Europe and the euro integration crisis and policies

The deepening process took a crucial step forward in 1999 withthe creation of the Economic and Monetary Union EMU, which nowinvolves 19 countries adopting a common currency Eurozone.Howe

Europe and the Euro

Integration, Crisis and Policies

Foreword by Paul De Grauwe

University of Brescia

Brescia, Italy

University of Perugia Perugia, Italy

ISBN 978-3-319-45728-4 ISBN 978-3-319-45729-1 (eBook)

DOI 10.1007/978-3-319-45729-1

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even than security and peace.

Europe was the source of the cultural achievements from which

The sovereign debt crisis that erupted in 2010 exposed the design ures of the Eurozone These have long been known Right from the start

fail-of the Eurozone many economists warned that these design failureswould lead to problems and conflicts within the currency union, andthat the Eurozone in the end would fall apart if these failures were notcorrected

‘Visionary’ European politicians brushed aside the warnings from omists in the 1990s that the euro is based on a flawed construction.Nothing would stop their great monetary dream, certainly not the objec-tions of down-to-earth economists What are these design failures?

The European monetary union (EMU) lacked a mechanism that can stopdivergent economic developments between countries Some countriesexperienced a boom, others a recession Some countries improved theircompetitiveness, others experience a worsening These divergent develop-ments led to large imbalances, which crystallised in the fact that somecountries built up external deficits and other external surpluses

When these imbalances had to be redressed, it appeared that themechanisms to redress the imbalances in the Eurozone (internal deva-luations) are very costly in terms of growth and employment, leading

to social and political upheavals Countries that have their own rency and that are faced with such imbalances can devalue or revaluetheir currencies In a monetary union, countries facing external deficits

cur-ix

are forced into intense expenditure reducing policies that inevitablylead to rising unemployment This problem has been recognised by theeconomists that pioneered the theory of optimal currency areas (Mundell,1961; McKinnon, 1963; Kenen, 1969) Later important contributionsinclude Bayoumi and Eichengreen (1993) and Krugman (1993).

The standard response derived from the theory of optimal currencyareas is that member countries of a monetary union should do struc-tural reforms so as to make their labour and product markets moreflexible By increasing flexibility through structural reforms the costs ofadjustments to asymmetric shocks can be reduced and the Eurozonecan become an optimal currency area This has been a very influentialidea and has led Eurozone countries into programmes of structuralreforms

It is often forgotten that although the theoretical arguments in favour

of flexibility are strong, the fine print of flexibility is often harsh Itimplies wage cuts, less unemployment benefits, lower minimum wages,easier firing Many people hit by structural reforms, resist and turn toparties that promise another way to deal with the problem, including anexit from the Eurozone From an economic point of view flexibility isthe solution From a social and political point of view flexibility is theproblem

There is a way to reduce the costs of the adjustment to imbalances

in a monetary union if this adjustment can be made to operate metrically Thus, if the inevitable austerity by the deficit countries can

sym-be compensated byfiscal stimulus in the surplus countries, the negativeaggregate demand effects in the former can be compensated by posi-tive demand effects in the latter Such a symmetric adjustmentmechanism did not operate in the Eurozone after 2010, when thelarge external imbalances in the Eurozone were exposed The deficitcountries were forced into austerity while the surplus countries tried tobalance their budgets The result has been to create a deflationary bias

in the Eurozone

Contrary to what was promised, the EMU has failed dismally in ing on these promises, that is, that EMU would lead to more economicgrowth and employment The opposite has occurred Member countries

deliver-of the Eurozone have on average experienced less growth and moreunemployment than the EU countries that decided to stay out of theEurozone Such an outcome, if maintained, undermines the social con-sensus in favour of a monetary union

FRAGILITY OF THESOVEREIGN IN THE EUROZONE

When the Eurozone was started, a fundamental stabilising force thatexisted at the level of the member states was taken away from thesecountries This is the lender of last resort function of the central bank.Suddenly, member countries of the monetary union had to issue debt in acurrency they had no control over As a result, the governments of thesecountries could no longer guarantee that the cash would always be avail-able to roll over the government debt Prior to entry in the monetaryunion, these countries could, like all stand-alone countries, issue debt intheir own currencies thereby giving an implicit guarantee that the cashwould always be there to pay out bondholders at maturity The reason isthat as stand-alone countries they had the power to force the central bank

to provide liquidity in times of crisis

What was not understood when the Eurozone was designed is that thislack of guarantee provided by Eurozone governments in turn couldtrigger self-fulfilling liquidity crises (a sudden stop) that would degenerateinto solvency problems This is exactly what happened in countries likeIreland, Spain and Portugal.1 When investors lost confidence in thesecountries, they massively sold the government bonds of these countries,pushing interest rates to unsustainably high levels In addition, the eurosobtained from these sales were invested in‘safe countries’ like Germany

As a result, there was a massive outflow of liquidity from the problemcountries, making it impossible for the governments of these countries tofund the rollover of their debt at reasonable interest rate

This liquidity crisis in turn triggered another important phenomenon Itforced countries to switch-off the automatic stabilisers in the budget Thegovernments of the problem countries had to scramble for cash and wereforced into quick austerity programmes, by cutting spending and raisingtaxes A deep recession was the result The recession in turn reducedgovernment revenues even further, forcing these countries to intensifythe austerity programmes Under pressure from the financial marketsand the creditor nations,fiscal policies became procyclical pushing coun-tries further into a deflationary cycle As a result, what started as a liquiditycrisis in a self-fulfilling way degenerated into a solvency crisis

The Eurozone crisis that emerged after 2010 was the result of a nation of two design failures First, booms and busts continued to occur atthe national level, leading to large external imbalances The lack of asmooth mechanism to correct for these imbalances created large economic

combi-and social costs Second, the stripping away of the lender of last-resortsupport of the member state countries allowed liquidity crises to emergewhen the booms turned into busts These liquidity crises then forcedcountries to eliminate another stabilising feature that had emerged afterthe Great Depression, that is, the automatic stabilisers in the governmentbudgets As a result, some countries were forced into bad equilibria.

As economists, we should think harder of what happens to politicalsystems when countries are forced into bad equilibria As we have seen, inmany countries where this happened, the political systems were badlyshaken and extreme parties either increased in importance or came topower In several of these countries, the newly emerging political partiesexhibit an open hostility to the monetary union and promise a betterfuture outside the Eurozone

This book of Enrico Marelli and Marcello Signorelli comes at the righttime We now know more or less what the nature of the Eurozone crisis is.And we can start thinking about the ways to go forward to make theEurozone sustainable in the long run Enrico Marelli and MarcelloSignorelli provide an excellent analysis of the causes of the Eurozone crisisand of the strategies that we will have to follow to ensure the survival ofthe euro

Paul De GrauweLondon School of Economics, UK

In Europe, six decades of economic integration among a group of nationscontributed to the continent’s longest period of peace Economic progressenhanced peoples’ well-being, and the European Union (EU) was – andstill is– one of the most prosperous areas in the world In 2004, the longprocess of enlargement momentously extended to many Central andEastern European countries, that for several decades before the fall ofthe Berlin Wall (1989) had been subject to a centrally planned economicsystem The deepening process took a crucial step forward in 1999 withthe creation of the Economic and Monetary Union (EMU), which nowinvolves 19 countries adopting a common currency (Eurozone).

