Download - Euro Crisis Dec 2010
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Creating the Monetary Union
led to the current crisis, butbreaking up the Euro would be
difficult and costly
by
Assaf Razin
December, 2011
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The creation of the euro should now be
recognized as an experiment that has led tothe sovereign debt crisis in several countries,the fragile condition of major European banks,the high levels of unemployment, and thelarge trade deficits that now exist in mostEurozone countries.
Although the European CentralBank managed the euro in a way thatachieved a low rate of inflation, othercountries both in Europe and elsewhere havealso had a decade of low inflation withoutincurring the costs of a monetary union.
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What led to Monetary Union
The initial impetus that led to the EuropeanMonetary Union and the euro was actually
political rather than economic. Politicalleaders generally favored the creation ofthe euro as a step toward deeper
political integration.
The shift of responsibility for monetarypolicy from national capitals to a singleEuropean Central Bank in Frankfurt would
signal a shift of political power.
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History
The Treaty of Rome launched the Common
Market in 1957.
The Common Market developed into theEuropean Economic Community in 1967and the European Union in the Maastrichttreaty of 1992, creating not only a largerfree trade area but also providing for themobility of labor and other aspects of anintegrated European market for goods and
services.
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Monetary Union
The political process evolved through theMaastricht Treatys creation of the
European Monetary Union and the plansfor the single currency which eventuallybegan in 1999
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A single currency means:
1. that all of the countries in the monetaryunion have the same monetary policy andthe same basic interest rate, with interestrates differing among borrowers only
because of perceived differences in creditrisk.
2. A fixed exchange rate within the
monetary union and the same exchangerate relative to all other currencies, evenwhen individual countries in the monetary
union would benefit from changes in
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The Euro Deal
As the euro became a done deal,countries that had previously had to pay alarge interest premium found themselvesable to borrow on the same terms asGermany; this translated into a big fall intheir cost of capital. The result was
bubbles, inflation, and in the aftermath ofthe bubbles and inflation.
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When a county has its own monetary policy, it canrespond to a decline in demand by lowering interest ratesto stimulate economic activity.
But the European Central Bank must make monetarypolicy based on the overall condition of all the countriesin the monetary union.
This means interest rates that are too high for thosecountries with rising unemployment and too low in othercountries where wagesare rising too rapidly.
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The shift to a monetary union and the toughantiinflationary policy of the European CentralBank caused interest rates to fall in countrieslike Spain and Italy where expectations of highinflation had previously keptinterest rates high.
Households and governments in thosecountries responded to the low interest ratesby increasing their borrowing, withhouseholds using the increased debt tofinance a surge in home buildingand house prices while governments borrowedto finance budget deficits that accompaniedlarger social transfer programs.
The result was rapidly rising ratios of public
and private debt to GDP inseveral countries, including Italy, Greece,Spain and Ireland. Despite theincreased risk to lenders that this implied,the global capital markets didnot respond by raising interest rates on
countries with rapidly risingdebt levels.
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A different market dynamic affected therelation between the commercial banks andthe European governments. Since the
banks were heavily invested in governmentbonds, the declining value of thosebonds hurt the banks.
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During the euro-bubble yearsthere were huge capital flows to
peripheral economies, leadingto a sharp rise in their costs
relative to Germany
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Capital inflows to Spain
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Now that the bubble bursts,should the adjustment be rising
wages in Germany or fallingwages in Spain? The ECBsignals that no inflation inGermany will be tolerated. The
recipe is for a prolonged slumpin the periphery.
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Fiscal Federalism
The transfer of economic resources frommembers with healthy economies tomembers who suffer economic setbackcan best be done through fiscalfederalismmost of the risk is privatelyuninsurable.
This is a key difference between US andEurozone. It remains to be seen whetherthe EU will develop more elaborate
institutions for carrying out fiscal transfers
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Iceland vs. Ireland
Icelands positive swing has been abouttwice as large as Irelands and weretalking an extra 10 points of GDP here.Thats a lot of extra stimulus, and to theextent that it was due to devaluation, thatsa major plus for having your own currency
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UK Government Bonds vs. Spain
Government Bonds Financial markets can force monetary
union countries sovereigns into default.
