The eurozone crisis:the theory of optimum currency areas bites back Barry Eichengreen
Review Essay Task
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Notenstein Academy White Paper Series
The eurozone crisis:
the theory of optimum
currency areas bites back
Barry Eichengreen
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Notenstein Academy White Paper Series
Contents
Lesson 1: Asymmetric shocks are intrinsic to monetary union
Lesson 2: Monetary union without banking union will not work
Lesson 3: A normal monetary union needs a normal central bank
Lesson 4: Labour mobility in monetary union is a mixed blessing
Lesson 5: Fiscal union has distributional consequences, making it untenable
Lesson 6: Fiscal stabilisation can be provided nationally only if debt overhangs are removed
Lesson 7: The eurozone needs a mechanism for restructuring unsustainable debts
Lesson 8: Monetary union is forever, more or less
Conclusion
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The eurozone crisis:
the theory of optimum
currency areas bites back
2011 was Europe’s annus horribilis, arguably the nadir of the
eurozone crisis. It was the year after the crisis surfaced in
what were initially dismissed as a handful of small countries
with special problems, starting with Greece, Ireland and
Portugal, before infecting the monetary union as a whole. It
was the year preceding Mario Draghi’s “whatever it takes”
speech which laid to rest fears of eurozone break-up and
ended the acute stage of the crisis.
Ironically, 2011 was also the 50th anniversary of Robert Mundell’s classic article “The Theory of Optimum Currency
Areas,” which provided the analytical framework through
which academics and policy makers think about preconditions for a smoothly functioning monetary union.1 Few other
articles published fully 50 years ago in the American Economic Review – much less articles running to just eight short
pages – have had such a powerful and enduring influence.
In fact, the coincidence of timing was just that, a coincidence.
That said, the two events were not entirely unrelated. The
theory of optimum currency areas, as developed by Mundell
and his followers, led by Ronald McKinnon and Peter Kenen,
contained important insights, which is of course why it remained so influential for 50 years.2 But the theory was also
incomplete and misleading in important respects, at least as
applied to the circumstances of Europe at the turn of the 21st
century.
As articulated by Mundell, McKinnon and Kenen, the theory
of optimum currency areas emphasised convergence, labour
mobility and fiscal integration as preconditions for a smoothly
functioning monetary union.3 Convergence means greater
similarity in the economic structures of participating member
states, minimising the kind of asymmetric shocks that might
require a different monetary-policy response in different parts
of the monetary union (something that would not be possible
following the adoption of a common currency, by definition).
Labour mobility refers to the importance of encouraging
worker flows from high- to low-unemployment states as a
mechanism for adjusting to shocks in the absence of a national
monetary policy. Fiscal integration refers to the need to create
a system of budgetary transfers between (or budgetary coinsurance among) the participating member states, so as to aid
temporarily depressed regions that no longer possessed a
national currency to depreciate and therefore had limited
scope for exporting their way out of difficulties.
These were important insights, which is why they remained as
influential as they did for 50 years. But the theory, having been
articulated at the middle of the 20th century, was ominously silent about important economic aspects of the 21st. And having
been developed to explain the smooth operation of monetary
union within existing federations like the USA and Canada
(both Mundell and McKinnon, recall, were Canadian), the
theory was also silent about the political prerequisites for a
smoothly functioning European monetary union.
Specifically, the theory of optimum currency areas and the literature that developed around it said nothing about banks as
propagators of asymmetric shocks or about the need for
banking union to accompany monetary union, since banking
systems at mid-20th century were still tightly regulated and
constrained in their operation. It said nothing about the selective emigration of the most skilled workers from the members of the monetary union experiencing adverse shocks,
since exceptionally deep and long-lived shocks of the sort suffered by the members of the eurozone periphery starting in
2010, which might lead to a serious brain drain, were not anticipated by the theory’s fathers. It said nothing about the
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need for the central bank in the monetary union to act as a
lender of last resort or about the need for it to backstop the
bond and financial markets of the individual member states,
since serious sovereign debt and banking crises like those of
the 1930s were only a distant memory. It said nothing about
the desirability of a mechanism for the orderly restructuring
of sovereign debts in an environment where participating
member states inherited a debt overhang and had no recourse to the inflation tax, since the debts of existing monetary union members (US states and Canadian provinces, of
course, being everyone’s favourite example) did not begin to
approach the levels reached in eurozone member states subsequently. It said nothing about the reversibility of monetary
union, since the idea that a member of the US or Canadian
monetary unions might exit was not part of 1960s discussion.
