Euro crisis – Analysing from Optimal Currency Area perspective

I have been trying to read up on old literature on euroarea issues. Especially the opinion of Europe based economists. I am surprised to find quite a few critiques of Eurozone and EMU even in early days.

I was reading this very interesting speech/paper from Paul De Grauwe. It is quite interesting to know how certain economists/policymakers had thought about this European crisis so long in advance. I had pointed to this Poland central bank speech earlier. And this paper is also in similar light. Infact Grauwe has been talking about this for a very long time.

This speech is a nice way to think about this european problem theoretically. Grauwe looks at Optimal Currency Theory and plays out the European crisis in 2003 which finally did happen in 2010. He says most research on OCA has a happy ending feel to it. But that may not happen.

With up to twenty-seven members instead of the present twelve, the challenge for ensuring a smooth functioning of the enlarged Eurozone will be daunting. The reason is that in such a large group the probability of what economists call ‘asymmetric shocks’ will increase significantly. This means that some countries may experience a boom and inflationary pressures while others experience deflationary forces. If too many asymmetric shocks occur, the ECB will be paralyzed, not knowing whether to increase or to reduce the interest rates. As a result, member countries will often feel frustrated with the ECB policies that do not (and cannot) take into account the different economic conditions of the individual member countries. This leads us to the question whether the enlarged EMU will, in fact, be an optimal currency area.

He looks at a simple model of OCA  with divergence and economic integration as two axis. The idea for OCA is that as integration increases, divergence declines. The same is expected from EMU. However, opposite may be the case.

He points to research from economic geography which says because of increasing returns certain regions end up specialising in a particular good. so as Europe integrates more, countries might end up specialising certain goods and become more divergent. Some might become export-driven, some consumption based, some would have more foreign bank branches etc. This is  precisely what has happened. The shock hit europe and as each country had different growth models etc they were impacted differently. Amazing stuff.

He adds that european policymakers often talk about structural reforms. This basically means labor markets more flexible. This looks ok to talk but becomes awry when shocks hit an OCA:

Structural reforms have a similar character of a ‘Happy End’-story to that of our OCA-story. If Europe were to introduce such reforms, everything would be fine. It is important, however, to stress what the implications of structural reforms would be in the context of our discussion of the survival of the monetary union. If a country is hit by negative shocks brought about by agglomeration effects, the wage cuts necessary to deal with these shocks will inevitably be very large. To give an example: If Ford Motor were to close down a plant in Belgium and to invest in Poland instead, the wage cut of Belgian workers that would convince Ford Motor not to make this move would have to be 50% or more given that the wage not feasible, then flexibility dictates that the Belgian workers be willing to move.

Thus, if agglomeration effects are large, mobility has to be increase as well. The effect would be a relative depopulation of countries experiencing negative shocks. Most countries would not accept the consequences of this kind of flexibility. In the ‘good old days’ when governments had no responsibility for social security, they let this happen, and we have seen how regions and countries depopulated as a result of economic integration. Today, governments perceive their role differently. Rather than face depopulation, governments may choose to exit the  union instead. While structural reforms of the labour market are often heralded as being necessary for a proper functioning of the monetary union, they can also become the cause of the demise of the monetary union if the asymmetric shocks are severe enough.

Again very well put. He adds ECB people talk about this often but they do not know the pain of losing a job or pay cut!

Excellent suff again from Grauwe. I have started reading his papers hugely. More to follow.


2 Responses to “Euro crisis – Analysing from Optimal Currency Area perspective”

  1. Árfolyamok Hivatalos Napi Árfolyam Says:

    Árfolyamok Hivatalos Napi Árfolyam…

    […]Euro crisis – Analysing from Optimal Currency Area perspective « Mostly Economics[…]…

  2. Creating The Euro Zone « Across the Pond Says:

    […] theoretical grounds, arguing that the EU does not constitute an Optimum Currency Area (OCA). An OCA should have high capital and labor mobility, a mechanism for fiscal transfers to disadvantaged regions, and […]

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