The financial markets attach a muchhigher default risk on Spanish than on UKgovernment bonds. In early 2011 thisdifference amounted to 200 basis points.
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UK Government Bonds
Suppose that investors fear that the UKgovernment might be defaulting on its debt.They will sell their UK bonds, driving up the
interest rate. After selling these bonds theseinvestors would have pounds that they wouldwant to get rid of by selling them in the foreignexchange market. The price of the pound would
drop until somebody else would be willing to buythese bonds. UK money stock will remainunchanged.
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Investors cannot precipitateliquidity crisis for a non sigle
currency area country
Even if the UK government cannot find the
funds to roll over its debt it would force theBank of England to buy up the governmentsecurities.
Thus, investors cannot precipitate aliquidity crisis in the UK that could forcethe UK government into default.
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e t ynam cs: mem er o asingle currency area and non
member UKcurrency depreciation follows
sovereign debt crisis and inflation
increases. Real value of debt falls.
SpainTo regain competitiveness wages
are cut following sovereign debt crisis.Deflation raises the real value of the debt.
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Internal depreciation vs. Real
Depreciation The only way is to reduce costs, relative tocountries inside and outside the currencyarea. Economists sometimes refer to thisas a real depreciation orinternaldevaluation. That requires slower priceand wage growth or faster productivity
growth than elsewhere. Given todays lowinflation rates, it means outright declines inprices and wages.
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Inflation in the north deflation
in thesouth Real exchange rate changes within a
currency area come about with inflation inthe north deflation in the south. But ifthe north pursue strict anti-inflationpolicy, deflation in the south is enhanced.
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Competitiveness within the Euro-zone: decade and a half before the
crisis Greece, Ireland, Portugal and Spain lost
a lot of competitiveness:
Low interest rates led to a surge indomestic demand. And sharp rises in realwages.
Productivity growth was not vigorousenough to compensate.
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Debtcrisis and fixed
exchangerate:lessons from Latin America
Argentina is a case in point. In 2001, it ranthrough a series of governments beforetriggering the worlds then-biggest default($100bn; so small compared to Italys
1.9tn bond market).
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To restore competitiveness without breakingArgentinas euro-like currency peg, heengineered a synthetic devaluation . Across-the-board export subsidies and import dutiescame straight out of the textbooks, but didntwork. Just as they often do in Europe today,
investors saw the countrys debt dynamics stillworking against it.
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Restoring competitiveness
against bad debt dynamicsTo restore competitiveness withoutbreaking Argentinas euro-like currencypeg, he engineered a tax-baseddevaluation. Across-the-board exportsubsidies and import duties came straightout of the textbooks, but didnt work. Just
as they often do in Europe today, investorssaw the countrys debt dynamics stillworking against it.
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Bad debt dynamics
Default fears led to higher bond yields,which led to lower growth and smallergovernment revenues. This made defaultmore likely in a process that soon became
self-fulfilling. After three years ofrecession, much of southern Europe mayalready on the brinks of default.
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Trends in Euro zone
Prolonged recession
Beyond Greece there will be more debt
restructurings Banks will be nationalized
ECB buys debtprice stability plays back
role to financial stability
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Three difficult-to-solve Problems
1. Absence of adequate adjustmentmechanism to correct current accountimbalances among member states.Internal devaluation lead to currencymismatch on a members balance sheet.The result: Heavily indebted,
uncompetitive, countries. 2. Absence of bank regulation at the level
of the union leads to race-t-the-bottom
regulation competition among members.
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3. Inadequate supply of liquiditybecause national governments
in the south have limitedcapacity to issue and redeem
safe assets that can be boughtand sold at predictable prices.The ECB is reluctant to be a
lender of last resort to nationalgovernments.
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Sovereign Debt And Banks
By the fall of 2011, several Europeancountries had debt to GDP ratios
that made default a serious possibility.Sharp writedowns in the value of theirsovereign debt would do substantialdamage to the European banks andpossibly to banks and other financialinstitutions in the United States.
