Chapter 4: Costs and Benefits Compared De Grauwe: Economics of Monetary Union

Costs and benefits of a monetary union Costs and Benefits (% GDP) Costs Trade (% GDP)

Two views about costs and benefits of MU (a) The monetarist view (b) The Keynesian view Benefits Benefits Costs and benefits Costs and benefits Costs Costs T* T* Trade (% GDP) Trade (%GDP)

Two views about costs of MU The 'monetarist‘ view : Monetary policies are ineffective as instruments to correct for different developments between countries The cost curve is close to the origin Thus, many countries in the world would gain by relinquishing their national currencies, and by joining a monetary union

The 'Keynesian' view: The world is full of rigidities Monetary policy (including exchange rate policy) is a powerful instrument in eliminating disequilibria The cost curve is far away from the origin Relatively few countries should find it in their interest to join a monetary union

Since the early 1980s the 'monetarist' view has gained adherents, and has changed the view many economists have about the desirability of a monetary union The popularity of monetarism helps to explain why EMU became a reality in the 1990s

Costs and benefits with decreasing rigidities With decline in wage and price rigidities and an increase in labour mobility: Cost curve shifts downwards Monetary union becomes more attractive Benefits Costs and benefits Costs T* T** Trade (% GDP)

Is EMU an optimal currency area? In order to answer to this question there are different parameters to evaluate: Intra-EU trade Degree of rigidities Degree of asymmetry of shocks

Table 4.1: Intra-union exports of EU countries (% of GDP) in 2005 Large differences in openness of EU countries with the rest of the Union For countries with a small degree of openness (UK and Greece), it is less clear that they belong to an optimal currency area with the rest of the EU Cost-benefit analysis is likely to show net benefits of being in EMU for Benelux, and small central European countries

Asymmetric shocks and labour market flexibility Not only the degree of labour market flexibility which matters for determining whether a monetary union will be attractive to countries Also asymmetry in demand and supply shocks matters There is a link between labour market flexibility and asymmetric shocks in a monetary union

Asymmetric shocks and labour market flexibility in monetary unions Downward sloping OCA-line shows minimum combinations of symmetry and flexibility that countries must have in order for a monetary union to provide more benefits than costs Countries or regions located below the OCA line do not have enough flexibility given the level of symmetry they face Countries to the right of the OCA line have a lot of flexibility given the level of symmetry they face Evidence about how many countries in EU form OCA is not clear-cut Eurozone Symmetry USA EU-25 OCA Flexibility

How can this be achieved? There are essentially two strategies: The challenging task for the EU-25 is to move to the other side of the OCA-line, i.e. to make a monetary union less costly How can this be achieved? There are essentially two strategies: Reduce the degree of real divergence (political union) Increase the degree of flexibility of labour markets

Case-study During the early 1980s the industrial world was hit by a severe recession Two examples: Michigan in the USA Belgium in Europe Both regions are of a comparable size Unemployment increased significantly more in Michigan and Belgium than in the USA and in Europe, respectively.

How did these two regions adjust? In Michigan: mainly outward migration In Belgium: mainly real depreciation This helped to restore competitiveness, and started a process of gradual recovery leading to a significant narrowing of the unemployment differential between Belgium and the EC

Case-study suggests that even small countries like Belgium, for which the benefits of being in EMU probably outweigh the costs, have taken some risk When in the future they will be subject to large shocks they will not have a national monetary and exchange rate instrument to soften the blow As a result, given the rigidity of their labour markets, the adjustment to such large disturbances is likely to be painful

Costs and benefits in the long run The European Commission view of monetary integration Upward sloping line (TT) because as trade integration increases the degree of symmetry between the countries involved declines Downward sloping line (OCA): Less symmetry makes a monetary union more costly. More integration reduces the costs of a monetary union. Thus a reduction in symmetry must be compensated by more integration to make a monetary union worthwhile (in terms of costs and benefits) Points on OCA line are minimal combinations of symmetry and integration for which monetary union has zero net gain T Symmetry EU-25 T OCA Trade integration

Costs and benefits in the long run The pessimistic view of monetary integration T´ T Symmetry EU-25 T OCA T´ Trade integration

Two possibilities for the long-term prospects of monetary union: One is represented by the TT line. In this case, although today the EU-25 may not be an optimum currency area, it will move into the OCA zone over time (right side of OCA) The second case is represented by the steep T’T’ line. Integration brings us increasingly farther away from the OCA zone. The net gains of a monetary union do not increase fast enough with the degree of integration. Thus, the costs of asymmetry overwhelm all the other benefits a monetary union may have Second case is implausible

