The Eurozone: A Suboptimal Currency Area

The euro seemed like just another step towards economic integration that would bring political coherence and booming trade to the European continent. However, what ensued can only be described as falling short of that dream. Could disaster have been averted? A number of economists did indeed see this coming, and the viability of a common currency in Europe has always been somewhat questionable. The common European currency can be made more viable, but this would require deeper political and fiscal integration among Eurozone members.

Initially, the creation of the euro had some obvious advantages. A common currency would reduce transaction costs, eliminate currency risk and could possibly lead to more competition, as prices are easier to compare. Furthermore, it was thought that a common European currency might lead to a large increase in intra-European trade. Trade between European countries did pick up after the introduction of the euro, but the effect of the common currency on trade was not nearly of the size that was expected. Additionally, there are significant disadvantages to a single currency that economists have warned for since the 1960s. According to the theory of the optimum currency area (OCA), the main disadvantages of a currency union are due to a loss of flexibility to adopt adjustments in the face of asymmetric shocks that affect only part of the currency area. At the time of its creation, European leaders and other supporters of the euro project thought these worries were overblown.

The OCA centres around two main ideas. First of all, economist Robert Mundell argued in a 1961 paper that a single currency is more likely to be workable if the regions sharing that currency are characterised by high labour mobility. For example, if one country in the currency area faces an asymmetric negative shock to its economy that reduces employment, full employment can be restored through emigration. Secondly, Peter Kenen argued in 1969 that fiscal integration, which requires a large federal component to spending at the regional level, can ameliorate asymmetric shocks. It has been clear for decades that the Europe fails to meet both criteria, yet European leaders went ahead with the single currency.

Once the euro was introduced, the currency area was immediately plagued by asymmetric shocks. Ironically, the creation of the euro itself also caused a major asymmetric shock. The single currency initially led to more cross-border investment. However, when the flow of private capital from the “core” countries, like Germany, to the “periphery”, which includes Spain and Greece, stopped the peripheral economies were left with prices and labour costs that were much higher than in other parts of the currency area. This adjustment problem could not be solved through currency devaluation, and restoring competitiveness by cutting wages in the periphery has been extremely difficult. Furthermore, countries hit by large asymmetric shocks have even faced solvency issues, as the adjustment problems of peripheral economies turned into fiscal emergencies. Thus, the lack of fiscal integration seems to have had a larger impact on the Eurozone’s woes than labour immobility.

Despite the problems of a single European currency, some measures could be taken to make the euro more practicable. For example, the Eurozone could adopt an American-style fiscal compensation mechanism for areas hit by asymmetric shocks. However, the implementation of such measures depends on the willingness of Eurozone countries at the core to give up spending power in aid of countries at the periphery. So far, this willingness has been severely lacking, leaving countries at the periphery in a structurally disadvantaged position. Alternatively, breaking up the Eurozone would be a more drastic solution, if not too drastic due to the political implications of the euro’s failure. Nevertheless, the single European currency has the potential to foster an ever closer Union, but European leaders should reconsider and resolve the defects of the current arrangement.

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