The economics of a common currency in the context of Eurozone

Abstract

The adoption of the Euro was one of the most significant steps in the road to economic and financial integration of Europe that started in 1957, with the formation of the European Economic Community (EEC). Over the years, under the European directives, the member states started to ease capital controls and deregulate interest rates to pave the way for a single financial market. The Maastricht Treaty, signed in Feb 1992, created the foundational pillars for the European Union and the adoption of a single currency Euro. Besides furthering the economic integration of Europe, proponents of Euro believed that it would reduce transaction costs, increase capital movement across borders and eliminate currency risks. While all these are hard to quantify, thus making it difficult to validate these perceived benefits, there has been growing literature on the hampered recovery post the 2010 Euro crisis because of loss of flexibility due to a common currency (Hishow, 2007). Thus, the benefits seem to have been skewed and even periphery nations that benefitted initially, such as Greece and Spain, have faced recessionary environment for years (Hurtado, 2012). Before the adoption of the Euro, the Eurozone adopted the Stability and Growth Pact that enforced budgetary discipline on the countries adopting the common currency. However, little attention was paid to the institutional frameworks necessary for supporting the smooth functioning of a common currency. More importantly, for the adoption of a common currency, the political establishment should have worked with economists and factored the conditions and geography under which a common currency can operate. In academic parlance, this is often referred to as the Optimum Currency Area. In this paper, we first analyze the various definitions of Optimum Currency Areas as described by Mundell, McKinnon and Kenen, who are regarded as pioneers in this field. We then review whether the member states met the conditions for an Optimum Currency Area. We also evaluate the homogeneity of the member states on the factors that would be necessary for adopting a common currency and for dealing with asymmetric shocks such as the one that has been observed in the Eurozone in 2010. We then analyze what are the institutional frameworks necessary for the sustainability of a common currency, which of these have already been created in the Eurozone and which need to be created to avoid a breakup of the Eurozone.