An analysis of the Eurozone crisis from Optimal Currency Area Perspective.- a simple story behind stock and shares.
The Eurozone crisis or also known as the European sovereign debt crisis could be considered as one of the longest lasting crisis in the history of Europe. What was triggered by the global financial meltdown in 2008, still leaves the Eurozone in a deep mess. In an attempt to make sense of the crisis, this paper will analyse the Eurozone crisis through Optimal Currency Area framework.
Optimal Currency Area (OCA) is the concept introduced by Robert Alexander Mundell in 1961. It was this concept that sparked the creation of the Eurozone as a single currency area. At its origins, the OCA was introduced as an attempt to resolve the international disequilibrium system caused by the fixed exchange rate system. He believed that by providing a criteria for an optimum currency area, such issues would be resolved. Overtime, it was developed by several economists and eventually used as a cost-benefit analysis for analysing whether or not to join a single currency area.
In an attempt to provide a well-organised analysis of the Eurozone through OCA perspective, this paper will follow the preceding order. Section 2 will provide a Literature Review of OCA by exploring the works of Mundell, Krugman and other economists devoted in the OCA framework. Then, these concepts will be applied to the Eurozone crisis with recent examples from the Eurozone countries and also use patterns in trade, interest rates and other data to strengthen the analysis. Last section concludes the paper with thoughts on the future of the Eurozone.
2.0 Literature Review:
In 1961, Robert Alexander Mundell questioned whether nations should remain in a fixed exchange regime, be freed to fluctuate against other currencies or to abandon national currencies and join a currency area with single currency. Since then, he flirted with the idea that nations could abandon national currencies and experiment to be part of a currency area. He believed that, “ a conception of what constitutes an optimum currency area can clarify the meaning of these experiments” (Mundell, 1961:657).
Firstly, he differentiates between a currency area with single currency and a currency area with more than one currency that are pegged to one another. He explains that when two countries with pegged national currencies engage in trade, a demand shift causes disequilibrium between two nations, which causes unemployment in the country with the lower demand and inflation in the country with higher demand. If the country with higher demand is inflation-averse (like Germany), they would implement contractionary monetary policy to lower aggregate demand and reduce price levels. However, this contraction in money supply would add more burden to the country with lower demand; unless if this country reduces real income to adjust to the falling demand, it will have to reduce output and unemployment. Therefore, it is apparent that in this case, “the pace of employment in deficit countries is set by the willingness of surplus countries to inflate” (Mundell, 1961:659). But in the case of a common currency, there would be a central monetary authority that decides whether or not to reduce money supply. This means, in a single currency area, “the pace of inflations is set by the willingness of central authorities to allow unemployment in deficit regions” (Mundell, 1961:659). Central authorities in the case of the eurozone is the European Central Bank led by Mario Draghi. This collective decision making to eliminate unemployment by tolerating inflation in surplus nation, was a compelling argument for Mundell to implement single currency areas. However, he points out that, in the case of single currency area, both unemployment and inflation cannot be eliminated. In order to minimise the issues arising from such drawback, he believes that the whole world cannot be a single currency area and therefore it was crucial to point out the optimum currency area.
According to him, “an essential ingredient of a common currency, or a single currency area, is a high degree of factor mobility…” (Mundell, 1961:661). Factor mobility is the ability of factors of production (land, labour and capital) to move through a geographical location to the other. He also addresses a dilemma that factor mobility is “likely to change over time with alterations in political and economic conditions” thus “the greater is the number of separate currency areas in the world, the more successfully will these goals be attained” (Mundell, 1961:662). He calls this the stabilisation argument, which appeals to keeping currency areas small enough not to be deterred by political or economic conditions. On the contrary, he states that having small currency areas defeats the role of money as a medium of exchange. and it can be easily affected by any single speculator.
It is clear that even Mundell was unsure of what the size of an optimal currency area should be. But since then, several economists have explored the idea of OCA. Frankel and Rose (1998) provide four criteria for a potential OCA: factor mobility, similarity in business cycles, extent of trade and system of risk-sharing. These factors can be explained as follows. When there is a fall in aggregate demand in a particular nation within the OCA, its price level would fall. If the products are diversified and there is a high factor mobility, labour and capital could flow into other nations where there are higher returns on investments, more work opportunities and higher wages. Therefore, unemployment in the OCA would remain low. To point out the benefit of trade, Rose (2008) proved that a 1% increase in trade raised the correlation coefficient of their GDP by about 0.2. Such increase in business cycle synchronisation means that price levels are similar within the region. This allows the central banks, to implement monetary and fiscal tools that fits all member nations. Figure 1 shows the importance of business cycle synchronisation. A synchronised business cycle (as shown on 1a) helps solve issues in both nations whereas a differing business cycle (as shown on 1b) improves economic conditions of one country at the cost of worsening conditions for another country. Lastly, a system of risk-sharing ensures that when a particular nation suffers a fall in aggregate demand, other nations would provide fiscal transfers to stimulate the economy and ensure that their business cycles remain synchronised.
