Joint lessons for the Eurozone & Economic theory

The theory of the optimal currency area was very insightful, but it did leave out the crucial role of banks.

The theory of the optimum currency area (OCA) allows us to look at the costs and benefits for a country that is considering joining a fixed exchange rate area. As we like to do on this blog, a simple diagram helps to paint the dilemma facing these potential joiners.

 

We have two curves. The first of these is the GG curve, which allows us to represent the monetary efficiency gain. This gain comes from the ease of which individuals and business’s can make transactions as they now share a currency. They no longer face the uncertainty of exchange rate fluctuations, calculations and transaction costs. This curve has a positive slope as the efficiency gain from joining a currency union will increase as the country’s economic integration with the area rises.

The LL schedule represents the economic stability loss, which is also related to the degree of economic integration between the joiner and the area. The major areas of loss for the joiner is the ability to control it’s exchange rate and monetary policy decisions. This is highlighted in the scenario where the joiner suffers an asymmetric shock in the currency union. With this type of shock, the joiner will not see the depreciation of its currency that might normally happen after a shock, and thus, it will not receive the automatic benefit of a depreciated currency. A closer degree of economic integration implies a smaller adjustment to this shock, as it’s goods will become more attractive to the rest of the currency area, and it’s people can move to other countries in the area, thus restoring full employment more quickly. For these reasons, the LL schedule slopes downward.

OCA lessons for the EU & vice versa

The theory of the OCA suggests macroeconomic policies that could help the Eurozone in its’ adjustment process, mainly by increasing the degree of economic integration. Such improvements would be achieved by increases in labour mobility and free trade in services across countries. Importantly, however, the OCA did not consider the importance of a banking union.

A banking union consists of three main pillars: a central supervisor, a central fund for bank recapitalisation and a system wide scheme of deposit insurance. It looked as though the eurozone took important steps towards a banking union at its last summit, but the backlash has been swift. A group of German economists have penned a letter vehemently opposing the banking union, mainly due to the perceived impossibility of the German taxpayer standing behind depositors in the entire eurozone. Luckily, a response to this critique has been formed by another group of German led economists (http://www.voxeu.org/article/manifesto-banking-union-economists-germany-austria-and-switzerland). This group talks of the critical need to break the link between the refinancing of banks and the solvency of national governments. Moreover, they point out that this would also encourage the supply of credit in eurozone economies at a time when fiscal consolidation is occurring.

On the concerns about taxpayer liabilities, they state the importance of making bank creditors liable for risky investments so that any taxpayer funded bailout is minimised.

Whose model is consistent?

Interestingly, respected FT journalist Wolfgang Munchau has reluctantly stated that the claims of the anti-union economists are more consistent (http://www.ft.com/cms/s/0/a82c9de0-cce3-11e1-9960-00144feabdc0.html#axzz21C6dBgnZ). He states that the pro-banking union economists claim that no transfers need to take place in this union. But I did not interpret their views this way. They made an effort to stress the idea of bailing-in senior bank creditors to limit taxpayer involvement, but this does not rule out any taxpayer involvement at all. I disagree with Munchau as I find the position of the anti-banking union economists to be inconsistent – if they openly state the euro must break up, then this is consistent with their opposition to a banking union. For this group to be against a banking union within a currency area, they must show evidence of a successful currency union which did not also have a banking union.

Finally, Gillian Tett has used the US as an example of what is needed for an EZ banking union (http://www.ft.com/cms/s/0/749328c2-cf32-11e1-a1ae-00144feabdc0.html#axzz21C6dBgnZ). Citing her work with the FDIC (Federal Deposit Insurance Corporation), she highlights the trust and clarity with which this organisation operates. Exemplifying this trust in the system of bank resolution, 445 sick banks have been shut down in America since 2008. This is remarkable as it shows the stark contrast with the current Eurozone framework. One could be reasonably confident that if even a few European banks were to go under, it would spark a banking crisis similar to that of the Great Depression.

Overall, the OCA provides a useful first look at what countries might be suitable for a currency union. Adding the analysis of a banking union is necessary to ensure a currency union’s sustainability and credibility. The lessons for theory and practice, therefore, seem to go both ways.

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One response to “Joint lessons for the Eurozone & Economic theory

  1. Pingback: Another great addition to the Euro debate from Paul De Grauwe & Yuemei Ji | globalmacromatters

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