And it said nothing about how much further political integra-
tion might be required for fiscal integration, or alternatively
whether the limited fiscal integration that was compatible
with limited political integration would be enough to support
the smooth functioning of Europe’s monetary union.
The remainder of this paper enumerates eight lessons of the
eurozone crisis not anticipated by the fathers of the theory of
optimum currency areas for the smooth operation, or otherwise, of Europe’s monetary union. 4 The purpose is not simply
to show where the founders of optimum currency area theory
went wrong. Assembling those lessons also has a positive purpose, namely to derive implications for Europe’s success in
drawing a line under its crisis. Those implications, and whether
policy makers show resolve in addressing them, are directly
relevant to investors choosing to bet for or against the monetary union and for or against the successful revival of E
urope’s
economy.
Lesson 1.
Asymmetric shocks are intrinsic
to monetary union
The theory of optimum currency areas took the symmetry or
asymmetry of aggregate disturbances across the countries or
regions potentially participating in a monetary union as a
given. That is, it took the pattern of disturbances as an exogenous criterion to guide the decision of whether or not to form
a monetary union and, if that decision was positive, as a guide
to what the contours of the monetary union would be. Thus, in
his original article Mundell speculated that Canada’s western
provinces together with the western US states might constitute a natural monetary union, given similarities in their resource endowments and the sharp differences in industrial
structures between the eastern and western parts of North
America. My own work with Tamim Bayoumi (Bayoumi and
Eichengreen 1993) estimating the symmetry of aggregate
supply and demand disturbances across European countries
and US regions similarly took the pattern of disturbances as
given, although we also speculated about how such correlations might change in the future.
There were three notable exceptions to this exogeneity rule.
First, Frankel and Rose (1998), writing on the eve of
Europe’s monetary union, pointed out that European integration, extending to monetary integration, might lead to
changes in the industrial structures that Mundell emphasised as the source of asymmetric shocks. If integration resulted in more inter-industry trade, regions might become
even more specialised in different industries, leading to even
more asymmetric shocks (insofar as shocks are industry-
specific). If it led mainly to more intra-industry trade,
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regional industrial structures might overlap more than
before, leading to less asymmetric shocks. Analysing the
connections between the growth of trade and the inter-
regional correlation of business cycles led them to conclude
that intra-industry trade and more symmetric shocks would
dominate. Not to worry, in other words.
A second exception was the literature that attributed asymmetric shocks not to different industrial structures per se but
to the different levels of economic development associated
with those shocks and with other tensions in the monetary
union. The problem was the large gap in development between Europe’s core and periphery; the corresponding solution was policies of cohesion (structural fund transfers to
finance infrastructure spending) and policy discipline (like
that conferred by monetary union membership), which would
permit the economies starting out behind to catch up. Here
the evidence from the 1990s suggested that cohesion was
working and that the convergence process was in fact underway (see inter alia Crespo-Cuaresma and Ritzberger-
Grunwald 2005, Jelnikar and Murmayer 2006). Again, the
reassuring conclusion was not to worry.
The third, unsettling exception was Walters (1990), who
warned that inflation rates were unlikely to converge quickly
across the members of the monetary union. In particular, inflation would continue to be higher at Europe’s periphery.
This might be a fundamentally healthy phenomenon insofar
as the prices of nontraded goods rise faster in fast-growing
peripheral economies (a tendency known as the Balassa-
Samuelson effect). Or it might be unhealthy insofar as the
poor economies of the eurozone periphery continued to
pursue lax fiscal (and other) policies with inflationary consequences. Either way, if a single level of nominal interest
rates prevailed throughout the monetary union, as it should,
the result would be lower real interest rates at the periphery,
leading to an unsustainable consumption and investment
boom, ultimately with destabilising consequences.