However, the last decade was dominated by a dramatic‘double crisis’ inthe Eurozone, aggravated by inadequacies in the EU’s policies and insti-tutions In particular, mainly due to deficiencies in the design of anadequate multilevel governance, the ‘too little too late’ approach inEuropean policies contributed to a deep recession followed by stagnationand deflation The economic crises also caused severe social crises: severalEurozone countries are still characterised by unacceptably high levels ofunemployment, especially among young people In addition, EU institu-tions showed an inadequate capacity to address new issues like the adop-tion of safety nets and appropriate adjustment policies to offset thenegative impact of globalisation and liberalisations (on certain regionsand segments of the population) More recently, failures in the manage-ment of immigration flows and in the implementation of a commonsecurity system with respect to terrorist risks have become apparent As aconsequence, a growing part of the population of the EU has joined

xiii

populist or nationalist movements characterised by Europe’ or Euro’ stances The ‘Brexit’ process, which began with the result of theJune 2016 referendum in the UK, could be afirst step towards the EU’sdramatic disintegration; or it could conversely be an opportunity to rede-sign the functioning and policies of the EU’s institutions, and, especially,

‘no-to move the Eurozone ‘no-towards a truly sustainable path

In this regard, it should be recalled that 5 years ago the Euro was close

to collapse as a consequence of the turmoil generated by the sovereigndebt crisis Then, thanks to more active interventions by the EuropeanCentral Bank (ECB) (including effective statements by President Draghi),the Euro’s crisis seems to have been resolved However, the sovereigndebt crisis, together with the impact of the previous Great Recession,caused widespread stagnation, deflation, job destruction and high unem-ployment in several countries In our view, this highly unsatisfactorymacroeconomic performance was favoured by the uncertain, delayed,and inadequate policy responses of the EU institutions and individualgovernments

As regards the content of this book, we acknowledge that there arealready many books and articles on the causes, characteristics, and con-sequences of the crises in the Eurozone On the other hand, the number

of publications on the process of European economic integration is evengreater Nevertheless, there are still few studies that combine the twoperspectives (which are valuable for teaching purposes as well) Thisbook tries tofill this gap

Thefirst three chapters are devoted to the process of European tion (Chap 1), the convergence to the monetary union and its building(Chap 2) and key features of the European monetary policy (Chap 3).These chapters not only describe the developments in the areas mentionedbut also discuss updated empirical evidence (for instance on the weight ofthe EU’s economy in the world) and conduct critical assessment of theweaknesses that have characterised the EMU since the onset Hence,

integra-Chap 2 contains some empirical investigations on the issue of real nomic convergence in the euro area

eco-Chapter 4constitutes a bridge between thefirst and the second part ofthe book because it not only illustrates the European rules onfiscal policies(Stability and Growth Pact and Fiscal Compact) but also critically dis-cusses the negative impact of the‘austerity’ policies followed in the recentperiod.Chapter 5provides an account of the‘double crisis’ affecting the

EU countries, in particular the euro area Once again discussed is updated

empirical evidence (especially for selected countries) regarding key variables; the specific focus is on the collapse of aggregate demand and onthe fact that some peripheral countries of the Eurozone are still far fromresuming their pre-crisis performances– especially considering output and(un)employment rates Chapter 6 conducts thorough discussion of theeconomic policies adopted after the crises (including the ‘save-State’funds), which in general have been delayed or insufficient Only themonetary policy has progressively become more accommodative: thenew unconventional measures have been adequate to preserve, so far,the Euro, but not to end the stagnation and counteract the deflation.The concluding chapter (Chap 7) deals with two issues: (i) the immedi-ate changes needed in macroeconomic policies and (ii) the enduringreforms necessary to guarantee the long-run survival of the Euro On thefirst point, a strong aggregate demand shock is the only effective solution;

macro-in fact, structural reforms are important for economic growth only macro-in along-run perspective In particular, we propose a major‘Eurozone plan ofpublic investment’, much more ambitious than the unsatisfactory Junckerplan As to the second point, the reforms of EU governance suggested– to

be adopted as soon as possible, though some of them may require changes

in the treaties– should lead to a monetary union effectively completed by

an economic union For example, the Eurozone should have a specificbudget (with adequate resources); a Eurozone Finance Minister, or aEuropean Fiscal Institute, should be created Eurobonds (both projectand stability bonds) should be introduced with a simultaneous reduction

of national public debts A European unemployment insurance system andother stabilisation functions should be partly centralised at the Eurozonelevel In general, the principle of risk reduction should be accompanied byrisk-sharing mechanisms The reforms should be much more ambitious, inboth content and timing, than those foreseen by the recent ‘FivePresidents’ Report Finally, in compliance with the Subsidiarity Principle,

an appropriate transfer of political decision-making power at the Eurozonelevel should be accompanied by an improvement of democratic controland participation, also in order to favour better attunement betweenEuropean citizens and politicians

We are aware that, today, the political conditions for adoption of all thementioned reforms seem to be absent, mainly due to a lack of trust amongmember countries However, far-sighted policymakers should convincecitizens that it is only by enacting these reforms that the survival of theEuro– and perhaps the EU as a whole – can be assured, while at the same

time achieving satisfactory economic performances and enduring socialprogress As mentioned above, the‘Brexit’ could paradoxically favour amore rapid move towards a complete and genuine Economic andMonetary Union (EMU) More generally, although a‘federal union’ isunrealistic at the moment, it should be the ultimate goal, as dreamed bythe ‘founding fathers’ of the European Community Otherwise, a frag-mented Europe will vanish in a globalised world– and this would be agrievous shame borne by future generations.

