Index of European Monetary Integration (January, 2017)

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1 Research Report. Executive summary Institute of International Monetary Research Index of European Monetary Integration (January, 2017) Project coordinators: Dr. Juan Castaneda, Institute of International Monetary Research (IIMR) and University of Buckingham Dr. Pedro Schwartz, Camilo Jose Cela University in Madrid and University of Buckingham Project team: We want to thank Jordan Taylor, Lucia Novak, Sam Burton, Thomas Hergert and Nikita Rai for their assistance in the collection of the dataset, and Valentina Milanova, Markus Grothe and Boris Pavourdjiev for helping us with the literature review. And Noor Bahman for the display and presentation of the data on our website. Project supported by the Beloff Centre for the Study of Liberty (University of Buckingham) and the internships programme of the Institute of Economic Affairs. 1.1 Introduction This is not a normative study in political economy but a positive analysis of monetary arrangements. The use of a single currency markedly reduces transaction costs and thus benefit trading partners; however, there are also economic costs to using a single currency that explain why dealing in a number of currencies separated by flexible exchange rates may be a second best solution. In addition, the use of a single currency may be subject to political constraints that make it too costly for Governments to adopt. We test whether persistent differences in levels of output, unemployment, inflation, real rates of exchange, and the relative size of the bail-out funds needed to avoid the lapse of a member-state explain when single monetary zones are unstable and tend to split. In particular we use the variance of these economic indicators across the Eurozone member states to produce several indexes on the optimality of the euro as a currency union since its creation in These measurements will show in a single figure how much integrated (or disintegrated) the Eurozone has become in the last 18 years, and more crucially during and after the outbreak of the Global Financial Crisis. 1.2 The purpose of the project. The calculation of the index of optimality The destructive character of large variances of (1) unemployment and (2) inflation in monetary zones is selfexplanatory. How would a single and common monetary policy for all fit several member states suffering from soaring inflation while others benefit from moderate inflation, low unemployment and stable economic growth? A single monetary policy does not fit well in an area made of countries that do not share (at least) a fairly common economic cycle and similar inflation rates. To these indicators we add (3) the variance of unit labor costs, (4) the variance of real exchange rates as proposed by Roland Vaubel (1978) 1, the variance of the government deficit 1 Roland Vaubel in his Strategies for Currency Unification: The Economics of Currency Competition and the Case for a European Parallel Currency (1978) proposed the dispersion of real exchange rates to measure the distance of a monetary zone from optimality. Even if in nominal terms all parts of a monetary zone appear to have the same kind of money, they

2 and debt to the GDP, and (6) a measure on cycle synchronicity (the variance of GDP growth across member states). It is clear and well-established in both theoretical and empirical papers on this topic that it is much more difficult to run a single monetary policy when member states show persistent and notable differences in the above indicators. If, on top of that, the single monetary area lacks in markets flexibility so labour mobility is scarce and prices and wages are relatively sticky, the deterioration of competitiveness in a member state (for example, because of higher relative costs and prices) may well end up in significant and unsustainable imbalances within the area. The Eurozone has been the dire example of this problem in recent years. As shown in the data collected for this project, the real exchange rate of several (so-called) peripheral economies such as Spain, Greece, Portugal, Ireland or Italy deteriorated quite rapidly in the years running up to the Global financial Crisis (GFC); as some of those countries accumulated substantial trade deficits which were mainly financed by surplus (core) countries at too low interest rates. Not surprisingly, money growth and (asset price) inflation also soared in some of these economies (notably in Ireland and Spain), which would have required at the time a less expansionary monetary policy in these countries; something the European Central Bank (ECB) could not deliver without imposing too restrictive monetary policy to the Eurozone core countries. In this policy scenario, characterised by ample disparities in the economic performance of member states across the monetary area, a single monetary policy does not really fit all well. This is why keeping the dispersion of the main economic indicators low enough across the member states is key to insure the well-functioning (and even the survival) of the monetary area as a whole. As shown in the Eurozone dispersion charts nehicp-realx/dashboard1, the outbreak of the GFC exacerbated these internal imbalances and made even more and more difficult to manage the Eurozone as a single and effective common currency area. What we do in our project is: 1. To collect and provide the relevant data to assess the optimality of the Eurozone (fully available at the IIMR website) 2. And to calculate the indexes to assess the optimality of the Eurozone as a single currency area since 1999 to present OptimalityEurozone/Dashboard1 To this purpose we have calculated the variance of the GDP growth, unemployment rates, inflation, the real exchange rate, changes in unit labour costs and public deficit and debt ratios to the GDP all across member states 2. Then we have calculated the overall index of optimality 3, in the Eurozone as the arithmetic average of the variance of those seven indicators. In addition, we have calculated three sub-indexes which summarise the performance and internal asymmetries of the Eurozone in three separate major fields: (a) Competitiveness, (b) Public finance and (c) Cycle synchronicity. The competitiveness sub-index is the result of calculating the average in the variance of changes in unit labour costs, inflation and the real exchange rate. The public finance sub-index only takes into account the variance of public deficit and debt ratios to the GDP, whereas do not when the common currency is corrected for structural inflation. The greater the variance of their real rates of exchange, the deeper the dispersion in economic structure and the more fragile their monetary union. 2 All is Eurostat data, accessed online. 3 As calculated it is effectively an index of dispersion in the Eurozone, so the greater the index the greater the dispersion of the seven indicators listed above and thus the greater the asymmetries within the Eurozone.