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Strategies to deal with
this situation1. The Eurozone leaders agreed inOctober 2011 that the banks should
increase their capital ratios and that theEuropean Financial Stability Facility(EFSF) should be expanded from 400
billion euros to more than a trillion Euros toprovide insurance guarantees that wouldallow Italy and potentially Spain to accessthe capital markets at reasonable interest
rates.
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2. All 17 members of the Eurozone, plus 6other countries who wish to join the Euroone day, signed in December 2011, anintergovernmental pactthat wouldenforce stricter fiscal discipline. Sanctionswill be imposed on countries that fail to
stay with limits of budget deficits, insertingbalance budget legislations of members,with the European Court in charge.
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This plan to increase the banks capitalwont work because the banksdont want to dilute current shareholders by
seeking either private or public capital.Instead, they are reducing their lending,particularly to borrowers in other countries,causing a further slowdown in Europeaneconomic activity.
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2. The second strategy calls for theEuropean Central Bank to buy thebonds of Italy, Spain and other high debt tokeep their interest rates low.
The ECB has already been doing that to alimited extent but not enoughto stop Greek and Italian rates fromreaching unsustainable levels.
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3. The third strategy is favored by thosewho want to use this crisis toadvance the development of a political
union. They call initially for atransfer union or a fiscal union in whichthose countries with budgetsurpluses would transfer funds each yearto the countries runningbudget deficits and trade deficits.
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Greece
The Greek budget deficit of 9 percent ofGDP is too large to avoid a further outrightdefault on its national debt. With a current
debt to GDP ratio of 150 percent and thecurrent value of Greeces GDP falling in
nominal euro terms at 4 percent, the debtratio would rise in the next 12 months to170 percent of GDP. Rolling over the debtas it comes due and paying higher interestrates on such debt would raise the total
debt even more quickly.
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Cutting the interest bill in half by a 50percent default while balancing the rest ofthe budget would only reduce the deficitvery slowly, from 150 percent now to 145percent after a year, even if no paymentsto bank depositors and other creditors
were required. It is not clear that financialmarkets will wait while Greece walks alongthis fiscal tightrope to a sustainable debtratio well below 100 percent.
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Italy is much better
Italy already has a primary budget surpluswith tax revenue exceeding noninterestgovernment outlays by about one percent
of GDP and a slightly positive rate ofgrowth. With interest on the national debtnow equal to about 5 percent of GDP,
Italys total budget deficit is about fourpercent of GDP. A two percent of
GDP reduction of that deficit would beenough to start a decline in the ratio of
debt to GDP.
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But this is not going to solve the
competitiveness problemReducing the problem of large budgetdeficits and the related problem of thecommercial banks that have invested ingovernment bonds would still not solve thelongterm competitiveness problemcaused by monetary union.
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Leaving the Euro?
The alternative is for Greece to leave theEurozone and return to its own currency.Although there is no provision in theMaastricht treaty for a country to leave,political leaders in Greece and othercountries are no doubt considering that
possibility for Greece. While Greece iscurrently receiving transfers from the otherEurozone countries, it is paying a veryhigh price in terms of unemployment and
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Bank crises in Greece?
The primary practical problem of leavingthe euro is that some Greek businessesand individuals have borrowed in Eurosfrom banks outside Greece. Since thoseloans are not covered by Greek law, theGreek government cannot change the
obligation from Euros to New Drachmas. The decline in the New Drachma relative
to the euro would make it much more
expensive for the Greek debtors to repay
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Strings attached
But Germany is now prepared to subsidizeGreece and other countries to sustain theeuro, Greece and others mightnevertheless decide to leave if theconditions imposed by Germany aredeemed to be too painful to accept.
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But breaking up the Monetary
Union would be difficult andcostly.
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Ireland Boom
Philip Lane ofTrinity College notes: Therewas a genuine Irish economic miracle,with very rapid output, employment andproductivity growth during the 1994-2000period. Without entry into the eurozone,this might have petered out. But the fall in
interest rates increased the risk that acredit-fuelled property bubble wouldemerge. So, indeed, it did.
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Ireland Bust
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The ratio of private credit to GDP jumped fromaround 100 per cent in 2000 to 230 per cent in2008. Foreign lenders played a huge role infunding this boom: the net foreign liabilities of
domestic banks went from 20 per cent of GDP in2003 to over 70 per cent in early 2008.