Brescia and Perugia

July 6, 2016

Enrico Marelli and Marcello Signorelli

1 A Progressively Integrated European Community

within the Global Economy 1

2 The European Monetary Union and OCA Theories:

A Common Currency Awaiting a Real Economic Union 15

3 Monetary Policy and the European Central Bank:

A Progressive Divorce from the Bundesbank Legacy? 45

4 Fiscal Policies and the EU’s Governance: Only Rules

and a Lack of Stabilisation Measures 59

5 The Double Crisis in the Eurozone: Recession, Stagnation

6 The EU’s Policy Response: Too Little Too Late 113

7 The Need for Innovative Policies and Further Integration:

A Real‘Economic and Monetary’ Union Leading

to a Future Political Union? 139

xvii

Fig 2.1 Central (or federal)-level public expenses versus regional

(or country)-level public expenses in some federal

Table 1.1 The main EU expenditures (multiannual financial framework

Table 1.5 Leading merchandize exporters and importers (2014)

in billion US$ and per cent share (in parentheses, shares

Table 2.1 Absolute convergence in per capita GDP (Beta coefficients) 30 Table 2.2 Extended beta convergence in per capita GDP (Beta

Table 2.3 Correlation coef ficients of GDP growth (quarterly

data seasonally adjusted) with European averages

Table 2.4 Elasticities of countries’ GDP growth (quarterly data

seasonally adjusted) with respect to European averages

Table 4.1 General government expenditure (ratios over GDP) 64 Table 4.2 General government total revenue (ratios over GDP) 65 Table 4.3 Public account balances (ratios over GDP) 66

Table 4.6 The austerity (procyclical) policies (period 2010–2014) 72

xxi

Table 5.2 Unemployment rates 87 Table 5.3 Interest expenditure (general government) as percentage

Table 5.4 Export of goods and services (percentage changes on

Table 5.5 Private consumption expenditure, volume

(percentage change on preceding year) 98 Table 5.6 Total Investment, volume (percentage change

Table 5.7 Public Investment: percentage change on previous year

(as percentage of GDP in parenthesis) 100 Table 5.8 Potential growth rates and output gaps 103

Table 5.10 Long-term unemployment rates (as percentage

Table 5.13 Not in employment, education or training (NEET)

Table 6.1 ESM: Capital by participating countries (as of 18 March

A Progressively Integrated European Community within the Global Economy

Abstract This chapter illustrates the integration process of the EuropeanUnion (EU), focusing both on the ‘deepening perspective’ (from theoriginal European Economic Community and Customs Union to theSingle Market) and on the‘widening viewpoint’ (from the initial 6 members

to the current 28, including enlargement to the East with the admission ofseveral formerly planned economies, and the United Kingdom for the timebeing) It also considers competition policy and structural funds It thenevidences the weight and composition of the EU budget, with a briefdiscussion of its evolution over time The EU’s integration process isassessed within the globalization trend, including evidence on the economicweight– of EU countries and the EU as a whole – in the world economy.Keywords European Economic Community (EEC)
European Union(EU)
World economy
EU budget
Customs Union
Single Market
Structural funds

The Second World War (1939–1945) was the greatest human and economicdisaster of history, and it was particularly dramatic in the European context–almost all the nations of the Continent were involved – with around

40 million deaths and massive destruction At the end of this historical

© The Author(s) 2017

E Marelli, M Signorelli, Europe and the Euro,

DOI 10.1007/978-3-319-45729-1_1

1

event, several international initiatives emerged They involved not only theEuropean economies but also the Western countries, and in general thewhole world The 1944 Bretton Woods Agreements designed a new inter-national monetary and financial system and led to the creation of theInternational Monetary Fund and other institutions that were later mergedinto the World Bank The United Nations was created in 1945; a GeneralAgreement on Tariffs and Trade (GATT) was signed in 1947 Also withinthe Old Continent several initiatives promoted growing collaborationamong the European countries (the European Convention on HumanRights was signed in Rome in 1950 and came into force in 1953).

The Treaty establishing the European Coal and Steel Community wassigned in Paris in 1951 (and came into force in 1953) by six countries:Belgium, France, Federal Republic of Germany, Italy, Luxembourg and theNetherlands.1 However, it was with the Treaty of Rome, signed in 1957(it came into force on 1 January 1958), establishing the European EconomicCommunity (EEC) among the six previously mentioned countries, thateconomic integration in Europe effectively began with the aim of achievingbalanced and sustainable development A simple but crucial idea was thateconomic integration and collaboration between European nations wouldboth favour economic growth and reduce the risk of new dramatic conflicts.2

The instruments with which to achieve European economic integrationwere already defined in the Treaty of Rome: (i) a Customs Union (i.e theabolition of internal tariffs and other quantitative restrictions, and theintroduction of common external tariffs); (ii) a common agriculturalpolicy (CAP) [which initially absorbed three quarters of the EuropeanUnion (EU) budget]; (iii) other policies, including a competition policy(control of restrictive practices and abuses of dominant positions, state aidsand tax harmonization); free movement of persons and services; a socialpolicy; common policies in some sectors (e.g transport and energy);monetary policy coordination among the national central banks

It should be noted that, during the 1960s, there were two opposingviews on how to proceed along the road of further integration: awideningprocess vs adeepening one Hence, on the one hand, a progressive enlar-gement of the EEC to new countries was encouraged, while, on the otherhand, the need to support a deepening strategy with progressive economicintegration– i.e an ‘ever closer union’ (in view of a possible final ‘politicalunion’) – was suggested

Over time, there have been several enlargements: in 1973 the UnitedKingdom, Denmark and Ireland joined the six initial countries; Greece in

1981 and Spain and Portugal in 1986 were followed by Austria, Finlandand Sweden in 1995; in 2004 a historic enlargement involved eight for-merly planned economies (Poland, Czech Republic, Hungary, Slovenia,Slovakia, Estonia, Latvia and Lithuania) and two small Mediterraneanislands (Malta and Cyprus), followed by Bulgaria and Romania in 2007andfinally Croatia in 2013 The currently named ‘European Union’ (EU)now comprises 28 countries.

It should be recalled that, before the fall of the Berlin Wall (1989) and thecollapse of the Soviet Bloc, the European continent was politically andideologically divided into two geographical parts (West vs East) with verydifferent structures and functioning of the economic systems In the early1990s, all the formerly planned economies (and the newly created countries)started a difficult transition towards market economy institutions andmechanisms (see Marelli and Signorelli2010a) and some of those countriesentered the EU in the new century Currently, some candidate countries areawaiting EU membership (Albania, Bosnia-Herzegovina, the formerYugoslav Republic of Macedonia, Montenegro, Serbia, Iceland andTurkey), while other European countries (e.g Norway and Switzerland3)have decided to remain outside the EU Moreover, other types of agree-ments with the EU (which do not imply ‘full membership’) includeAssociations, Accession Partnerships, the ‘neighbourhood policy’, variousforms of partnership and cooperation, which in some cases also provide somefinancial help from the EU

Recently, for thefirst time a country has decided to exit from the EU; infact, the United Kingdom – despite having obtained specific favourableconditions for its permanence in the EU – voted in the June 2016Referendum, with a thin majority (51.9%), to leave the EU.4 The UKreferendum represented a negative event for European integration, suggest-ing that a country can bargain and obtain some exceptional benefits and thatexit from the EU is a real option that can be considered The fear is that other

EU countries may follow this option, leading in the worst scenario to theruin of the EU However, there is an alternative scenario and Brexit may be

an opportunity to redesign the functioning and policies of EU’s institutionsand to move the Eurozone towards a truly sustainable path.5

The deepening process can be illustrated by citing the key content of thetreaties introducing substantial modifications to the Treaty of Rome.6The

