Sunday, May 20, 2012

Is the path to an OCA paved with wasted euros?

First off, apologies to my blog followers for not posting in a couple of months!  I have been through a very stressful time at University ( - a lot of politics!), plus I am organizing a workshop in EU economics at George Mason University on the Euro area in 2 weeks time, so time has been in short supply!

It is always dramatic to hear when someone says "Europe is at a fulcrum" as Jim Cramer did the other day in his excellent program Mad Money on CNBC - but this time (and boy there have been many times recently), I think this call is spot on.  The main problem is that things are beginning to spiral out of control, and from a variety of perspectives there is no political consensus on how to fix things.  But before we get into the nitty gritty details about what might happen and what will probably happen, let's take a step back from the "rolling crisis" in Europe and look at the whole situation in a broader context.

The European Union was essentially a political project - one that would bind the countries of Europe together so that the events of the first and second World Wars would never be repeated.  In that the EU has been phenomenally successful as we have had no or little tension between the members of the European Union, countries that at one time were mortal enemies, since the founding of the Union in 1958.  But the EU has always had economic aspirations, aspirations that any entity its size are likely to have to be a major actor on the world stage.  The single market was the first real sign of those aspirations, and with the visionary Jacques Delors at the helm, the single market became a reality in 1992.  This is basically establishing the EU as a step beyond a free trade area - it is a customs union - a free trade area with common external tariffs.  A free trade area for Europe was a way of stimulating all the economies in Europe after a sclerotic period in the 1980s and the economic theory was completely behind it, as any student of economics will tell you.

All well and good - but Jacques Delors was not content to sit on his hands and let the momentum he had got behind the single market go to waste.  So the single currency was born on the shoulders of the single market, and justified by a now famous document called "One Market, One Money" which was published by the Commission as a justification for moving to a single money as a way to capture all the benefits from the single market plus some additional external benefits as well.  The only problem with a single money is that the economic theory behind adopting a common currency didn't back this further level of integration.

The theory behind adopting a common currency had been done in the 1950s and 1960s by the Canadian nobel-prizewinning economist, Robert Mundell, and is called "optimal currency area theory".  The theory essentially says that countries that have similar macroeconomic variable trajectories over time are likely to be good candidates to join a single currency.  And if there are some countries that don't quite fit the norm, as long as you have a single market for all factors of production and the equivalent of a federal government standing ready to do some redistribution of income, everything should work out alright.  In terms of the application of this theory, only a few decades later when a couple of seminal studies by a UK economist by the name of Michael Artis (University of Manchester) came out using cluster analysis in the late 1990s was it shown how problematic this was in the case of the EU.  If you looked at the pattern of movements in macroeconomic variables for all the candidates eligible and wanting to join the euro, there were clearly at least 3 distinct groups when compared with Germany - the most powerful country in Europe.  One was the so-called "hard core" of countries (all in Northern Europe) that tended to follow the German economy in almost lock step, one was the so-called "soft core" of countries that tended to be in Southern Europe and the third group was a rag-tag group of countries with different circumstances (Finland, Ireland, the UK, to name a few).  Clearly the UK was not what one would refer to as an "optimum currency area".  I even did my own update to the work of Michael Artis and others and it is available in working paper format from the Bank of Finland here.

Now as a side note, some economists (Jeffrey Frankel and Andrew Rose initiated this train of thinking)  made the point that even though the EU has nothing like a federal government to do some transfers of resources between countries that get into trouble, there is likely to be a harmonizing effect as all the member states adopting the euro will have the same monetary policy, which was not the case before they adopted the euro.  This so-called "endogeneity of optimal currency areas" (article available here) was a comfort, and led many to believe that the EU did not need to have the apparatus at a federal or (what the Europeans call a) supranational level in order for the euro to work.

So let's now fast forward to the current problems.  If we look at the groupings of euro area member states (and I am just about to finish a paper which does exactly this) based on how their growth rates are moving together (or otherwise), it is clear that there are basically 3 groups of euro area member states - those that are still in the "hard core", those that have transitioned or are transitioning towards the "hard core", and those that are still far from being in the "hard core" and if anything are moving in the opposite direction (read Greece).  It is therefore clear that unless something is done to give support to Greece's membership at the supranational level (which is unlikely given German opposition to such a development), it should leave.  The big question though is what would happen if Greece left, and how serious the "contagion" would be (some commentators have already claimed that these effects have started see Gavyn Davies's article in the FT here).  I would suggest that economic policymakers should look very carefully at what the economic studies are saying about the other member states that are likely to seek assistance if contagion occurs following a Greek exit (or Grexit as it is now called), before they go down the same path that they have with Greece.  Not all paths are paved with gold, and some might be paved with an awful lot of wasted euros!

The main point here is that if push comes to shove politics will once again trump economics.  The EU leadership can do only a certain amount to help Greece stay in the euro, and because there is little consensus on further help, a point will likely come when Greece either defaults or exits or both.

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