The global financial crisis caused animmediate cessation in the capital inflows.In panic-stricken response, the Irish
government guaranteed bank debt inSeptember 2008. As the fiscal costsmounted, driven by the slump and theneed to rescue the banks, what began as afinancial crisis ended up as a crisis inpublic debt.
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The direct costs of recapitalizing the systemare set to be around 36 per cent of GDP.Forcomparison, the cost of the Asian financialcrisis to South Korea was 31 per cent of GDP,while the cost of todays crisis to Icelandmight be only 13 per cent of GDP. On the last,according to the IMF, general government
debt could be 123 per cent of GDP by 2014. Alittle over a third of this increase in the publicdebt ratio would then be a direct result ofrecapitalizing the banks
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Irelands Banks run
Ireland borrowed massively to stop itsrun70 percent of GDP, including $90billion from the European Union Loan,
leaving the country with more debt-to-GDPthan Greece.
By saving the banks, and their creditors,the government bankrupted the country.
Unemployment is 14 percent and output isdown by 10 percent.
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Ireland Debt Overhang
The overhang of toxic debt accumulated after a decadein which Irish banks borrowed in the internationalwholesale markets to finance a property developmentbubble.
Following the burst of the bubble the governmentcommitted 50 billion Euros-one third of GDP-to fill thehole.
Back in 2008 the government gave 100 percentguarantee to all bank deposit and to most of their debt.
By September and October 2010 ECB lent to Irish banksone quarter of all ECB lending to Eurozone banks.
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sector debt
crisis
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Irelands volatile FDI inflows
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Spain
These big capital inflows raised demandfor Spanish goods and services, leading tosubstantially higher inflation in Spain than
in Germany and other surplus countries.
Both countries are on the euro, so thedivergence reflects a rise in Spains
relative prices.
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Spain: The aftermath of thehousing bubble
When the bubble burst, it left Spain with muchreduced domestic demand, and highlyuncompetitive within the euro area thanks to therise in its prices and labor costs.
If Spain had had its own currency, that currencymight have appreciated during the real estateboom, then depreciated when the boom wasover.
Since Spain does not have its own currency itseems doomed to suffer years of grindingdeflation and high unemployment.
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Relative Price ofNon-Tradables
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Where are Spains budget deficitsin all this?
Spains budget situation looked very goodduring the boom years.
It is running huge deficits as a consequence,not a cause, of the crisis:
Tax revenue has plunged, and thegovernment has spent some money trying
to alleviate unemployment.
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The Crash of 2008 and the rescueof the banks
In the absence of the lender of last resort forthe ECB, there is a risk to the Euro when eachmember state attempts to rescue the banksindependently.
In the aftermath of the financial crisis Spain,Greece, Italy, and Ireland created huge budgetdeficits
The European authorities must coordinate arescue package across different member statesto facilitate fiscal consolidation of high deficitcountries.
But how sharp could be the budget cuts?
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Greece: A Vicious circle
Greek high budget deficits raise the riskpremium on Greek government bonds.
High risk premium puts Euro arrangements at
risk. Euro authorities for budget cuts.
Budget cuts depress economic activity andreduce tax revenues.
The further increase in the deficit raises the riskpremium on Greek government bonds.
Etc., Etc.,
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Sovereign debt spread
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Germany vs. France
S ill b
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Spillover between euro-zonemember states
When investors dump government bonds,they also raise interest rate in thesesbonds and force the government to reduce
its budget deficit. This is likely to reducedownturn; hence increase in deficits. Thusby selling country 1 bonds they also
increase riskiness of government 2 bonds.
I t t i t id i k
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Investors trying to avoid riskcreate more risk elsewhere
The essence of the problem is thatinvestors who sell government bonds ofone country do not take into account the
spillover effects on other country bonds.The problem of contagion is high in euro-zone because of the intensive tradebetween its members.
By forcing early exit strategy in onemember state they also force othermember states to do so.
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Current Account Imbalances
E t l I t l
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External vs. InternalDevaluation
Theeuro allowed these internal
imbalances to grow unchecked and
now stands in the way of a speedyadjustment,becauseeuro-area
countries whose wages are out of
whack withtheirpeers cannotdevalue.
