EURO CURRENCY DOES NOT CIRCULATE IN AN OPTIMAL CURRENCY AREA

1. PRIVATE VICE, PUBLIC VICE

In the "Fable of the Bees" (1705) Bernard Mandeville represented the paradox "private vices, public benefits"[1].

He showed that actions which may be considered vicious from the individual perspective, give benefits for the collectivity. By rewording this sentence, one would say that prosperity relies on expenditure (vice) rather than on saving (virtue). And going a step further, if that  assessment were applied in terms of the whole private and public sectors, then one would expect that deficits of the private sector yields benefits to the public sector.  

Instead, this is not always the case. Especially when the imbalance in the private sector becomes too large. 

In a previous post [here] we introduced the fundamental identity of macroeconomics which allows to assess the contribution of both the private sector and the public sector to the formation of the current account balance: 

10) PS - I = CA + (T - G) 

where PS: private savings, I: investment, CA: current account balance, T: general government revenue, G: general government expenditures.

In other terms, it describes the interdependence among the imbalances of the public, private and external sectors, by means of the government structural deficit T-G,of the financing deficit of investment with the private savings PS - I, and the current account balance CA.   Actually, imbalances in the right side of the equation 10) may explain the crises in the private (say, banking) sector. For example, the occurrence of a negative current account balance, i.e., CA < 0, implies that: 

11) CA = (PS - I) - (T - G) < 0         

then 

11') PS - I < T - G

and consequently  either the public sector returns a budget deficit (T - G) < 0, or the investment outstrips the private savings (PS - I < 0) so as  to make  the general equilibrium in the economy reinstated. 

But since under recession it is more likely decreasing investment and increasing private savings (i.e., PS - I > 0), the government structural balance is expected to run in deficit. The larger the deficit in the private sector so much the bigger  this "shrinkage" effect by which the operators of the private sector deleverage their balance sheets. This would trigger (or accelerate) the downturn and the banking crisis because of the loss of liquidity in the banking system. Next, larger government budget deficits will be necessary to balance the economy  and to replace savings in banks. This is why big  private deficits turn into raising deficits of the public sector. The countries will have more problems to sell their assets and government bonds in the problem countries will be no longer perceived by the markets as risk free. 

The combination of weak macroeconomic basics and current account imbalances causes structural deficits in the public sector and banking crisis, even though there had been no "fiscal irresponsibility" (e.g., Ireland, Spain) [2].

2. EURO AREA: A DISHARMONIC UNION

Heterogeneity marks the euro area (EA). Seventeen countries shares the same currency, but  neither their income levels nor their economic structures nor their real inflation rates are as close as it would be required in a common currency area. Basically, we can recognize initially a core group of the northern countries with stronger economic and structural conditions relative to the group of peripheral countries (Italy, Spain, Portugal, Greece, Ireland, Cyprus, Malta, Slovenia, Estonia, Slovak Republic). The former group shows balance surpluses, while the latter suffers from balance deficits.

These different macroeconomic and structural starting conditions activated the adverse mechanism which is known as cycle of Frenkel [here].  For a few years, from the accession to the euro, the peripheral countries have experienced decreasing interest and inflation rates, increasing levels of investment and consumption expenditures (supported by improved financial conditions). Over the time these scenario have caused the inflow of capital from abroad and current account deficits in the periphery, while the core countries have recorded surpluses in the balance of payments. High-risk borrowing and lending practices have also been encouraged up to 2008 [3]. Of course, the current account imbalances subsume as drawback the accumulation of foreign liabilities and hence the growing of the external debt. In a period of positive growth rate of the economy, the euro-system seemed to play its best performance. 
But the system was (and still is) inherently weak: they have not been provided rules for facing with downturn phases of economy and the European Central Bank is not a "lender of last resort". Thus, the occurrence of an external shock in 2008 (the U.S. subprime mortgage crisis) have found the EA exposed: huge resources have been drained away from the public sector to support the banking system (e.g., in Ireland the bailout of the banks has cost 80 percentage points of the ratio government debt to gross domestic product in the period 2007-2011which passed from 24% to 106%). Loss of liquidity has derived from sudden stop of capital flows and credit crunch which have reduced the capacity of holding the volume of production and of investment in the peripheral countries. Governments have been compelled to raise taxation and/or cut the expenditures. All these adverse conditions have changed the recession into economic depression.  


3. EFFECTS OBSERVED ON THE RELATIONSHIPS BETWEEN IMBALANCES OF THE PUBLIC, PRIVATE AND EXTERNAL SECTORS

The crisis and the effects of some measures (deflation) adopted to react, has deteriorated the macroeconomic fundamentals in the EA, especially in the peripheral countries. Since the current account balance is the pivotal quantity around which interact all the main macroeconomic identities, it seems worth to display the relationships between the imbalances of thepublic, private and external sector (see Figure 1 and Figure 2) in the EA  between 2007 (pre-crisis) and 2011 (overt crisis). 