This was a prescient warning. Much as Walters had forecast,
the countries at the periphery of the eurozone saw booms in
construction spending (Ireland, Spain), consumption spending (Portugal) and government spending (Greece), as the
cost of borrowing for households, firms and governments
came down. Their spending booms were financed by large
capital flows from the monetary union’s core to its periphery, and they were reflected in equally large current account
deficits for the eurozone periphery and surpluses for the
core. When doubts arose in 2009-10 about the sustainability
of the process, those capital flows came to a sudden stop, imparting a destabilising asymmetric shock.
The clear implication, emphasised by Walters, was that this
asymmetric shock was intrinsic to the operation of the monetary union. It was not simply bad luck, an asymmetric draw
from the macroeconomic urn. Rather, it was fundamentally
connected to the real-interest-rate effects of monetary unification. Why Walters’ warning was not heeded is unclear even
now. It could be that a warning coming from a strident
Euro-sceptical critic was easier to dismiss than warnings from
more sympathetic Continental quarters.5 With hindsight it is
clear that this source of intrinsic asymmetric shocks to the
stability of the eurozone was not paid adequate attention.
The policy implication is that cross-border capital flows and
current account imbalances within the eurozone cannot be
treated with benign neglect. Those capital flows enable public and private sector excesses in the countries on the receiving end. They expose the economies of the recipients and
the banking and financial systems of the suppliers to disruptions when doubts arise about the sustainability of the process. These problems will be especially acute within a monetary union where there are no impediments to capital flows
and no exchange risk to deter cross-border borrowing and
lending. They will therefore require a policy response.
The EU, having learned this lesson the hard way, is now moving in the requisite direction. In December 2011 it introduced
a Macroeconomic Imbalance Procedure as part of the socalled “Six Pack” of reforms, portions of which are now embedded in the Fiscal Compact. That procedure consists of a
scoreboard of early warning indicators, of which the threeyear backward moving average of the current account balance is one, then an in-depth analysis of countries with unfavourable indicators, and finally an Excessive Imbalance
Procedure for countries with imbalances that jeopardise the
functioning of the eurozone.
As always, the proof of the pudding is in the eating. In this
case the eating depends on what steps will be taken to forcefeed distasteful portions to countries reluctant to ingest them.
Regulation No. 1174/2011 on “enforcement measures to correct excessive macroeconomic imbalances in the euro area”
relies, unfortunately, on the same weak sanctions that have
not worked in the case of the Stability and Growth Pact.
Violators are required to make deposits of 0.1 percent of
GDP that convert into annual fines in the case of continued
noncompliance. The decision to apply sanctions is made by
the Council on a recommendation from the Commission.
Logic suggests that member states will be reluctant to fine
themselves. There is now more than a decade of historical experience with the Stability and Growth Pact that points in the
same direction.
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More comprehensive macroeconomic surveillance is all to
the good. But recent institutional innovations bearing on
enforcement are not reassuring. Europe would have a
brighter future if these weaknesses were addressed.
The other way of attempting to limit the booms and busts
caused by destabilising cross-border capital flows and current account imbalances within the eurozone is by regulating the banking systems that are the conduit for these flows.
This in turn brings us to a second important lesson of the
eurozone crisis.
Lesson 2.
Monetary union without banking
union will not work
That monetary union requires banking union – a single financial rulebook, a single bank supervisor, an adequately funded
single resolution mechanism for bad banks, and harmonised
deposit insurance – seems obvious in light of recent events.
Europe’s financial system is heavily bank based. Banks play
an important role in cross-border capital flows in the eurozone.6 Supervision and regulation in one country that does
not adequately take into account the cross-border implications of the home banks’ lending policies can have destabilising implications for its neighbours.
Similarly, the absence of a mechanism for the orderly resolution of insolvent banks leaves only bailouts as an alternative.
This fosters moral hazard, leaves problem banks undercapitalised, threatens the solvency of the sovereigns responsible
for recapitalisation, and gives rise to the spectre of zombie
banks and firms. Insofar as the problem of inadequate capitalisation and resolution are neglected, confidence in the
banking system as a whole can be damaged, and that damage
may
not be limited to the initiating country.
These problems are common to a financially globalised
world, but they are especially pervasive in a monetary union
with a single financial market, where there is neither exchange risk nor significant statutory impediments to bank-
intermediated cross-border capital flows. Early work on the
theory of optimum currency areas neglected these dangers
for the simple reason that banks were tightly regulated and
cross-border lending and borrowing was strictly limited in
the 1950s and 1960s.