‘Single Act’ (in force since 1987) was the first significant change to theTreaty of Rome, and introduced the ‘four liberalizations’ in view of theSingle Market (to be launched by the end of 1992); the Maastricht Treaty

(signed in 1992 and adopted in 1993) defined the process and the tions for the creation of the Economic and Monetary Union7; theAmsterdam Treaty (signed in 1997) explicitly promoted the Europeanemployment strategy, and provided further integration in the field offoreign policy and justice; the Treaty of Nice (signed in 2001) introduced

condi-a number of institutioncondi-al reforms; condi-and,finally, the Lisbon Treaty (signed inDecember 2007 and entered into force in December 2009) is currently inforce The main institutional innovations of the Lisbon Treaty8 are asfollows: (i) a‘permanent’ President of the European Council, elected fortwo and a half years (renewable once); (ii) as for decisions by qualifiedmajority of the European Council, only two thresholds are defined (55% ofthe countries and 65% of the population); (iii) a High Representative iscompetent for the Common Foreign and Security Policy; (iv) theEuropean Parliament acquires greater powers, including ‘co-decision’with the Council with respect to legislative power; (v) other significantinnovations are‘enhanced cooperation’ (i.e a subgroup of countries canproceed in certain areas through closer integration) and the provision of an

‘exit clause’ from the EU

The acts of the EU institutions include: (i) the Regulations, whichare issued by the European Council and are directly applicable in theMember States; (ii) the Directives, which find application through thesubsequent national legislation; (iii) the Decisions, which are binding forspecific targets (not necessarily Member States); (iv) Opinions andRecommendations

First of all, it should be highlighted that the EU’s economic and socialpolicy has three major objectives: growth, stability and cohesion In accor-dance with the vision of the Maastricht Treaty, macroeconomic stability(price stability and sustainable publicfinances) is seen as a condition forgrowth However, a competitive environment is considered important tosupport economic growth, as emphasized in the Lisbon Agenda and theEurope 2020 plan Moreover, a competitive framework favouring eco-nomic growth must be accompanied by environmental sustainability andsocial cohesion (with low income inequality and high equality of opportu-nities) In particular, Europe follows the so-called‘social market economy’

model, whereby the efficiency of markets should be integrated by socialaims and equity goals; and the‘structural funds’, especially those devoted

to economic convergence and social cohesion (see the next section), can beconsidered as a key instrument functional to this model

From the outset, European integration was focused on the removal ofbarriers to trade and the introduction of a competition policy In particular,the elimination of internal tariffs (gradually realized and substantially com-pleted at the end of the 1960s) and the unification of external tariffs towardsthird countries created a Customs Union called the ‘European CommonMarket’ The expected effect was an increase in trade with consequent ‘staticgains’ Balassa (1974) has shown that, by creating a European CustomsUnion, the‘trade creation’ effect (within the area) becomes greater than apossible‘trade diversion’ effect (i.e reductions in trade with third countries);the latter effect was absent or insignificant, also as a consequence of a long-runprocess of growing international trade (globalization), favoured by transportand other cost reductions as well as by the liberalizations promoted by theGATT To these‘static gains’ (including production and income growth, andconsumer gains due to a larger variety of productions and lower prices), some

‘dynamic gains’ (passing through competition, economies of scale in largermarkets, productivity gains, higher investment and economic growth) should

be added As regards the objective of having a competitive environment, itshould be recalled that the Treaty of Rome already prohibited collusiveagreements betweenfirms, the abuse of dominant positions and public aid

tofirms, and it suggested a regulation for mergers and acquisitions

Although the abolition of customs duties within the European communitywas completed in the 1960s, only since the second half of the 1980s haveseveral ‘non-tariff barriers’ (customs controls, technical standards require-ments, wide differences in VAT rates and so on) been gradually removed(mainly through Directives) In particular, the‘Single Act’ was adopted in

1985 and it entered into force in July 1987 with the main objective of creating

a true Single Market by 1992 through the four liberalizations regarding theflows of (i) goods, (ii) services, (iii) persons and (iv) capitals

In addition, the Single Act explicitly introduced some key principles ofEuropean governance as follows: (i) the principle of (vertical) subsidiarity,according to which economic policy decisions must be taken as close aspossible to citizens (unless it is proved that it is more efficient or fair thatdecisions are taken at a higher level), (ii) the principle of ‘partnership’,suggesting collaboration between different levels of government and,especially, between the public and private sectors (also including economic

and social partners); (iii) the principle of mutual recognition (wherebynational rules must also be accepted in other countries in the transitionperiod, i.e before the harmonization of rules and regulations at theEuropean level is complete).

A crucial limitation in the European construction is the very small EUbudget, approximately 1% of EU’s gross domestic product (GDP), com-pared to national public expenditures and revenues (which come close, onaverage in Europe, to 50% and 47% of GDP, respectively) Moreover, as

we will discuss inChap 7, the Eurozone does not have its own budget.The EU prepares both annual financial statements and a multi-yearbudget (now for 7 years), in which expenditure items are specified withtheir caps Here we briefly consider the revenue classification and thedeclining role of agriculture in the EU budget expenditure, with afinalfocus on the current period 2014–2020

The main EU budget revenues are: (i) tax on agricultural production;(ii) customs duties (deriving from the common external tariff)9; (iii) theVAT resource (0.3% included in the VAT rates established at national leveland applied on a tax base calculated according to common criteria); (iv) the

‘fourth resource’ (or income-based resource): this is provided by nationalgovernments, and currently amounts to about 0.7% of gross national income

of each country; it is a‘marginal’ resource, i.e used to guarantee a balancedbudget, once the total expenditures have been defined Over time, the revenuestructure has changed radically, with a decline of‘traditional resources’ (from100% in the 1970s to 10% in 2013) and an expansion of the income-basedresource (which now accounts for about three-fourths of the total revenues)

As regards the composition of the EU expenditure and its changes overtime, it should be recalled that, after the Treaty of Rome, the EEC paidspecial attention to agriculture (mainly due to the post-war food crisis, thepoverty and the technical backwardness of the agricultural sector) withhuge consequences on the European budget In particular, the CAPstarted in 1962 with two main objectives: (i) to stabilize the markets ofagricultural products, with reasonable prices for farmers (mainly withprices support and/or export subsidies) and (ii) to encourage rural devel-opment The CAP has been criticized for several reasons: (i) the excessiveburden on the Community budget (it initially absorbed three-fourths ofthe budgetary expenditure), (ii) the higher prices for European consumers

and the resulting implicit transfer of income from consumers to producersand among the Member States, and (iii) the protectionist approachtowards non-member countries, especially developing economies Inrecent decades, several CAP reforms have been approved (e.g., the

2014–2020 CAP emphasizes the objectives of convergence, innovationand environmental sustainability) and a gradual reduction in the weight onthe European budget has occurred (it will amount to about one-third ofthe overall EU expenditure at the end of the current period) Somecountries have demanded a much more rapid reduction of the CAPexpenditure in favour of other policies, such as the structural funds

