The merits of one money

The economic benefits of Europe’s single currency could be substantial. But, as the second in our series of briefs on the euro explains, there remain plenty of doubts about whether it will operate smoothly across such a broad range of countries

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THE euro’s launch would be a risky venture at the best of times. With markets in turmoil, it may look even more so. But so far it has been a blessing for once-shaky currencies such as the French franc and Italian lira. While pegs around the world come unstuck, and other European currencies yo-yo, theirs have stayed solid (see chart 1). Come January, the periodic crises that have rocked Europe’s currencies over the past 30 years should be a thing of the past.

Currency stability will benefit the euro economies. So too will the promise, underwritten by an independent European Central Bank, of low inflation. That will be a particular boon for countries with poor inflation records, such as Italy and Spain. Greater macroeconomic stability is a prize well worth having.

But the euro’s biggest benefits may be microeconomic. Businesses and individuals will save by handling one currency not many. According to the European Commission, the benefits of lower transaction and hedging costs could be worth around 0.5% of EU GDP—some $40 billion a year.

Even these gains are small change compared with the boost to the EU’s single market that the euro may provide. The single market has so far delivered fewer efficiency gains than many had hoped. But when the euro arrives, more consumers and companies will have to treat the euro-zone as a single entity, even though national tax systems and regulations will still differ.

It will instantly be easier to compare prices and wages across the euro area. That will encourage arbitrage, which will increase efficiency. For example, traders will be able to ship cars from Italy, where they are cheap, to France, where they are dear, without fear that currencies will move against them. And remaining barriers against parallel imports—in this case, exclusive car-dealerships—will look even more outrageous than now.

Transparent pricing will increase competition because it will be easier for companies to sell across the euro-zone and for consumers to shop around. That should force European companies to restructure faster, further boosting economies.

The single currency will also give a boost to the development of a liquid euro-wide capital market, lowering the cost of capital and improving its allocation. This could be especially helpful to smaller companies that have in the past relied on backward domestic banks. For investors and pension funds, too, it will mean a wider choice of securities at keener prices.

Currency certainty, low inflation, increased trade and more efficient markets: all promise big benefits. But a single currency involves big risks too. Euro members are giving up both the right to set their own interest rates and the option of moving exchange rates against each other. That loss of flexibility may be a big sacrifice if their economies do not behave as one and cannot easily adjust in other ways.

How well the euro-zone functions will depend on how closely it resembles what economists call an “optimal currency area”. If Finland and Portugal, say, are to share a currency, they should not, in an ideal world, be exposed to different sorts of shock. Their business cycles need to be broadly in line, and the structures of their economies alike. And if they are affected differently by an economic shock—if a recession in Latin America hits Portuguese exports more than Finnish ones, say, or if Finnish productivity rises relative to Portugal’s—they need to be capable of speedy adjustment.

One way to deal with such “asymmetric” shocks is for capital and labour to move out of a depressed region (Portugal, say) and into a flourishing one (Finland). Another is for wages—and thus prices—to fall in Portugal and rise in Finland, boosting the demand for Portuguese products at the expense of Finnish ones.

Another response is to make transfers from regions doing well to those doing badly—either through governments or through individuals earning returns on foreign assets. But if the effects of shocks persist, fiscal transfers merely delay the day of reckoning; ultimately, wages or people (or both) must shift.

The United States has a single currency, but it may not be an optimal currency area. There are asymmetric shocks—recall New England’s recession in the mid-1980s when the rest of America was booming. But Americans readily move to where the jobs have shifted, even if this means crossing state lines. And the federal government also makes stabilising resource transfers: according to one 1980s estimate, up to 40% of any fall in gross state product is offset by higher spending by, and lower taxes paid to, the federal government.

The euro-zone does not remotely resemble an optimum currency area. Asymmetric shocks have been frequent. Some, such as Germany’s reunification, are huge. And adjustment is painfully slow. Wages in the EU are notoriously inflexible. Europeans are loth to up sticks within their own country, let alone moving abroad. They hold few foreign assets. EU-wide fiscal transfers are small—and increasing them, when the Germans and Dutch are already complaining about their net EU budget contributions, would be hard. To top it all, governments have agreed on a crazy fiscal straitjacket called the “stability pact” (see

Yet the arrival of the euro will change Europe. The single currency may itself make the euro-zone more of an optimum currency area. Asymmetric shocks may become rarer as economies become more closely intertwined. And the pressure to deregulate labour markets and increase fiscal flexibility will grow.