Like it or not (and not all politicians and publics like it), the
eurozone’s progress on completing its banking union is a key
litmus test for whether Europe will face brighter growth
prospects and a superior combination of growth and stability
going forward.7 Here again, Europe talks the talk but doesn’t
walk the walk. There is a shared commitment to create a fullfledged banking union, but there is less than full agreement
on the details.
Fully analysing the challenges of creating an effective banking union would require a paper (or papers) of its own. But
the key points run as follows. First, the emphasis of policy
makers on, inter alia, banning proprietary trading by the
largest banks risks neglecting more important issues. More
important would be regulations addressing the risks posed
by the excessive concentration of sovereign debts in the
portfolios of domestic financial institutions. Ceilings could
be placed on domestic sovereign debt held by banks. More
flexibly, the risk weights attached to domestic sovereign debt
could be conditioned on the extent of the banks’ exposure.
Second, the workability of a system in which the ECB supervises “significant” credit institutions while national authorities remain responsible for supervising the rest remains to be
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established. National supervisors and the ECB are supposed
to coordinate seamlessly and share information, hand in
glove. Time will tell.
Third, the decision making process envisaged in the proposed
Single Resolution Mechanism is overly complex, and an adequate financial backstop will not exist for years. A decision to
place a bank in resolution would involve the board of the Single Supervisory Mechanism (24 members), the ECB Governing Council (24 members), and possibly the boards of the Single Supervisory Mechanism Mediation Panel (3 members),
SSM Executive Board (10 members) and Single Resolution
Mechanism Board (23 members) – after which the Council
(28 members) would have to give its assent, based on a proposal by the European Commission (28 members). A commitment to establish a common backstop of EUR 55 billion
by 2025, or even 2019, is too little, too late.8 In the meanwhile,
the resolution fund will be split into national compartments;
the effective resolution regime as a result will not differ significantly from the status quo. In particular, it will do nothing
to break the “diabolic loop” connecting banking and sovereign debt problems. This is not a single resolution regime in
any meaningful sense of the term.9
Coming finally to a harmonised or single deposit insurance
scheme, it is important to recognise that the rationales for
harmonised and single insurance are different. Harmonising
national deposit insurance schemes is designed to prevent
eurozone members from adopting beggar-thy-neighbour in-
surance policies (as when Ireland raised its deposit insurance
ceiling in 2008 and drained deposits from other eurozone
banks). Some steps have now been taken in the direction of
further harmonisation (the EU has harmonised minimum
levels of deposit insurance coverage and maximum payout
periods), but the basic problem of beggar-thy-neighbour policies remains unaddressed.10
In contrast, the argument for a single deposit insurance
scheme backed by a common fund is that the funding available at the national level may not be adequate. Efforts to
move to a single scheme have foundered on German opposition, however, the fear there being that fees paid by German
banks (and passed on to their customers) will be used to bail
out reckless banks in other countries. But it should be incumbent on those opposing a single insurance scheme to offer an
alternative. The alternative is to prevent bank liabilities from
growing so large that they exceed the resources of the national insurance fund and the capacity of the sovereign to
top it up. But German opposition to a single scheme has not
resulted in pursuit of this alternative. Until one or the other
option is pursued, Europe’s banking union will remain incomplete.
The best that can be said is that Europe’s banking union remains a work in progress, the implication being that faster
progress is now needed. The worst that can be said is that this
is a pale imitation of a true banking union, which does not
bode well for the euro’s future.
Lesson 3.
A normal monetary union needs
a normal central bank
The fathers of the theory of optimum currency areas did not
address the question of what exactly the common central
bank should do. In this case, at least, the sins of the fathers did
not automatically translate into the sins of the children. Already in 1992, Folkerts-Landau and Garber argued that a
European Central Bank would have to do more than follow a
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monetary policy rule (whether a money supply growth rule, a
Taylor rule, or an inflation target rule). In addition it would
have to be cognisant of its role as lender and liquidity provider of last resort, of its responsibility for the stability of
Europe’s payments system, and of its contribution toward supervising the banking system.11
With hindsight, this was another prescient diagnosis and
warning, right up there with that of Alan Walters, not that it
was taken to heart. In its first decade, the ECB focused narrowly on its inflation target (along with, initially, the money
supply target that constituted the second pillar of its monetary policy strategy) to the all but total exclusion of other considerations. Under the leadership of Jean-Claude Trichet, the
central bank famously raised its policy rate twice in the spring
and summer of 2011 in response to a temporary deviation of
headline inflation above its 2 percent target, despite the fact
that European banks, sovereigns and economies were already
reeling from the crisis.
