it has been in the past so that living standards can be improved in areas of relative decline and to maintain social cohesion across the country as a whole.

Greek Tragedy

Many of Greece’s economic difficulties are of her own making. The economy enjoyed a period of rapid growth when money was cheap (real interest rates were negative) and credit was easily available, but much of the short-term growth was built on sand and the recession has revealed an appalling fiscal problem and a looming sovereign debt crisis.

Greece is an outlier in the currency union

a) It has had higher average inflation than core Euro members - making it uncompetitive over a number of years

b) It’s business cycle is out of sync with the Euro Area

c) It has more stringent employment protection laws than many of the other participating countries

d) It’s fiscal deficit is way beyond what is allowed and (previous) Greek government systematically lied about their finances - tax revenues as a share of GDP are low and the shadow economy is more than 20% of national income

We are witnessing perhaps the biggest stress-test of the single currency since it was established in 1999. The stresses are most obvious in the market for government bonds but the fall-out is also seen in the currency markets where the Euro has depreciated against the US dollar. This helps improve the competitiveness of Euro Area exporters in non-EU countries but does nothing to restore competiveness for countries such as Greece and Spain within the currency union.

For all of the protestations of supporters of the Euro that the currency union is strong, my instinct is that a single currency is only as strong as its weakest link. The sub-optimal architecture of the Euro is exposing these weaknesses for all to see and the financial markets will be unforgiving of the countries that have become very uncompetitive within the system. Britain lies outside the Euro but is not immune to the crucial developments of recent weeks. British banks have a large balance sheet exposure to the troubled Club Med nations – estimated by the Bank for International Settlements to be around £240bn.

This is an updated version of a previous blog - brought up to date to assist students revising for their June 2010 papers

Check some of the blog posts below for more on the Euro / Greek crisis