Figure 1. The relationship between current account balance and government balance in the EA (2011 vs. 2007). 
Source: International Monetary Fund, World Economic Outlook Database, October 2012 [download dataset]

Figure 1 shows the government structural balances of the EA countries in function of the current account balances. Both the variables are expressed as percentage points to gross domestic product (GDP). The brown-shaded area highlights the countries exposed to the European Commission procedure for excessive deficit (EDP) [here the EU documentation] in correspondence of the threshold of -3% of government deficit. The green shaded area focuses attention on the best performing countries which are further on from the mentioned threshold of -3% and have surplus in the current account. The blu squares refer to the 2011 data while the red circle to the pre-crisis data (2007). The dotted lines are obtained by the linear regression fitting method (R²=0.4278 and 0.2963 for 2007 and 2011, respectively). We can note a significant down shift of the regression line from -1.933 ± 0.7147 (in 2007) to -3.832 ± 0.6146 (in 2011) (F = 4.2566, degreees of freedom = 1 and 27, p value = 0.0487). The slope of the lines is not significantly changed, therefore it is possible to calculate the pooled slope that equals 0.2835. In other terms, at each variation of 1 percentage point in the current account balance, we could expect a variation of 0.28 percentage points in the government deficit. The fundamentals of the Greece economy in 2007 were absolutely deteriorated (indeed warning signals have become evident since  the previous years). All the countries have government deficit, except for Luxembourg  (2007) and Finland (2007, 2011). The "austerity" measures allowed, in general, a mild improvement of the current account balance in the peripheral countries (but only Ireland pass through the negative area of the current account). The worsening of the government balance resulted particularly strong for Spain and Portugal and Cyprus. Slovenia and Slovak Republic reached the  zero cross line but payed the cost of trespassing the -3% limit for the government deficit. Italy and France show similar patterns in both years in an area around the -3% limit of the government deficit and the zero cross line of the current account deficit. From the group of core countries, only the Nederlands and Belgium have left the green area and fell in the brown area. The Nederlands, however, still remains with a strong surplus of the current account.   

Figure 2. The relationship between current account balance and private savings in the EA (2011 vs. 2007). 
Source: International Monetary Fund, World Economic Outlook Database, October 2012

Figure 2 shows the private savings balance of the EA countries in function of the current account balances. Both the variables are expressed as percentage points to gross domestic product (GDP). The green shadowed area represents the condition of jointly positive current account balance and positive private balance. The adopted deflation measures caused the decrease of the domestic aggregate demand in the peripheral countries. The balance of the private sector has moved to the positive area. This change has been particularly remarkable for Spain, while Ireland has entered the green area. The improvement of Greece did not suffice to pass through the negative area. Cyprus is absolutely the outlier of the EA, being stuck in a default dip. Cyprus accessed euro in 2008, but since 2007 (or even before) it should have been clear that the country was not ready yet. The core countries, with relevant surplus of the CA have not increased their domestic demand and keep on scoring high levels of positive private balance.               


4. EURO AREA IS NOT AN OPTIMAL CURRENCY AREA

The accession in the monetary union returns benefits in  terms of efficiency, but can also imply for each country the cost of renouncing to one  instrument of policy economic: the exchange rate, that is  a usual measure to stabilize employment and output in front of external shocks. The theory of optimum currency areas, formulated by R. Mundell in 1961[4] studies the conditions under which a country the benefits of monetary union are greater than the costs. In particular, concludes that the convenience to enter a monetary union is greater the greater the degree of trade integration already existing between the countries.

The benefits of the single currency are:

1. the elimination of transaction costs (the cost determined from the conversion of currencies represents a deadweight loss).
2. Reduction of price discrimination (if the goods have prices expressed in the same currency, it is more difficult to hide price differences in different countries).
3. The reduction of the variability of exchange rates (fluctuations exchange rate creates uncertainty for companies trading between EMU countries).

The most significant cost that an economic system must address in joining a monetary union is to give up their national currency and, therefore, the ability to determine independently its monetary policy and to take advantage of changes in the external value of the currency to the macroeconomic adjustments.

A group of countries with a high degree of trade integration, strong labor mobility, market integration securities and which is not exposed to shocks in aggregate demand asymmetric is defined optimum currency area (OCA).

The benefits of the single currency are larger the higher the degree of trade openness of countries forming the monetary union.


The degree of trade openness of countries (see Figure 3) can be calculated as the ratio:

12) 100*(Export + import) / GDP

The higher the degree of openness the higher the transaction costs, the efficiency losses due to the uncertainty of change and the probability that by joining a monetary union with stable prices even in the acceding country the prices will tend to stabilise.

Figure 3. The degree of trade openness in european countries (1995-2004).

Source: Eurostat

Many European countries have a high degree of openness to trade. However, labor mobility and flexibility of real wages (and flexibility of labor markets in general) tend to be low, and although the adoption of the euro has fostered the integration of markets
wholesale capital in the euro area, the retail financial markets remain strongly restricted at the national level [5]. Therefore, should they occur important differences between the economic cycles into the euro area, the lack of a policy monetary policy and exchange-rate independent would be felt strongly . 

Overall, the low labour mobility and the lack of fiscal federalism make the euro area not satisfying the conditions necessary for being considered as an optimal currency area. 






1. The Fable of the Bees: or, Private Vices, Public Benefits consisted of a poem, The Grumbling Hive, or Knaves Turn'd Honest, along with a prose Preface. The poem had appeared in 1705
2. P. Alessandrini, M. Fratianni, A.H. Hallett, A.F. Presbitero, (2012). External imbalances and financial fragility in the Euro Area. MOFIR (Money and Finance Research group) see here the document
3. IMF, Group of Twenty, 2012, Euro Area imbalances (Annex 2) see here the document
4. Mundell, R. A. (1961). "A Theory of Optimum Currency Areas. American Economic Review 51 (4): 657–665.  see here.  The theory, originally developed in 1961 by Nobel laureate in economics Robert Mundell, has been supplemented over the years by other leading academics, including Friedman and McKinnon. 
5. The retail financial markets provide services (such as transactional banking, savings and credit facilities) to individuals and small businesses, the wholesale financial markets support larger bodies - corporates, public sector organisations, governments, investors (e.g. pension funds) and financial institutions. Through these markets companies and governments can raise finance or acquire products that help them reduce the risk of doing business.
6. Having different national fiscal policies of the countries that form a monetary union can give rise to a problem free riding in the extent to which a country can issue a large amount of public debt at a rate of interest lower than that which would have to otherwise, causing his behavior with an increase interest rate for all other member countries.