The central bank’s stance then changed with the transition
from Trichet to Draghi, with the new central bank president’s “whatever it takes” remarks in the summer of 2012,
and the ECB’s programme of Outright Monetary Transactions, in which it promised to purchase the bonds of eurozone sovereigns on the secondary market if disorderly conditions threatened the operation of the payments system,
interfered with the transmission of monetary policy, and
raised doubts about the cohesion of the eurozone.12 The
preceding period had seen what looked like a self-fulfilling
panic, where collapsing bond prices led to doubts about sovereign finances and bank solvency, which then fed on themselves. OMT was enough to put this panic to rest. That its
mere announcement was sufficient to calm the markets is
impressive evidence of the stabilising influence of a central
bank prepared to act as a lender of last resort.
Press reports had Bundesbank President Jens Weidmann and
other members of the ECB Governing Council opposing
OMT on the grounds that it would weaken the commitment
of member states to reform. This past February the German
Constitutional Court then opined that the ECB had massively exceeded its competences and mandate with OMT.13
This raises questions about whether the ECB will engage in
lender-of-last-resort type operations in the future. More fundamentally, it points to the question of whether it is properly
the function of a central bank to apply pressure on governments to pursue structural reforms. That the ECB participates in the Troika, applying pressure for reform in return for
financial assistance to troubled sovereigns, creates a conflict
with its other objectives. This has led some to suggest, not
without reason, that the ECB, as a normal central bank,
should not participate in future Troika-like arrangements in
order to focus on its core mandate.14
The ECB also remains slow to react to the risk of deflation.
Since those mid-2011 interest-rate hikes, policy remains
tighter than counselled by a textbook Taylor rule. Now that
the zero lower bound is binding, the ECB is reluctant to turn
to unconventional monetary policies. It remains disinclined
to embrace the Bernanke doctrine, which counsels acting
preemptively to prevent deflation from developing in the
first place, since once it develops it may be extremely difficult to dispatch.15 This is another notable departure from
what is now regarded in most circles as normal central banking practice.
It may be that the ECB’s focus on headline rather than core
inflation allows it to be distracted by volatile food and fuel
prices. It may be reluctant to antagonise important shareholders like Germany, where inflation is running above the
eurozone average and scepticism abounds about unconventional monetary policy. A Governing Council of 24 members
may be too large and unwieldy to act swiftly and preemptively. Ten years ago the ECB put forward a proposal for restructuring country representation on the Council into constituencies, but no progress has been made on that front.16
Until these issues are addressed, the ECB will remain less
than a normal central bank. And continuing unwillingness
to address them does not bode well for the future of the
euro and the European economy.
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Lesson 4.
Labour mobility in monetary union
is a mixed blessing
Mundell emphasised labour mobility as an alternative to
changes in monetary policy and exchange rates in adjusting
to region-specific shocks. In 1992 Blanchard and Katz then
documented the importance of labour flows between the 50
US states as a mechanism for adjusting to state-specific disturbances.17 The fact that migration within the eurozone is
oungani (2014) show that even the relatively strong migraL
tory response in the USA has been insufficient to prevent
sharp increases in unemployment and reductions in the
labour force participation rate in particular regions.
