Europe and the Euro (National Bureau of Economic Research Conference Report)

It is rare for countries to give up their currencies and thus their ability to influence such critical aspects of their economies as interest and exchange rates. Yet ten years ago a number of European countries did exactly that when they adopted the euro. Despite some dissent, there were a number of arguments in favor of this policy change: it would facilitate exchange of goods, money, and people by decreasing costs; it would increase trade; and it would enhance efficiency and competitiveness at the international level. A decade is an ideal time frame over which to evaluate the success of the euro and whether it has lived up to expectations. To that aim, Europe and the Euro looks at a number of important issues, including the effects of the euro on reform of goods and labor markets; its influence on business cycles and trade among members; and whether the single currency has induced convergence or divergence in the economic performance of member countries. While adoption of the euro may not have met the expectations of its most optimistic proponents, the benefits have been many, and there is reason to believe that the euro is robust enough to survive recent economic shocks. This volume is an essential reference on the first ten years of the euro and the workings of a monetary union.

Chapter One

The Breakup of the Euro Area Barry Eichengreen

1.1 Introduction

The possibility of the breakup of the euro area was already being mooted, even before the single currency existed. These scenarios were then lent new life five or six years on, when appreciation of the euro against the dollar and problems of slow growth in various member states led politicians to blame the European Central Bank (ECB) for disappointing economic performance. Highly placed officials, possibly including members of the governing council of the German central bank, reportedly discussed the possibility that one or more participants might withdraw from the monetary union. How seriously should we take these scenarios? And how much should we care? How significant, in other words, would be the economic and political consequences?

The conclusion of the author is that it is unlikely that one or more members of the euro area will leave in the next ten years and that the total disintegration of the euro area is more unlikely still. The technical difficulties of reintroducing a national currency should not be minimized. Nor is it obvious that the economic problems of the participating member states can be significantly ameliorated by abandoning the euro, although neither can this possibility be dismissed. And even if there are immediate economic benefits, there may be longer-term economic costs and political costs of an even more serious nature. Still, as Cohen (2000, 180) puts it, "In a world of sovereign states ... nothing can be regarded as truly irreversible." Policy analysts should engage in contingency planning, even if the contingency in question has a low probability.

The remainder of this chapter considers such scenarios in more detail. While it is widely argued that the technical and legal obstacles to a country unilaterally reintroducing its national currency are surmountable, it will be argued here that the associated difficulties could in fact be quite serious. To be sure, there are multiple historical examples of members of monetary unions introducing a national currency. It has also been suggested that the legal problems associated with the redenomination of contracts can be overcome, as they were when the ruble zone broke up or when Germany replaced the mark with the reichsmark in 1923/1924. But changing from an old money to a new one is more complicated today than it was in Germany in the 1920s or in the former Soviet Union in the 1990s. Computer code must be rewritten. Automated teller machines must be reprogrammed. Advance planning will be required for the process to go smoothly, as was the case with the introduction of the physical euro in 2002. Moreover, abandoning the euro will presumably entail lengthy political debate and the passage of a bill by a national parliament or legislature, also over an extended period of time. Meanwhile, there will be an incentive for agents who are anticipating the redenomination of their claims into the national currency, followed by depreciation of the latter, to rush out of domestic banks and financial assets, precipitating a banking and financial collapse. Limiting the negative repercussions would be a major technical and policy challenge for a government contemplating abandonment of the euro.

The economic obstacles revolve around the question of how debt servicing costs, interest rate spreads, and interest rate-sensitive forms of economic activity would respond to a country's departure from the euro area. A widespread presumption is that departure from the euro area would be associated with a significant rise in spreads and debt-servicing costs. But further reflection suggests that the consequences will depend on why a country leaves. (The defector could conceivably be a Germany, concerned with politicization of ECB policy and inflationary bias, rather than an Italy, facing slow growth and an exploding public debt.) They will depend on whether credible alternatives to the ECB and the Stability and Growth Pact are put in place at the national level (whether national central bank independence is strengthened and credible fiscal reforms are adopted at the same time that the exchange rate is reintroduced and depreciated). It seems likely that there would be economic costs but that these could be minimized by appropriate institutional reforms.

The political costs are likely to be particularly serious. The Treaty on European Union makes no provision for exit. Exit by one member would raise doubts about the future of the monetary union and would likely precipitate a further shift out of euro-denominated assets, which would not please the remaining members. It might damage the balance sheets of banks in other countries with investments in the one abandoning the euro. Diplomatic tension and political acrimony would follow, and cooperation on nonmonetary issues would suffer. The defector would be relegated to second-tier status in intra-European discussions of nonmonetary issues. And, insofar as they attach value to their participation in this larger process of European integration, incumbents will be reluctant to leave.