It should be mentioned that, besides the funds related to the CAP, themain structural funds are as follows: (i) the European Regional Develop-ment Fund, created to reduce regional disparities, mainly by co-financinginterventions such as private and public investment and R&D expendi-ture; the target regions which can make use of this Fund are the laggingregions (with a per capita GDP of less than 75% of the EU average), orregions with employment problems or affected by structural change;(ii) the European Social Fund for employment and social interventions,including education and training; and (iii) the Cohesion Fund, intro-duced by the Maastricht Treaty, in favour of the States with a GDP percapita below 90% of the EU average The regions receiving the largestpart of structural funds used to be all located in Southern Europe(Portugal, Greece, Southern Spain and Southern Italy), but since the

2004 enlargement the Eastern European regions have absorbed thebulk of the EU transfers

Considering the current period 2014–2020, the overall EU plannedexpenditure has undergone a contraction in real terms (–3.3% from theprevious 7 years) for thefirst time in the history of European integration.Considering the structure of expenses (seeTable 1.1), we can highlightthe following two most significant items (corresponding to more than 80%

of the overall expenditure): (1)‘smart and inclusive growth’, distinguishedinto two sub-items: (1a) ‘competitiveness for growth and employment’(12% of the total budget, with 57% dedicated to Horizon 2020 forresearch and innovation and 15% to infrastructure projects), and (1b)

‘economic, social and territorial cohesion’ (33% of the total budget,which includes 49% for regional convergence, 19% for the CohesionFund, and 16% for competitiveness); (2)‘sustainable growth and naturalresources’ (these are essentially the costs of the CAP, corresponding to37% of the total budget) The expenditure distribution across countries

(and regions) depends on several factors (mainly the level of developmentand other structural conditions) Some studies have identified which coun-tries are net contributors to the EU budget in that they pay more than theyreceive from the various funds, and which countries are net recipients.However, the real problem lies in the strong limitations of theCommunity budget– a problem which constitutes a major obstacle onthe path to further economic integration and, above all, for the function-ing itself of the Monetary Union (as we shall see in the next chapters).

If we adopt a historical perspective, the relative declines and rises of countries(and regions) in the world are particularly striking (see Maddison 2007);many factors can be considered as key determinants of this long-rundynamic Moreover, in around 1870 a complex process of globalizationstarted, and since 1980 there has been the so-called ‘third phase’ of

Table 1.2 The decreasing weight of Europe in world GDP: share (%) of world total (PPP): 1980 –2019

1980 1990 1999 2007 2014 2019* Emerging and Developing Economies 36.2 36.0 44.7 50.2 57.0 60 Advanced Economies 63.8 64.0 57.6 49.8 43.0 40

European Union 29.8 27.2 23.7 20.7 16.9 15 United States 22.4 22.5 21.3 18.6 16.2 15

globalization (e.g World Bank2002; Maddison2001) with further signicant implications for the Old Continent and each European country.

fi-As regards this last period, Table 1.2 shows the growing weight ofemerging economies’ GDP share (from around 36% in 1980 to anexpected 60% in 2019) with respect to advanced economies In particular,

it shows the decreasing weight of the European countries in the worldGDP (in less than 40 years the share declines have been larger than 50%,and now the individual weights of Germany, France, United Kingdom andItaly are around 2% or 3% of global GDP) Conversely, during the sameperiod, China has moved from 2% to an impressive 19% expected in 2019,overtaking both the United States and the EU (28 countries)

In a longer perspective (Table 1.3), starting from the onset of the‘firstphase’ of globalization (1870), we can better detect the prevailing relativedecline of European countries with respect to the United States (essentially

Table 1.3 The long-run relative decline of European countries ’ GDP in PPP (US = 100)

Countries 1870

GGDC

GK

1913 GGDC GK

1950 GGDC GK

1950 GGDC EKS

1973 GGDC EKS

2015 GGDC EKS (p)

2015 Ranking

Note: (p) = preliminary estimations GK = The GDP_GK series is expressed in 1990 US dollars and it is

2014 US dollars and it is presented in 2014 PPPs, which are based on the World Bank/ICP 2011-round, updated using the change in national GDP deflators relative to the United States

until 1950 and in the most recent period 1973–2015) and the ‘U-shaped’relative dynamics of China and India.

Considering the level of development [per capita GDP in purchasingpower parity (PPP) inTable 1.4], we highlight the huge gap still existingbetween developed countries (like the main European countries and theUnited States) and the emerging ones (despite their recent fast growth)and, as a consequence, the significant margin still existing for emergingeconomies (like China and India) to accomplish their catching-up process.Obviously, the convergence or divergence dynamics depend, also in(European) developed countries, on several factors (including structuralconditions and macroeconomic and structural policies) Of course,

Table 1.4 does not include many smaller countries, also in Europe,whose development level is higher than that of the listed countries.The current weight of the main countries (and the EU) in a globalscenario can be also detected by considering the leading countries inglobal trade (Table 1.5) Excluding intra EU-28 trade, the weight of the

EU was around 15% of both global (merchandize) imports and exports in

Table 1.4 The relative development levels: Per capita GDP in PPP (US = 100) Country 1870

GK

1913 GK

1950 GK

1950 EKS

1973 EKS

1990 EKS

2015 EKS (p)

Ranking 2015 United

States

100.0 100.0 100.0 100.0 100.0 100.0 100.0 1 Germany 75.2 68.8 40.6 41.4 78.2 79.1 84.6 2 United

Kingdom

130.5 92.8 72.6 73.0 72.4 71.2 73.7 3 France 76.7 65.7 55.1 54.9 81.0 77.0 70.8 4 Japan 30.1 26.2 20.1 20.6 70.1 82.9 68.1 5 Italy 61.3 48.4 36.6 39.5 68.7 75.8 62.6 6 Russia–

Note: (p) = preliminary estimations GK = The GDP_GK series is expressed in 1990 U.S dollars and it is

2014 US dollars and it is presented in 2014 PPPs, which are based on the World Bank/ICP 2011-round,

2014, similar to China’s (as regards exports) and to the United States’(as regards imports).10 If we consider the main EU countries (and theintra EU-28 trade), Germany is the leading European country (8% ofglobal exports and 6.4% of global imports) followed by the Netherlands,France and Italy (around 3%).