Migration as a mechanism of adjustment has been especially
problematic in the context of the Great Recession. Insofar as
lower than in the USA is a commonplace. Only 0.3 percent
the recent shock was global rather than local, there were few
of the population of the EU-27 states moved across national
booming regions for the residents of depressed regions to
borders in 2010. This compares with the 2.4 percent of the
migrate to. This may be part of the explanation for why the
total population of the USA that relocated across state lines,
migratory response to the crisis and subsequent recession was
and 1.5 percent cross-territory movement in Australia.
not greater.18 The same point can be made specifically about
Meanwhile, less than 1 percent of the total population
Europe, where a significant share of emigration by the resimoved across the NUTS-1 regions of Europe (the largest
dents of, inter alia, Spain, Portugal, Italy and Ireland has been
national subregions distinguished in EU statistics) accordto extra-European destinations – Latin America in the first
ing to the OECD.
three cases, English-speaking economies in the fourth. Other
Explanations for the contrast with the USA point to differauthors have pointed to the weak housing market as another
ences in language, limited access to local healthcare and benpossible culprit, since homeowners may be unable to sell their
efits, and uncertainties regarding the transfer of pension
houses in depressed markets and be reluctant (or in the
rights. These observations lead in turn to recommendations
European case, unable) to sell a home whose value is less than
for streamlining regulatory requirements for vesting periods
its mortgage, although this conclusion has also been disputed.
in pension plans and eliminating barriers to access to healthBe this as it may, the kind of severe global shock experienced
care and benefits for foreign workers. But the fact that migrain Europe after 2008 was not what the fathers of the theory of
tion is low even within EU countries, where linguistic differoptimum currency areas had in mind when they trumpeted
ences and vesting and access problems are not obstacles,
the advantages of labour mobility. Nor did they anticipate the
suggests that something more is at work. Still, the implication
collapse of housing prices in the crisis economies.
follows that the eurozone either needs to do more to encourIn addition, structural changes, such as the role of informaage labour mobility, or else it must develop other mechanisms
tion technology in creating job opportunities in a variety of
– greater wage flexibility or compensatory fiscal transfers, for
locations, dual career families, and polarisation of the labour
example – to deal with concentrations of unemployment.
market may also be making for a long-run secular decline in
Recent experience has cast the role of labour mobility within
labour mobility. Dao, Furceri and Loungani (2014) document
monetary union in a less favourable light. First, it has shown
a decline over time in both the unconditional gross migration
labour mobility to be a less powerful mechanism of adjustrate and the net inter-state migration rate conditional on
ment in the context of major shocks. Dao, Furceri and shocks in the United States.19 They speculate that financial
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integration (the relaxation of restrictions on interstate banking, for example) may have increased the correlation of regional business cycles, reducing the incentive for, and efficacy
of, migration (something that has obvious implications for
Europe, given the financial integration attendant on the euro).
Just as labour mobility may be a less effective mechanism of
adjustment in the case of major shocks, these other changes
may make it less effective in the future than in the past.
The selective nature of migration raises troubling issues. Outmigration from Spain, Italy and Greece is dominated by the
emigration of relatively high-skilled individuals, who have
relatively portable credentials and more knowledge of foreign job opportunities.20 Ciccarone (2013) similarly points to
evidence of a rise in the share of higher-skilled emigrants
from Italy. As a result of the crisis, the higher-skilled mobile
population within the EU has become increasingly concentrated within the so-called core countries at the expense of
the periphery (Holland and Paluchowski 2013).
This brain drain can have a permanent negative effect on the
productive potential of the sending economies. In turn, that
negative productivity effect can have a reinforcing impact on
competitiveness and unemployment in the adversely affected
regions (Brezzi and Piancentini 2010). In addition, the outmigration of the most skilled can weaken the incentive for the
adversely affected regions to invest in skills and training, with
further negative implications for their competitiveness.
It is relevant in this context to recall that Blanchard and
Katz’s classic article on the role of labour mobility in the
United States was entitled “Regional Evolutions,” not
“Regional Cycles.” Already in 1992, in other words, they were
warning that temporary regional shocks could produce permanent regional decline through the operation of these
mechanisms. Permanent decline of the population and economy of a city (Detroit) or a state (Michigan) might be politically tolerable in the United States. But the hollowing out of
a national economy through outmigration with reinforcing
negative effects would not be acceptable in Europe. Measures to enhance labour mobility will not be enough to solve
the eurozone’s problems. On the contrary, they may only end
up aggravating them. Alternatives should be sought.
Lesson 5.
Fiscal union has distributional
consequences, making it untenable
Seminal contributions to the theory of optimum currency
areas pointed to transfers accomplished through a federal
system of taxes and budgetary transfers as the alternative to
labour mobility. A limitation of this early