Less shocking

At least policy-induced shocks should diminish after the euro’s launch. Granted, the European Central Bank’s monetary policy may affect economies differently, because some are more responsive to interest-rate changes than others. But national monetary policies will no longer differ and devaluations will no longer create or amplify shocks, as they did during the 1992-93 currency crisis when the French jacked up interest rates to defend the franc and the Italian lira fell too far.

More importantly, the euro will boost trade. If countries increasingly trade similar products—French Renault cars for German Volkswagens, for example—their business cycles may converge. Even if they do not, trade increases spillovers between economies. If Germany and France trade more, an upturn in Germany will mean that French exports to Germany rise by more than before.

There is, admittedly, a risk that asymmetry could rise if euro countries specialise more. If Germany (like Detroit) specialises in cars, say, and France (like Silicon Valley) in computers, their economies may diverge more than now. But empirical evidence suggests this is unlikely. Using 30 years of data from 20 rich countries, Jeffrey Frankel and Andrew Rose, both at the University of California, Berkeley, have found that closer economic integration has tended to produce more highly synchronised business cycles.

Asymmetric shocks may be rarer after the euro arrives, but there will still be some, especially in its early years. Broadly speaking, the euro economies will face two challenges: how to smooth differing cycles of boom and bust; and how to adapt to structural change.

When the euro economies are not growing in unison, a common monetary policy risks being too loose for some and too tight for others. The euro interest rate set by the European Central Bank may be too low to keep a lid on inflation in booming economies such as Spain or Ireland and too high to stimulate growth in flagging ones such as Germany or Italy.

This loss of national monetary autonomy need not matter too much, so long as fiscal policy can take the strain instead. The Germans, say, could ease fiscal policy to kick-start their economy. The Spanish could raise taxes or cut government spending to cool theirs. But stability-pact constraints may stop the first; while, after years of belt-tightening to qualify for the euro, booming countries will find it politically hard to squeeze budgets further, especially when they are in surplus.

A different way of smoothing divergent business cycles would be to increase EU-wide fiscal transfers. To get the biggest bang for its euro, Brussels could spend any increased tax revenue on cyclical spending, such as unemployment benefit. Then if Spain were booming while Germany was in recession, Brussels would, in effect, tax Spanish workers to pay Germans’ unemployment benefit, limiting Spanish growth and stimulating Germany’s. But imagine selling a scheme like this to the Spanish government.

If not public, could private transfers play a role instead? If French investors, say, held a large portfolio of international assets, they would be cushioned by the income from those investments when the French economy was doing badly. Look again at America. When New England’s economy slid in the 1980s, residents’ net income from investments across America was worth around 9% of regional GDP.

Unfortunately, most EU residents have hardly any foreign financial assets. Net foreign investment income is worth only around 0.2% of GDP in France and Germany. That may change, though, as euro-wide capital markets develop.

Changing habits

Structural change is likely to pose a bigger challenge than cyclical divergences. Adjustment to shocks will always be slow and painful so long as wages in the EU are highly inflexible and Europeans remain reluctant or unable—for cultural, language, or pension reasons, for instance—to move house to find a job. Regions that suffer an adverse shock could be stuck in a slump with high unemployment until they do adjust.

Such worries are not new. Southern Italy has long had a stagnant economy with high unemployment. Eastern Germany and Andalusia may be trapped in similar binds (see chart 3). And they could get worse after the euro arrives, since southern Italy could in the past hope for some relief by devaluing against the rest of the EU, even if not against northern Italy.

Until now, Italy, Germany and Spain have mostly thrown cash at regional problems rather than tackling their causes. After the euro’s launch, that will be costlier. Pressure for greater EU-wide aid may grow. But so too will the need to free up labour and product markets.

There are signs that EU labour markets are becoming less rigid, although they remain far less flexible than America’s. Companies are increasingly bypassing strict job-protection laws; and firms are freer to vary workers’ hours, although France’s (and Italy’s) moves towards a 35-hour week are worrying. It is conceivable that European workers will recognise that, with devaluation no longer an option, wage demands have to be more flexible. But it is also possible that they will not. After all, the French have hardly embraced flexible labour markets, even after years of pegging their currency to the D-mark and despite very high unemployment.

Unless Europe deregulates its product and labour markets, the risk is that some regions may overheat, while others face periods of stagnation. Many of the euro’s microeconomic benefits might also go unrealised. Thus, without structural reforms, the euro’s economic promise may be wasted. And stagnation and unemployment would raise political tensions too.