Endogeniety of monetary union A decision by an individual country to join EMU, even if it does not satisfy the OCA criteria, can have a self-fulfilling character In this case the process of integration is sped up by the very decision to join the monetary union, so that this new country grouping moves faster into the OCA zone OCA becomes endogenous

The challenge of enlargement of EMU Two challenges Enlargement poses problems for the 12 present members Enlargement poses problems for the newcomers

Is Euro-25 OCA? Openness as a criterion Figure 4.11: Exports of goods and services towards EU-25 as percentage of GDP (2005)

The central European countries are as open towards the EU as the EU-countries themselves The central European countries appear to be more integrated with the EU than Denmark, Sweden and the UK

Is Euro-25 OCA? Asymmetry of shocks Each point represents correlation between demand and supply shocks of particular country with EU-average Many CE-countries’ demand shocks negatively correlated with EU demand shocks Low correlation of supply shocks between CE-countries and EU Asymmetries in demand shocks may disappear partly in MU, asymmetries in supply shocks more likely to stay

Thus, not all CE-countries may be part of an optimal currency area with the rest of the European Union Despite relatively large openness of the CE-countries vis a vis the EU, many are subjected to relatively large asymmetric shocks, so that it is not obvious that they would gain from entering EMU However, for some of these countries entering EMU might be the best possible way to import monetary and price stability

How will present members be affected by enlargement to Euro-25? symmetry Euro-25 more subject to asymmetric shocks than Eurozone Original members of Eurozone (who are also part of Euro-25) are thrown out of OCA-zone Some original members will perceive policies of the ECB to be less receptive to their domestic shocks than prior to enlargement Eurozone OCA EU-25 Economic integration

Should the UK join EMU? Costs of a monetary union: Openness: the UK has the lowest degree of openness towards the rest of the EU Asymmetry of shocks: demand shocks in the UK are negatively correlated with the demand shocks in Euroland Flexibility: there is greater flexibility in the UK labour markets than in the Eurozone (see the inflation-unemployment of the UK, France and Germany). Thus easier adjustment in UK than in Eurozone It is unclear whether costs of monetary union are larger in UK than in Eurozone

Is Latin America an optimal currency area? Monetary instability has made the idea of forming a monetary union in Latin America popular Costs of monetary union in Latin America Latin American countries have very low levels of trade with the rest of Latin America

Figure 4.16: Intraregional exports of goods and services, EU and Latin America as a percentage of GDP (2005)

Degree of synchronization of output movements is low in Latin America, and asymmetric shocks are relatively large Very little empirical evidence has been undertaken to measure the degree of flexibility of labour markets Main driving force for popularity of MU is the hope to import price stability If monetary union comes about it will have to provide the right institutions guaranteeing price stability

Is East-Asia an optimal currency area? Source: IMF, IFS and Xu Ning(2004) Note: the exports of the East-Asian countries is to ASEAN plus China, Korea and Japan. The data for China relate to 2001.

Shocks are not more asymmetric in Asia than in Eurozone

Economic conditions for monetary union in East Asia seem to be satisfied Main stumbling block is political Desire for political unification is weak Contrast with Europe is great: process of political unification in Europe has been going on since 1960

Monetary Unions in Africa There is a history of monetary union in West- and Central Africa Legacy of colonization: CFA-zone New initiative to extend existing monetary unions: The Economic Community of West-African States (ECOWAS) This is a grouping of 15 states Do these form an OCA?

Figure 4.20: Intraregional exports of goods and services in West-Africa (2003) and the Eurozone (2005)

When using the Eurozone as a benchmark, the evidence on whether West Africa forms an optimal currency area is mixed: The degree of integration among West African countries is low, yielding relatively few benefits of a monetary union Labour mobility is substantially stronger The degree of asymmetry does not seem to be larger in West Africa than it is in the Eurozone West African countries (the members of WAEMU) have already set into place a series of institutions, such as a common central bank facilitating further steps towards a monetary union

Conclusion It is unlikely that the EU as a whole constitutes an optimal monetary union As integration moves on, the number of countries that are likely to benefit from monetary union will increase Enlargement of the Eurozone to 25 countries creates serious challenges Euro-25 is probably not an OCA, but may become one Enlargement will change the cost benefit calculus of existing members of the Eurozone. Some of these member countries may find out that the enlargement makes the monetary union less attractive

It is unlikely that Latin America and East Asia will come to monetary union soon, although reasons are different Evidence about West-Africa as an OCA is mixed Our analysis has been based on an economic cost-benefit analysis. Countries may also decide to adopt a common currency for political reasons The economic cost-benefit analysis remains useful, because it gives an idea of the price some countries will have to pay to achieve these political objectives