In the case of commercial services (not shown inTable 1.5) the EU-28

is the leading exporter in the world: it has an almost 27% share, compared

to 18% for the United States and 6% for China (in the case of services theUnited Kingdom is more important than Germany as an individual

Table 1.5 Leading merchandize exporters and importers (2014) in billion US$ and per cent share (in parentheses, shares excluding intra-EU-28 trade)

The Netherlands 672 3.6 United Kingdom 684 3.6

Korea (South) 573 3.0 (3.8) Hong Kong 601 3.2 (4.0)

Hong Kong 524 2.8 (3.5) Korea (South) 526 2.8 (3.5) United

Emirates

Saudi Arabia 354 1.9 (2.4) Russia 308 1.6 (2.0) Spain 325 1.7 Chinese Taipei 274 1.4 (1.8) India 322 1.7 (2.1) United Arab

Emirates

262 1.4 (1.7) Chinese Taipei 314 1.7 (2.1) Turkey 242 1.3 (1.6) Australia 241 1.3 (1.6) Brazil 239 1.3 (1.6) Switzerland 239 1.3 (1.6) Australia 237 1.2 (1.6) Source: WTO Secretariat

exporter) The ranking is similar also for imports of commercial services:20% the EU, 12% the United States, and 10% China.

As a conclusion, we can state that while the EU as a whole can still competewith other leading economic powers in the world– the United States, Japan,China (as well as India, Brazil and many other states in the future) – afragmented Europe will have a much smaller and declining influence

NOTES

1 This first economic integration in Europe was advocated by Robert Schuman (French Minister of Foreign Affairs) in an important speech (9 May 1950) putting forward proposals based on the ideas of Jean Monnet (9 May is now celebrated annually as ‘Europe Day’) Besides R Schuman and J Monnet, K Adenauer, A Spinelli and A De Gasperi can be considered the persons that contributed most – with ideas and/or political actions – to the realization of an integrated Europe.

2 The ‘European project’ has indeed been successful in favouring the longest period of peace in the European continent, and this eminent achievement led in 2012 to the award of the Nobel Peace Prize to the EU For a comprehensive overview of topics related to the process of European inte- gration in the post-World War II period, see Badinger and Nitsch ( 2016 ) For another review of the integration process taking into account econom- ics, politics and history, see Senior Nello ( 2011 ) See also the book edited by Alesina and Giavazzi ( 2010 ).

3 Notice that Norway, together with the 28 EU countries, Iceland and Liechtenstein, joins the ‘European Economic Area’ (EEA), where the free movement of goods, services, capital and persons is guaranteed, but also the free movement of persons (and there are some contributions to the EU budget) Switzerland, instead, enters various bilateral agreements with the

EU to obtain access to the internal market in speci fic sectors, rather than the market as a whole.

4 The extreme position of the United Kingdom was due to long-standing issues (such as the alleged ‘rigidity’ of Brussels bureaucracy) and recently bolstered by the dif ficulties and divergences in managing migration flows at the EU level At the same time, the growing ‘no-Europe’ or ‘no-Euro’ opinions in several EU countries were also favoured by the impact of the double crisis and the EU ’s wrong policy responses.

5 The possible advantages of the Brexit were described by some authors (e.g De Grauwe, 2016c ) even before the date of the referendum According to him ‘it is not in the interest of the EU to keep a country in the union that will continue to

be hostile to “l’acquis communautaire” and that will follow a strategy to further undermine it’.

6 It should be mentioned that signi ficant institutional innovations, although they are not actual treaties extended to all members, have been introduced in recent decades: the 1979 agreement on the European Monetary System (EMS); the Schengen Agreement (applied since 1990) on the free movement

of persons, as well as rules on visas, asylum and immigration; the Stability and Growth Pact (1997); the Lisbon Strategy (2000), now updated in the Europe

2020 plan; the treaties on the ESM and the Fiscal Compact (these treaties will

of decisions on speci fic matters, the Council of Ministers of the EU meets: for example, the Council of Economic and Finance Ministers, Eco fin (the Eurogroup is instead the Council of Economic and Finance Ministers of the Eurozone countries); (iii) the European Commission, whose members are appointed by the Member States (one for each state) and are in of fice for a period of 5 years, renewable; it has powers of initiative, preparation, decision and control; (iv) the Parliament, whose members are elected every 5 years; (v) the Court of Justice; (vi) other consultative bodies such as the Economic and Social Committee, the Committee of the Regions; (vii) bodies with wide autonomy, such as the European Central Bank (its role will be thoroughly discussed in

Chap 3 ), the European Investment Bank, the European Investment Fund; as well as those created after the sovereign debt crisis (EFSF and ESM).

9 This resource, together with the previous one, is known as ‘traditional own resources ’.

10 The well-known US trade deficit and the Chinese surplus are evident.

The European Monetary Union

and OCA Theories: A Common Currency Awaiting a Real Economic Union

Abstract After a brief description of the functioning of the EuropeanMonetary System and its crisis, this chapter analyses the objectives andcontent of the Maastricht Treaty, including the convergence criteria foradmission to the Economic and Monetary Union (EMU) The judgment

on the EMU’s construction is made by considering the Optimal CurrencyArea theories The chapter also includes an account of empirical evidence

on ‘real convergence’ – which is juxtaposed to ‘nominal’ and tional’ convergence – in the Eurozone, compared with the EuropeanUnion as a whole The empirical investigation is completed by analysingcycle correlations, sensitivity to the average EU cycle and trade intensity

‘institu-Keywords European Monetary System (EMS)
Economic and MonetaryUnion (EMU)
Optimal Currency Area (OCA) theories
Real convergence
Nominal convergence
Institutional convergence

Notice that, according to the Maastricht Treaty, EMU stands for ‘Economic and Monetary Union ’ This chapter is however chiefly devoted to the monetary union, and in Chap 7 we shall emphasize what is still needed to realize a true economic union.

© The Author(s) 2017

E Marelli, M Signorelli, Europe and the Euro,

DOI 10.1007/978-3-319-45729-1_2

15

2.1 FROM THE END OF THEBRETTON WOODSSYSTEM

An issue debated among economists for many decades is whether aexchange-rate system would be preferable to aflexible one The advan-tages of a fixed-rate regime include the encouragement of internationaltrade thanks to less uncertainty (about exchange rates), the ruling out ofexcessivefluctuations in exchange rates (which do not always reflect themarket fundamentals and are subject to speculative movements) and thelimitation of opportunistic behaviour by policymakers (including centralbanks) The main costs offixed rates are the exclusion, for a given timespan, of exchange-rate adjustments and the related demise of autonomousmonetary policies at the national level; as we shall see, this cost is exacer-bated in monetary unions Once a country has chosen between the twosystems, it must stick to the regime selected in order to preserve thecredibility of economic policies (Krugman et al.2016)

fixed-Historically, it is well known that at the end of the nineteenth centuryand the beginning of the twentieth there was afixed-exchange-rate regime

in the world: the Gold Standard This regime guaranteed the growth

of international trade and also of capitalflows (foreign direct investments),i.e the spurs of the ‘First Globalization’ After the Great Depression

in the 1930s, protectionism spread to many countries, comprising petitive devaluations, exchange-rate instability and huge falls in interna-tional trade

com-The Bretton Woods Agreements (1944) sought to reintroduce a regime

offixed exchange rates, called the ‘gold-exchange standard’, anchored tothe US dollar The new regime was fundamental in securing the effective-ness of the international payments system and the growth of internationaltrade (thanks also to the liberalizations carried out within the GeneralAgreement on Tariffs and Trade); in fact, the 1950s and 1960s are cited

as the ‘golden age of capitalism’, especially in the Western developedcountries However, the ‘Washington consensus’ (the InternationalMonetary Fund and the World Bank are based in Washington, DC) hasbeen criticized because of its extreme adoption of the free market ideology:for example, by requiring the countries assisted to undertake drastic liberal-izations, privatizations, structural reforms,financial deregulation, etc – insome cases, by means of‘shock therapies’ disregarding economic and socialconditions (Stiglitz2006)