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Integration of Public Finance in theEuropean Union
Makeshift assistance to Greece leavesSpain, Italy, Portugal and Ireland budgetproblems resolved.
Coordinated fiscal consolidation by Eurofinance ministries; and the creation of awell organized Euro bond market for
executing bailouts, seem to be high on theagenda.
The European Commission proposes the
establishment of European Monetary Fund.
P li i l d Fi l U i i
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Political and Fiscal Union requiresFiscal Coordination
The architects of the euro at leastpredicted such problems, even if theycould not solve them. The stability and
growth pact was supposed to limit eachcountrys budget deficit to 3% of gdp andpublic debt to 60% of GDP. It failed, in part
because France and Germany refused toabide by itand even rewrote the ruleswhen they breached the deficit limit.
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A Euro breakup?
No country can be forced off the Euroagainst its will
No country would voluntarily abandon itthe shock of leaving would outweighs anyadvantage of life outside
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Sources of Fiscal Problems
Pro-cyclical behavior by fiscal authoritiesbefore the recent financial crisis
Direct fiscal costs of the financial crisis
Government revenue sources weakenedby the financial crisis
End of asset booms
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Conclusion
The UK economist Charles Goodhart once describedbanks as international in life, but national in death. In the
case of a single currency union you should make themEuropean in death.
Wholesale banking is genuinely cross-border. Germanand UK banks have crippling exposures to Ireland,
French and German banks to Greece, Spanish banks toPortugal. If one peripheral country defaulted, we wouldsee a contagious banking crisis that would overwhelmsome governments ability to cope
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Indebtedness in the Eurozone
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Common Euro Bond
At that point the focus will shift to Italy. Italyaccounts for 18 per cent of the guarantees.I suspect Italy will not be willing to honourits bail-out commitment if and when Spain
were to enter the mechanism. Even if Italywere willing, it might not be able to do it,given its own debt sustainability problems.And once Italy defaults on its commitment,I cannot see Germany and France willingto bankroll the entire system unilaterally. At
that point, the intra-governmental approachwill break down and the eurozone willmake the big jump towards a commonEuropean bond.But a common Eurobond generates moralhazardgives an incentive to excessive
spending.
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Benefits of Currency Union
As we know from the theory of optimumcurrency area, there are benefits andcosts to currency integration.
Benefits are reduced costs of doingbusiness. If they are large, formingcurrency areas lead to large increases in
trade. Intra Eurozone trade has increasedbut not significantly since theestablishment of the EMU.
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Costs of Currency Union
The key problem is building concensus onhow best to stabilize prices andemployment after asymmetric shocks.
Labor mobility (Mundell), Fiscal integration(Kenen), A Strong central bank serving aslender of last recourse, and a fiscal unit to
bailout sovereign debts, lubricateequilibration, but do not automaticallyresolve member conflicting interests.
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LL schedule
Degree ofeconomic integration between the
joiningcountry and theexchangerate area
Economic stability
loss forthe joiningcountry
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The GG-schedule
Monetary efficiency gain The joiners saving from avoiding the uncertainty,
confusion, and calculation and transaction coststhat arise when exchange rates float.
It is higher, the higher the degree of economicintegration between the joining country and thefixed exchange rate area.
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GG schedule
Degree ofeconomic integration between the joining
country and theexchangerate area
Monetary efficiency
gain forthe joiningcountry
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The Extent of Intra European
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The Extent of Intra-EuropeanTrade
Charles Engel and John Rogersdemonstrate the while of pricediscrepancies decreased over the 1990s
(recall the Single Market Act of 1986), nofurther price convergence happened afterthe 1999 Euros introduction.
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Single Currency and Trade
Andy Rose suggested that on average,members of currency union trade threetimes more with each other than with
nonmember states. But Richard Baldwingreatly scaled back to the Eurozoneabout 9 percent increase in mutual trade.
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Asymmetric Macroeconomic
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Asymmetric MacroeconomicShocks
In the first decade of the Euro nominal bondrates converge but--
Inflation rates diverged
Divergence in unemployment rates
Divergences in growth rates
Divergences in budget deficits