The chapter starts by describing scenarios, revolving around high unemployment and high inflation, under which euro area participants may wish to leave. The immediately subsequent sections then evaluate the economic, political, procedural, and legal obstacles to doing so. An empirical section provides evidence on the realism of the exit scenarios by using survey data from the Eurobarometer and on the economic barriers by using data on the impact of euro adoption on commercial credit ratings. Following that is a discussion of reforms that might attenuate dissatisfaction with the operation of the single currency. A coda immediately preceding the conclusion discusses the implications of the 2008 financial crisis in Europe for the arguments of this chapter.

1.2 Scenarios

Different countries could abandon the euro for different reasons. One can imagine a country like Portugal, suffering from high labor costs and chronic slow growth, reintroducing the escudo in an effort to engineer a sharp real depreciation and to export its way back to full employment. Alternatively, one can imagine a country like Germany, upset that the ECB has come under pressure from governments to relax its commitment to price stability, reintroducing the deutschemark in order to avoid excessive inflation.

These different scenarios would have different implications for whether defection implies breakup—that is, for whether one country's leaving reduces the incentive for others to remain. In the case of Portuguese defection, the residual members might suffer a further loss of export competitiveness, while in the event of German exit, they might find their competitiveness enhanced. Specifically, if other countries are similarly experiencing high unemployment associated with inadequate international competitiveness, then Portugal's leaving will aggravate the pain felt by the others and may lead them to follow suit—but Germany's leaving may have no, or even the opposite, effect. Similarly, if discomfort with the inflationary stance of ECB policy is shared by other countries, then Germany's leaving, by removing one voice and vote for price stability, may heighten the incentive for others to do likewise.

More generally, if the country that leaves is an outlier in terms of its preferences over central bank policy, then its defection might better enable the remaining participants to secure an ECB policy more to their liking, in which case the likelihood of further defection and general breakup would be reduced. Disagreements over the stance of policy being an obvious reason why a participating member state would be disaffected, one might think that the defector would automatically be an outlier in terms of its preferences over central bank policy. But this is by no means certain: countries whose preferences differ insignificantly from those of other members could choose to defect for other reasons—for example, in response to an exceptionally severe asymmetric shock, or because of disagreements over noneconomic issues.

And if the country that leaves is small, this would be unlikely to much affect the incentives of other members to continue operating a monetary union that is valued primarily for its corollary benefits. The contribution of the euro to enhancing price stability would not be significantly diminished by the defection of one small member. The impetus for financial deepening ascribed to the single currency would not be significantly diminished. If Portugal left the euro area, would the other members notice? Even if it used its monetary autonomy to engineer a substantial real depreciation, would its euro area neighbors experience a significant loss of competitiveness and feel serious pain?

On the other hand, if Germany defected, the size of the euro area would decline by more than a quarter. This would imply significant diminution of the scale of the market over which the benefits of the euro were felt in terms of increased price transparency and financial deepening. Countries balancing these benefits against the costs of being denied their optimal national monetary policy might find themselves tipped against membership. Defection by a few could then result in general disintegration.

In practice, a variety of asymmetric shocks could slow growth and raise unemployment in a euro area member state and create pressure for a real depreciation. The shocks that have attracted the most attention are those highlighted in Blanchard's model of rotating slumps (Blanchard 2006). The advent of the euro has brought credibility benefits to members whose commitment to price stability was previously least firm and whose interest rates were previously high. Enhanced expectations of price stability have brought down domestic interest rates, bidding up bond, stock, and housing prices. Foreign capital has flooded in to take advantage of this convergence play. The cost of capital having declined, investment rises in the short run, and as households feel positive wealth effects, consumption rises as well. The capital inflow has as its counterpart a current account deficit. In the short run, the result is an economic boom, driven first and foremost by residential construction, with falling unemployment and rising wages.

But once the capital stock adjusts to the higher levels implied by the lower cost of capital, the boom comes to an end. Unless the increase in capital stock significantly raises labor productivity (which is unlikely insofar as much of the preceding period's investment took the form of residential construction), the result is a loss of cost competitiveness. The country then faces slow growth, chronic high unemployment, and grinding deflation, as weak labor market conditions force wages to fall relative to those prevailing elsewhere in the euro area. The temptation, then, is to leave the euro zone so that monetary policy can be used to reverse the erosion of competitiveness with a "healthy" dose of inflation.