3 the cycle synchronicity sub-index is made of the average in the variance of GDP growth and unemployment rates across the Eurozone. 1.3 Main findings The good years : Taking 1999 as the base year, coinciding with the launch of the euro, the overall index of dispersion (see the blue bar, Figure below) remains rather steady until 2008, which refutes the conviction expressed by the architects of the euro back in the 1980s and 1990s by which the launch of the single currency would foster further integration and diminish inter-countries disparities along time. As observed in the data, this has not happened. Even more, when we observe the data at a more disaggregated level, the value of the subindexes suggest that the performance of the Eurozone has been quite diverse and asymmetric as regards different indicators: 1. Output and unemployment across member states became more homogeneous (see the yellow bars, Figure 1 below) 2. Public finances variance (see grey bars, Figure 1 below) remained quite steady 3. As regards competitiveness within the Eurozone, we can observe a clear trend towards more dispersion until 2003, an improvement until 2007 and then another surge in dispersion from 2008 onwards. In this (macroeconomic benign) period of eight years, what the overall index of dispersion as well as the respective sub-indexes reveal is that the rates of growth of output and unemployment became more homogeneous across the Eurozone; but the area as a whole did not become more integrated in terms of competitiveness (and thus, inflation, costs and real exchange rates) nor public finance (public deficit and debt ratios to the GDP) performance. The GFC and the Euro crises: The hit of the GFC between 2007 and 2008, and the Euro crisis afterwards, is reflected in an increase in the dispersion observed in all indexes; particularly volatile is again competitiveness across the Euro zone, which shows exceptionally high dispersion in 2009 and In the absence of the possibility to make national exchange rates adjustments nor devaluations the only option for countries lacking in competitiveness has been internal devaluation, which aims at a cut in internal costs and prices. Internal devaluation has been applied to some extent in the periphery of the Euro zone, and is shown in the figure below in a reduction in costs and prices dispersion from 2010 to The growth in the economic cycle dispersion sub-index across member states is also quite striking: from 2008 onwards both output growth and unemployment rates have registered quite a different pattern across euro economies, exhibiting a high degree of dispersion which makes a single monetary policy very difficult to fit all countries. It is worth mentioning that the overall index of dispersion increased, and thus deteriorated 100% during the GFC and, which is ever more relevant, it has remained quite high and virtually stagnant since 2013, showing no signal of improvement in the last two years.

4 Figure 1: Overall index of optimality and sub-indexes ( ): competitiveness, public finance and cycle synchronicity Euro zone: indexes of dispersion (1999 = 100) Overall index Competitiveness sub-index Public finance sub-index Cycle synchronicity sub-index 2. REFERENCES A. Literature on optimal currency areas and the Eurozone - Abad, José; Löffler, Axel; Schnabl, Gunther and Zemanek, Holger (2012): Fiscal Divergence, Current Account Divergence and TARGET2 Imbalances in the EMU. University of Leipzig Working Paper Num Estrada, Ángel; Galí, Jordi and López-Salido, David (2012): Patterns of Convergence and Divergence in the Euro Area. Paper presented at the 13th Jacques Polak Annual Research Conference, International Monetary Fund. Washington, DC November 8 9, 2012 (accessed online). - Flaig, Gebhard and Wollmershaeuser, Timo (2007): Does the euro-zone diverge? A stress indicator for analyzing trends and cycles in real GDP and inflation. CESifo Working Paper Series Num Friedman, Milton (1953): The Case for Flexible Exchange Rates. University of Chicago Press.

5 - Mahlberg, Bernhard and Kronberger, Ralf (2004): Eastern Enlargement of the European Monetary Union: An Optimal Currency Area theory view. In F. Breuss, G. Fink, S. Griller (eds.) Institutional, Legal and Economic aspects of EMU. Pgs Springer Publisher. - Mundell, Robert (1961): A Theory of Optimum Currency Areas. In American Economic Review, vol. 51, num. 4, pgs Mundell, Robert (2012): The Case for a World Currency. In Journal of Policy Modeling, vol. 34, pgs Vaubel, Roland (1978): Strategies for Currency Unification: The Economics of Currency Competition and the Case for a European Parallel Currency. Mohr Verlag, Tübingen B. References on indexes - Canofari, Paolo; Marini; Giancarlo and Piersanti, Giovanni (2012): The Sustainability of Monetary Unions. Can the Euro Survive?. CEIS Working Paper Num Dorrucci, Ettore; Ioannou, Demosthenes; Mongelli, Francesco P.; Terzi, Alessio and Canofari, Paolo (2015): The Four Unions 'PIE' on the Monetary Union 'CHERRY': A New Index of European Institutional Integration.ECB Ocassional Paper. Num. 160 (February). - Schwab, Klaus and Sala-i-Martín, Xala (2015): The Global Competitiveness Report World Economic Forum. Geneva (accessed online).