From a technical point of view, the Bretton Woods regime was anasymmetric system and crucially depended on the credibility of the leadingcountry When the credibility of the United States’ fiscal and monetarypolicies slowly vanished at the end of the 1960s, new instability and crisesoccurred.1 In 1971, President Nixon declared the end of the dollar’sconvertibility into gold The dollar was devalued and 2 years later theBretton Woods regime collapsed Thus, after 1973,flexible exchange ratescharacterized the relations among the dominant currencies in the world.The new instability, together with supply-side shocks (in particular the oilshocks that began in 1973), affected macroeconomic developments inthe 1970s, with recessions and rising inflation – the so-called ‘stagflation’.The Keynesian concept of the Phillips Curve– i.e an inverse relationshipbetween inflation and the unemployment rate – came under attack.Monetary policies in many countries began to follow the prescriptions ofthe monetary school (M Friedman) and new classical macroeconomics(the‘rational expectation paradigm’ popularized by R Lucas).

The exchange-rate and macroeconomic instability was particularly terious for trade areas like the European Community, which, as we haveseen (Chap 1), had established a customs union already in the 1960s Thisunion could not survive in the long run, with unstable exchange rates.Moreover, the European economies are comparatively ‘open’, andexchange-rate movements produce large macroeconomic effects Finally,also the Common Agricultural Policy cannot properly function withfrequent exchange-rate movements Consequently, after the collapse ofthe Bretton Woods regime, in 1972–1973, an attempt was made to fix theexchange-rate of some European currencies: the so-called‘snake’; but thisexperiment also failed

dele-A more successful agreement was reached in 1978: the EuropeanMonetary System (EMS), which entered into force in March 1979 Itcomprised an‘exchange-rate mechanism’ (whereby the exchange rates ofthe participating currencies had afixed ‘central parity’ with the new virtualcurrency, the ECU2), rules regarding the intervention of central banks insupport of their currencies, and provisions concerning financial supportfor individual participating countries (when needed) The EMS was called

a ‘quasi-fixed’ exchange-rate system because there were two flexibilityfeatures: (i) afloating band of ±2.25% around the central parity (±6% forthe weaker currencies); (ii) the possibility of realignments, i.e changes ofthe central parities decided by the European Council, when the interven-tion of central banks (in support of weaker currencies) was insufficient

As a matter of fact, from 1979 to 1987 there were 10 realignments.3Therefollowed a period of 5 years, called the‘strong EMS period’, without anyrealignment and with a consequent real appreciation of the currencies inthe countries with higher inflation, leading to competitiveness losses.The EMS suffered from the same problem as the Bretton Woodssystem: its asymmetry The monetary policy was substantially decided bythe leading country, i.e Germany.4There was a risk that possible conflicts

in the conduct of monetary policy could cause crises In fact, in 1992interest rates were raised in Germany (as a consequence of expansionaryfiscal policy after Germany’s reunification accompanied by restrictivemonetary policy) The other countries in the EMS had the option offollowing Germany in raising interest rates (with negative consequences

in terms of recession and higher debt burden) or not changing them, thusabandoning thefixed exchange-rate system Speculative forces consideredthe second option more likely They consequently started selling theweaker currencies and– also through ‘self-fulfilling expectation’ mechan-isms– caused a major crisis in the EMS Some other causes included thepolitical instability generated by the rejection of the Maastricht Treaty inDenmark’s referendum (June 1992); the competitiveness gaps generated

in the long‘strong EMS’ period (a last correction of exchange rates wouldhave been necessary before the start of the monetary union); the economicsituation in individual countries (e.g the huge public debt in Italy).The intervention of central banks in support of weak currencies wasimportant but not unlimited (as required by the EMS agreement).Eventually, in September 1992 the Italian lira and the British poundwere ousted from the EMS (the lira re-entered in 1996); many othercurrencies were compelled to devalue; finally, in 1993 the speculativeattacks turned against the French franc Then, in August 1993 theEuropean Council adopted a drastic measure: a much wider floatinginterval (±15%) was allowed to all EMS currencies This was apparently asuccess, since speculative forces subsided in the following years

According to the‘irreconcilable triad’ (Mundell1963,1968), the followingthree conditions cannot be satisfied in a group of countries at the same time:fixed exchange rates, perfect capital mobility and central bank autonomy

In the European Union (EU), perfect capital mobility was achieved at thebeginning of the 1990s, within the Single Market framework (seeChap 1).

It was, paradoxically, the EMS crisis of 1992–1993 that stimulated thefurther integration required by the Maastricht Treaty, since intermediate

or provisional regimes, like quasi-fixed exchange rates, are unsustainable inthe long run: the monetary union would have implied irrevocably fixedexchange rates‘for ever’ and the contemporaneous delegation of monetarypolicy to a supranational entity Based on the old‘Werner plan’ (1969) and

on the more recent‘Delors Report’ (1989), the Maastricht Treaty, signed inFebruary 1992, envisaged the creation by the end of the century of the

‘Economic and Monetary Union’ (EMU) within the EU

According to the Treaty, the monetary union should be accompanied by

an economic union The latter required completion of the Single Market,the strengthening of competition policy, the reinforcement of structuralpolicies (also thanks to the newly established Cohesion Fund) and the co-ordination of macroeconomic policies As for the monetary unification, theTreaty opted for a gradual and conditional approach to the integration.The three steps foreseen were as follows: (i) in 1990–1992, the removal ofobstacles to the free movement of capitals and the prohibition of monetaryfinancing of public deficits; (ii) in 1994–1998, establishment of theEuropean Monetary Institute (based in Frankfurt) for preparation of thetechnical and legislative requirements in view of the introduction ofthe common currency; (iii) from 1999 onwards, the adoption of irrevoc-ablyfixed exchange rates and the creation of the European Central Bank(ECB), responsible for the common monetary policy

Transition from the second to the third phase was possible for countriessatisfying the following ‘convergence criteria’ (the so-called ‘Maastrichtcriteria’): (i) an inflation rate no more than 1.5% points higher than theaverage rate of the three countries with lowest inflation; (ii) a long-terminterest rate on public debt no more than 2% points higher than theaverage rate of the three countries with lowest inflation; (iii) a public

deficit no higher than 3% of GDP, save in exceptional and temporarycircumstances; (iv) a public debt no higher than 60% of GDP or in down-turn towards that ceiling; (v) an exchange rate within the normalfloatinginterval of the EMS for at least 2 years