This particular scenario has attracted attention, because it suggests that the tensions that could eventually result in defections from the euro area are intrinsic to the operation of the European Monetary Union (EMU). It suggests that the intra-euro-area divergences that are their source are direct consequences of the monetary union's operation. This story tracks the experience of Portugal since the mid-1990s—first boom, then overvaluation, and finally slump. There are signs of similar problems in Italy, where the difficulties caused by slow growth are compounded by the existence of a heavy public debt, and in Spain, which experienced many of the same dynamics as Portugal. The implication is that Greece and Slovenia (and future EMU members such as Estonia and Latvia) will then follow.

1.3 Economic Barriers to Exit

But would reintroducing the national currency and following with a sharp depreciation against the euro in fact help to solve these countries' competitiveness and debt problems? The presumption in much of the literature is negative. A country like Italy—where slow growth combines with high inherited debt/gross domestic product (GDP) ratios to raise the specter of debt unsustainability (that it would become necessary to restructure the debt or for taxpayers and transfer recipients to make inconceivable sacrifices)—might be tempted to reintroduce the lira as a way of securing a more inflationary monetary policy and of depreciating away the value of the debt, but doing so would result in credit rating downgrades, higher sovereign spreads, and an increase in interest costs, as investors anticipate and react to the government's actions. A country like Portugal—where high real wages combine with the absence of exchange rate independence to produce chronic high unemployment—might be tempted to reintroduce the escudo as a way of securing a more expansionary monetary policy and of pushing down labor costs, but doing so will only result in higher wage inflation, as workers anticipate and react to the government's actions. Estimates in Blanchard (2006) suggest that Portugal would require a 25 percent real depreciation in order to restore its competitiveness. It is not clear that workers would look the other way if the government sought to engineer this through a substantial nominal depreciation. Observers pointing to these effects conclude that exiting might not be especially beneficial for a country with high debts or high unemployment. To the contrary, the principal obstacle to exiting the euro area in this view is that doing so may have significant economic costs.

Yet, one can also imagine circumstances in which reintroducing the national currency might constitute a useful treatment. Assume that Portuguese workers are prepared to accept a reduction in their real wages, but they confront a coordination problem: they are willing to accept a reduction only if other workers or unions accept a reduction, perhaps because they care about relative wages. Under these circumstances, there will be a reluctance to move first, and wage adjustment will be suboptimally slow. Then, a monetary-cum-exchange rate policy that jumps up the price level, reducing real wages across the board, may be welfare enhancing; this is the so-called "daylight savings time" argument for a flexible exchange rate. Importantly, in the circumstances described here, there will be no incentive for individual workers or unions to push for higher wages to offset the increase in prices. The lower real wages obtained as a result of depreciating the newly reintroduced currency deliver the economy to the same full-employment equilibrium that would have resulted from years of grinding deflation, only faster.

Note the assumption here: whatever caused real wages to get out of line in the first place is not intrinsic to the economy, so the problem will not recur. Thus, the Portuguese example contemplated here is described under the assumption that real wages have fallen out of line for reasons extrinsic to the operation of the economy—for example, irrational exuberance on the part of workers in the run-up to Stage 3 of the Maastricht process, something that will not recur. If, on the other hand, real wages are too high because of the existence of domestic distortions—for example, the presence of powerful trade unions that exclusively value the welfare of their employed members—then it is implausible that a different monetary-cum-exchange rate policy will have an enduring impact.

There are similar counterarguments to the view that a country like Italy that reintroduced the lira in order to pursue a monetary-cum-exchange rate policy that stepped down the value of the debt would necessarily be penalized with lower credit ratings and higher debt-servicing costs. Sovereign debt is a contingent claim; when debt is rendered unsustainable by shocks not of the government's own making, and the source of those shocks can be verified independently, there are theoretical arguments for why investors will see a write-down as excusable. Even when the country's debt problem is of its own making, credible institutional and policy reforms—strict legal or constitutional limits on future budget deficits, stronger independence to insulate the central bank from pressure to help finance future debts—may reassure the markets that past losses will not recur. The fact that the debt burden has been lightened similarly makes it look less likely that prior problems will be repeated. There is ample evidence from history that governments that default, either explicitly by restructuring or implicitly by inflating, are able to regain market access by following appropriate institutional and policy reforms. The mixed findings of studies seeking to identify a reputational penalty in the form of higher interest rates are consistent with the view that this penalty can be avoided by countries that follow up with institutional and policy reforms, reassuring investors that the experience will not be repeated. The implication is that the cost in terms of reputation may not be a prohibitive barrier to exit.

(Continues...)