Krugman et al (2015) provided a framework to evaluate the cost and benefits of a currency area, particularly for countries planning to join the Eurozone. To do so, two schedules are presented on a graph, the GG and the LL schedule. The axises are given as monetary efficiency gain from joining a currency area on the y-axis and the degree of economic integration between the joining country and the exchange rate area. The GG schedule is an upward sloping curve that shows the possible gains from joining a currency area. These gains include certainty in business environment, fall in transaction cost, reduced confusion in trade and increased price transparency. These aspects lead to higher trade, increased consumer spending and growth in financial sectors within the region. The LL schedule is a downward sloping curve that represent the loss from joining a currency area. These losses are include include: the inability to stabilise macroeconomic conditions through monetary and fiscal policy, uncertainty brought on by other members in the area (e.g. high debt level from Greece) and the risk of speculative attacks. Figure 2 shows the two schedules. The point where these two curves connect is where the loss from joining the currency area equates to the gains from joining the area.
3.0 Application of OCA on Eurozone Crisis
The Eurozone crisis which was sparked by the global financial crisis in 2008 was a result of mismanagement by monetary authorities, corruption, moral hazard and greed. One of the flaws in the management of the European Monetary Union (EMU) is that it failed to implement strong criteria for entry in the eurozone. In particular, it failed to evaluate nations with the four criteria provided above: extent of trade, similarity in business cycles, factor mobility and system of risk-sharing.
Several economists, believe that the Eurozone took the approach of force-to-fit rather than finding the perfect match. Frank and Rose (1997) calls this approach the endogenous OCA theory. They believe that “a country is more likely to satisfy the criteria for entry into a currency union ex post than ex ante” (Frankel and Rose, 1997:22). When analysing the four criteria, it becomes apparent that this was the case.
Ijssennagger (2011) notes that trade in the region had increased a reasonable amount of 13 percent since the formation of euro. However, he also sites Willet et al. in claiming that trade in the euro region has since levelled off. Figure 3 seems to support such claims. According to the figure, the intra EU28 export trade fell drastically from 2008, started to recover in mid of 2009 and levelled off after 2011. The plunge in 2008 is clearly the effect of the global financial crisis but the levelling of trade may be the signs of slowing trade in the Euro. Figure 4 shows the trade in goods balance in the EU. According to the figure, there is a large discrepancy in balance of trade. This poses threat to the EU since the strong economies seems to be getting stronger but the weak economies seem to trail off. This also suggests the irregularities in the business cycle in EU, a major flaw in one of the OCA criteria and it contradicts Frankel and Rose’s claims on endogenous OCA.
Yet, as explained above, Mundell suggests that such issue could be resolved if there were strong factor mobility. For instance, when there is high unemployment rate in Greece, due to slowing growth in the nation, labour could migrate to other growing economies such as Germany or Netherlands. This way, Greece’s expenditure on benefits payments will fall. The labour force could also retrain, reduce working hours or move into other industries. All these factors could stabilise the economy within the currency area. In reality, there are unfortunately series of resistance towards labour mobility. Firstly, barriers in culture and language makes it hard for people in Greece to find work in other nations. Also, strong labour union makes it hard for industries in Greece to lower wages and adapt to the demand shock. As a last resort, the central monetary authority could intervene by implementing monetary and fiscal policy.
However, implementing monetary and fiscal policy to save one nation requires a behaviour or system of risk-sharing. This goes back to Mundell’s claim that such a system could be disrupted by political and economic condition that may change overtime. Such was apparent in the case of Greece. When the anti-austerity party came into power in 2014, there were strong resistance towards the austerity plans imposed by the ECB. This cause further panic in the eurozone and thus increased borrowing rate in Greece, Italy, Spain and other trailing nations.
The Eurozone crisis was also the result of moral hazard and greed. Prior to the 2008 crisis, the nations in the Eurozone enjoyed a period of low interest and widely available credit. Figure 5 shows that all nations in the Eurozone enjoyed the same interest rate during this period. These overvalued government bonds as well as an unjustifiably low interest rate created room for moral hazard and greed. The nations with poor managed governments invested extensively in property markets all around the world (e.g. Dubai, Ireland and others). When these investment projects went bust and interest rates started soaring, the GDP to debt ratio also soared higher than the prior limit of 60%. In the case of Greece, it was even worse. Corruption from the earlier government was unveiled in 2009 claiming that the debt of Greece reached around 113% of GDP (BBC, 2012).
From above analysis, it may seem clear that the Eurozone crisis was not the result of a shock from the global economy but rather decades of mismanagement and lack of barriers to enter in the eurozone. In order to take precautionary measures for the future, the EMU requires more strict measures in accessing the government spending of each nation within the eurozone and being tougher in accessing new entrants. However, such strict measures will, with no doubt, be constantly contested by the political state of each nation, as seen by the length of time taken in striking deals on Greece’s sovereign debt crisis. It is also crucial for the ECB to guide Greece in implementing supply-side policies since it is apparent that the issue in Greece is not only the result of fall in aggregate demand but also the result of fall in aggregate supply caused by long periods of crisis. Eurozone could learn lessons from East-Asia and implement large trade segmentation processes. Germany could export the earlier part of the manufacturing process to areas such as Greece where wages are lower. This could not only strengthen the Eurozone’s economy but also synchronise the business cycles between nations.
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