The inflation rate requirement was proposed to ensure that admitted tothe monetary union would be countries with a preference regarding infla-tion similar to that of core countries (in particular Germany) The purpose

of the interest rate condition was to prevent large capital gains or losses in

the transition to the common currency The exchange-rate criterion wasintended to exclude ‘last-minute’ currency devaluations The conditions

on public accounts were designed to prevent negative spillovers fromindebted countries (see also the discussion inChap 4).5

A more general consideration is that the process of monetary unificationand the related nominal convergence criteria reduced economic growthalready in the 1990s (De Grauwe2000), because of the deflationary effects

of restrictive monetary andfiscal policies undertaken by several countries atthe same time In particular, peripheral countries were hurt because of thestringency of the nominal conditions; although it should be noted that thebonus deriving from‘nominal’ convergence, especially lower interest rates,was not used by all countries to stimulate higher economic growth– also bymeans of structural reforms– and/or to improve public accounts sustain-ability (for countries with high debt levels) If in the new century suchcountries had continued the effort made in the convergence period to jointhe ‘euro club’, they would have been better prepared to deal with thesubsequent crises (after 2008–2009)

In any case, the examination of thefive criteria was made in May 1998.Eleven countries6were admitted to the monetary union from the start ofthe EMU in 1999; Greece joined 2 years later Although the exchangerates were irrevocablyfixed on 1 January 1999, and the ECB has beenresponsible for monetary policy since then (see also Chap 3), the newcurrency– the euro – began to circulate in 2002 In the new century manymore countries (which in 1998 were not even members of the EU) joinedthe Eurozone: Slovenia (2007), Cyprus and Malta (2008), SlovakRepublic (2009), Estonia (2011), Latvia (2014) and Lithuania (2015)

Was joining the euro area beneficial for the eleven countries in 1999, orthe 19 countries today? After all, many economists think that the eco-nomic case for the EMU was weak and that the decision was taken onstrictly political grounds Contrary to this opinion, Thygesen (2016) wellexplains that there was both a strong economic justification for movingtowards a single currency and a rare political opportunity to begin thatprocess in around 1990

Various explanations, more or less theoretically sound, have been putforward in the literature Here we prefer to start from an established economictheory: the Optimal Currency Area (OCA) theory, initially propounded by

Mundell (1961) and then developed by other authors It simply maintains that

a group of countries belong to an ‘optimal’ currency area if the benefitsderiving from participation in the monetary union are greater than the impliedcosts

The costs are mainly macroeconomic, namely the abdication of an omous (national) monetary policy and of use of the exchange-rate instru-ment.7 In general, there may be also some macroeconomic benefits (theforced monetary discipline with lower inflation, the credibility ‘imported’from high-reputation economies, the decreasing interest rates in the transi-tion to the new currency), but the OCA theory focuses on benefits of amicroeconomic nature The two most important of them are the removal oftransaction costs and the elimination of the exchange-rate risk (EC1990).Thus, not only internal trade would be increased, but also the free movement

auton-of people and capitals; the lesser segmentation auton-of national markets wouldreduce price discrimination and strengthen competition The reduction of

inflation and interest rates would spur investment and reinforce economicgrowth The mentioned benefits accrue in particular to the well-integratedeconomies, i.e to the countries which are‘open’ and characterized by a highproportion of reciprocal trade (McKinnon1963)

How important is the chief cost of the monetary union, i.e the loss ofthe exchange-rate instrument? The OCA theories maintain that this cost ishigh: (i) when the economic shocks are ‘asymmetric’ and (ii) when theadjustment mechanisms (alternative to the exchange-rate manoeuvre) arenot available or do not work properly

As regards point (i), it has been shown that the probability of metric shocks occurring is higher when the countries are dissimilar, i.e nothomogeneous primarily from the point of view of economic structure andproductive specialization (Kenen1969) Differences infiscal systems andinstitutions are important as well Apart from the static heterogeneities inthe variables mentioned, it is even more important to investigate how theymay change over time According to an optimistic view, economicallyintegrated countries tend to become more similar also in terms of produc-tive specialization, because international trade will become to a greaterextent‘intra-industry trade’, i.e imports and exports of similar products(Eichengreen1993) A pessimistic view maintains, on the contrary, thatthe increased international trade will lead to a heightened concentration ofproduction (also in order to exploit scale economies), more specialization,and thus to ‘inter-industry trade’, so that the productive structuresbecome more dissimilar (Krugman1993) The optimistic view has been

asym-further developed within the ‘OCA criteria endogeneity’ proposition,according to which – even if we admit that the OCA’s requirements(in particular the similarity of productions) are not satisfied ex ante – it isthe introduction itself of the common money that may lead to intensifiedtrade and more similar productions, thus fulfilling such requirementsex-post (Frankel and Rose1998; Rose2000).

Regarding point (ii), i.e adjustment mechanisms alternative to luation, Mundell (1961) argued that, when an asymmetric shock occurs

deva-in a monetary union (e.g an deva-increase of aggregate demand deva-in onecountry and a contemporaneous decrease in another country following

a shift in preferences), an adjustment mechanism can be found in themarket if prices and wages are flexible, and labour is mobile acrosscountries In the country adversely affected by the shock, prices andwages will start to fall, thus improving competitiveness, net exports andincome; at the same time, out-migration will reduce unemploymentand help labour-market adjustment Opposite adjustments will occur inthe country positively affected by the asymmetric shock, favouring theoverall rebalancing

We can now more precisely conclude that the cost of monetary unionsrelates to the deflation, recession and unemployment hurting the countrypenalized by the adverse asymmetric shock, for which a devaluation is notpossible: outside the monetary union, an exchange-rate manoeuvre would

be a simpler and more effective adjustment mechanism.8 These economic costs – deflation, recession and unemployment – would behigher and more persistent if the market adjustment mechanisms do notwork properly; for example, in the presence offixed (or not fully flexible)prices, sticky wages and obstacles to labour mobility

macro-Nevertheless, in addition to the mentioned market adjustment isms, the subsequent OCA literature has discovered some additional

mechan-‘insurance systems’ that can mitigate the negative impact of asymmetricshocks A first important insurance system is provided by the publicbudget, of which two kinds can be theoretically identified: a centralizedpublic budget and many public budgets decentralized at the national level

In the former case, there is a unique budget centralized for the entireunion or at least an important central budget accompanied by individualnational budgets: this is the case of the United States (seeFig 2.1for aninternational comparison on the incidence of the central/federal level overtotal expenses) When an asymmetric shock occurs, there will be automaticfiscal transfers from the countries positively affected by the shock to theones penalized by it: in the former countries more taxes will be raised and