The Euro is the latest and deepest step of economic integration of 19 member countries in the European Union (short: EU). These member countries constitute the Euro area (short: EA) through the introduction of a single currency. It functions as a system of irreversible fixed exchange rates as national currencies were given up entirely.
Back in 1992, member states of the then called European Communities laid the fundaments for the EA as they agreed upon the creation of the European System of Central Banks (short: ESCB) and the European Central Bank (short: ECB). A common European currency that would be later called Euro was set to replace national currencies (Kenen 1995, 1). All EU member countries1 obliged themselves to eventually join the Euro (European Commission 2019). Eleven EU countries started to share a common currency in 1999 and eight more joined the following years. As of today, there have been no exits from this single currency club, although such were discussed politically and in academia for some countries during Europe’s sovereign debt crisis (see inter alia Auerback 2010; Crum 2013; Overbeek 2012).
The expectation of economic benefits as a result of sharing a common currency is not new. Already back in the nineteenth century John Stuart Mill, philosopher and economist and one of the most prominent thinkers of classical liberalism stated: “So much of barbarism, however, still remains in the transactions of most civilised nations, that almost all independent countries choose to assert their nationality by having, to their inconvenience and that of their neighbours, a peculiar currency of their own” (Mill 2004, 572).
In line with Mill, EA members should expect a growth bonus. At least, this is in the Euro’s promise: economically, a common currency shared by different regions or countries increases integration.2 Entrepreneurs benefit from decreased uncertainty with respect to future prices for their foreign sales, procurement and from larger integrated markets that foster economies of scale. Consumers benefit from increased product varieties that better meet their needs and can enjoy greater utility in case of love-for-variety preferences. Competition enhances efficiency and promotes technological progress, in other words higher total factor productivity. However, so far this growth bonus has not materialized empirically (inter alia Dreyer and Schmid 2017).
Per definition, monetary policy is uniform for all EA member countries. Its primary goal of keeping inflation close to but below two percent has been reached since the Euro’s start in 1999. Recently, inflation rates have been well below the two percent limit but not negative. This, however, is no exception as other industrialized countries and, especially, EU members without the Euro have had very low inflation rates as well. Consequently, the Euro has not failed prima vista. Nevertheless, there have been many skeptics at both political and academic levels that have criticized the decision to introduce the Euro.
Some scholars have been concerned about the viability of the Euro as a common currency area because of increased stabilization costs that might outweigh the benefits of lower transaction costs. As early as 1990, Eichengreen (1990) stated that the EU was not prepared for a common currency as, in comparison to the United States, the EU lacked a system of fiscal federalism and showed only limited labor mobility. Friedman (1997) even predicted the risk of political tensions in the EU as flexible exchange rates cannot serve their role of automatic stabilizers in case of asymmetric economic shocks to single member countries. In his words: “I believe that adoption of the Euro would have the opposite effect. It would exacerbate political tensions by converting divergent shocks that could have been readily accommodated by exchange rate changes into divisive political issues” (Friedman 1997). Along the same lines, Feldstein (1997) called the Euro an economic liability for its members, arguing that “a single currency would cause at most small trade and investment gains but would raise average cyclical unemployment and would probably raise inflation, perpetuate structural unemployment, and increase the risk of protectionism” (Feldstein 1997, Abstract).
However, other scholars have been more positive about the EA project without neglecting the necessary further work to make a single currency area work. Obstfeld and Peri (1998) wrote before the Euro’s start: “EMU is about to be born, however, only because Europe has shown the creativity and determination to meet (..) challenges in the past. The same qualities will be needed in abundance to make EMU work” (Obstfeld and Peri 1998, 49).
So how well is the single currency faring today, more than twenty years after its birth?
1 Introduction to the Pivot Series
In this series of three pivots we set out to discuss the success of the EA more than two decades following its launch. We look at the work done so far and discuss what is still needed for the EA to be considered successful. We will build our investigation around the theory of optimal currency areas (short: OCA), analyzing the EA against the three OCA criteria that according to the theory need to be present for a currency area to be successful: (1) synchronization of business cycles, (2) factor mobility, and (3) risk sharing mechanism. We dedicate a pivot to each of the three criteria. We cover the basic ideas of each criterion and measure their degree of existence in the EA empirically. We use linear regressions to answer the following questions:
- Which variables determine business cycle synchronization and what can be learned from an EA perspective? (pivot 1)
- Did labor and capital mobility dampen asymmetric shocks among regions during the short history of the Euro? (pivot 2)
- Did the EA stability mechanism work as expected from a risk sharing mechanism such as a fiscal federalism system? (pivot 3)
Answers to these questions allow us to indicate the distance of the EA from an OCA and whether this distance has become shorter during the Euro’s existence endogenously. Moreover, we will show how these criteria can be met in a better way and, thus, derive policy recommendations that can serve this purpose.
1.1 Criteria of Optimum Currency Areas
The OCA criteria were developed by Mundell (1961), Kenen (1969) and McKinnon (1963). Mundell, himself a Canadian, was concerned by the differences between Canadian provinces that might not be well-prepared to share a common currency. The same could be said for the United States which provoked Mundell’s hypothesis that the borderline for the US and Canadian Dollar shall not separate the North from the South but the East from the West, grouping Western Canadian provinces and US states as well as their Eastern cousins together in two currency areas (Mundell 1961, 660).
For Mundell, a common currency is the final stage of economic integration between at least two regions, which can be separate countries or different regions within the same country. The crucial question for every possible currency union is whether the advantages outweigh its negative implications. For this purpose, the three OCA criteria can be used to evaluate the suitability of potential members.
In the following, we shortly introduce each of the three OCA criteria further.
1.2 Synchronization of Business Cycles Across Regions (Topic of Pivot 1)
For a successful common currency area, it is pivotal that the macroeconomic dynamics of the different regions inside the area are similar. Synchronized business cycles yield comparable price dynamics. This makes it easier for a central monetary authority to achieve its primary aim; inflation control: it can apply a unique monetary policy across all regions, with a view to accelerate inflation in case of deflationary pressure and contain inflation...