Excerpted from Europe and the Euro Copyright © 2010 by National Bureau of Economic Research. Excerpted by permission of The University of Chicago Press. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
Excerpts are provided by Dial-A-Book Inc. solely for the personal use of visitors to this web site. This Title Looks At A Number Of Important Issues, Including The Effects Of The Euro On Reform Of Goods And Labour Markets; Its Influence On Business Cycles And Trade Among Members; And Whether The Single Currency Has Induced Convergence Or Divergence In The Economic Performance Of Member Countries. The Breakup Of The Euro Area / Barry Eichengreen ; Comment: Martin Feldstein -- The Euro And Structural Reforms / Alberto Alesina, Silvia Ardagna, And Vincenzo Galasso ; Comment: Otmar Issing -- The Euro And Firm Restructuring / Matteo Bugamelli, Fabiano Schivardi, And Roberta Zizza ; Comment: Gianmarco I. P. Ottaviano -- Business Cycles In The Euro Area / Domenico Giannone, Michele Lenza, And Lucrezia Reichlin -- The Estimated Effects Of The Euro On Trade: Why Are They Below Historical Effects Of Monetary Unions Among Smaller Countries? / Jeffrey Frankel ; Comment: Silvana Tenreyro -- A New Metric For Banking Integration In Europe / Reint Gropp And Anil K. Kashyap ; Comment: Loretta J. Mester -- Why The European Securities Market Is Not Fully Integrated / Alberto Giovannini ; Comment: Richard Portes -- The Euro And Fiscal Policy / Antonio Fatás And Ilian Mihov ; Comment: Roberto Perotti -- How Central Bankers See It: The First Decade Of Ecb Policy And Beyond / Stephen G. Cecchetti And Kermit L. Schoenholtz ; Comment: Pervenche Berès -- Re-evaluating Swedish Membership In The Emu: Evidence From An Estimated Model / Ulf Söderström -- Euro Membership As A U.k. Monetary Policy Option: Results From A Structural Model / Riccardo Dicecio And Edward Nelson ; Comment: Carlo A. Favero. Edited By Alberto Alesina And Francesco Giavazzi. Includes Proceedings Of The National Bureau Of Economic Research Conference, Held Oct. 2008. Includes Bibliographical References And Index. It is rare for countries to give up their currencies and thus their ability to influence such critical aspects of their economies as interest and exchange rates. Yet ten years ago a number of European countries did exactly that when they adopted the euro. Despite some dissent, there were a number of arguments in favor of the euro: it would facilitate exchange of goods, money, and people by decreasing costs; it would increase trade; and, it would enhance efficiency and competitiveness at the international level. A decade is an ideal time frame to evaluate the success of the euro and whether it has lived up to expectations. To that end, "Europe and the Euro" looks at a number of important issues, including the effects of the euro on reform of goods and labor markets; its influence on business cycles and trade among members; and, whether the single currency has induced convergence or divergence in the economic performance of member countries. While adoption of the euro may not have met with the expectations of optimists, the benefits have been many, and there is reason to believe that the euro is robust enough to survive recent economic shocks. This volume is an essential reference on both the first ten years of the euro and the workings of a monetary union Contents......Page 8 Acknowledgments......Page 10 Introduction......Page 12 1. The Breakup of the Euro Area......Page 22 2. The Euro and Structural Reforms......Page 68 3. The Euro and Firm Restructuring......Page 110 4. Business Cycles in the Euro Area......Page 152 5. The Estimated Trade Effects of the Euro: Why Are They Below Those from Historical Monetary Unions among Smaller Countries?......Page 180 6. A New Metric for Banking Integration in Europe......Page 230 7. Why the European Securities Market Is Not Fully Integrated......Page 266 8. The Euro and Fiscal Policy......Page 298 9. How Central Bankers See It: The First Decade of European Central Bank Policy and Beyond......Page 338 10. Reevaluating Swedish Membership in the European Monetary Union: Evidence from an Estimated Model......Page 390 11. Euro Membership as a U.K. Monetary Policy Option: Results from a Structural Model......Page 426 Contributors......Page 466 Author Index......Page 468 Subject Index......Page 474 "A decade is an ideal time frame over which to evaluate the success of the euro and whether it has lived up to expectations. To that aim, Europe and the Euro looks at a number of important issues, including the effects of the euro on reform of goods and labor markets; its influence on business cycles and trade among members; and whether the single currency has induced convergence or divergence in the economic performance of member countries. While adoption of the euro may not have met the expectations of its most optimistic proponents, the benefits have been many, and there is reason to believe that the euro is robust enough to survive recent economic shocks. This volume is an essential reference on the first ten years of the euro and the workings of a monetary union."--Jacket