C.1 The European Monetary Union is now 10 years old.

Discuss the economic criteria that determine whether it has been an optimum currency area. [Tripos 2009]
The economic criteria that determine the optimality of a currency area are: integration, symmetry of shocks, and flexibility. According to these criteria evidence suggests that the European Monetary Union (EMU) has not been an optimum currency area. In terms of economic integration we can look separately at intra-EU1 trade as a measure of product markets integration, financial integration, and political integration. There is some evidence in favour of more product market integration after the adoption of the Euro in 1999: for example in 1999 intra-EU trade was only 16% of GDP, whereas in 2008 this increased to 23%. In 2007 about half of the euro area trade was carried with other European countries; the latter accounted for 53% of its exports and 46% of its imports (the respective figures for Asia are 20% and 30%). On the other hand, intra-EU trade remains much lower than US interregional trade. R. Baldwin (2006) shows that the euro has increased intra-euro zone trade by 9%. However at the same time trade between the euro zone and such countries as Britain, the Denmark or Sweden that did not adopt the euro, has also grown by 7%, therefore the extra potential gain for these countries from joining the euro area might be very small. In terms of price convergence, a study Ch. Engel and J. Rogers shows that intra-EU price differentials decreased over the 1990s, but the introduction of the euro has added little to this trend. Financial integration contributes to the optimality of a currency area by making regulatory standards of less developed markets converge to the highest ones, therefore providing them with access to cheaper sources of external finance, encouraging financial development and economic growth. According to Guiso et al. (2004) the growth dividend on EU manufacturing if all EU countries raise d their regulatory standards to the highest current EU one, is an extra 0.2 percent of GDP growth p.a. This full financial integration scenario assumes that a firm would be able to issue debt or take out loans in any other EMU country, which seems quite unrealistic given the present high degree of heterogeneity in financial development levels. Besides, the current crisis has shown that there is a great dispersion of interbank deposit and repo rates across the euro area. A two-tier system exists (ECB report, 2009) in the interbank money market with cross-border transactions being dominated by a few highly rated banks charging low rates among themselves. The large decline in the volume of cross-border money market activity since 2007, and the emergence of large and persistent interest rates differentials (Portuguese 10 year bond yield: 14%, German: 1.769%, Italian: 5% (07/03/2012)) clearly indicates that EMU financial integration is very incomplete. Political integration has a twofold impact on the optimality of a currency area (P. De Grauwe):

EU countries are included in the analysis as they are the potential joiners of the EMU, and most of them are already pegging the euro.

_ the implementation of a centralised budget decreases the cost of joining a currency union as it enables to create a redistributive system of transfers to countries in difficulties. Such a fiscal federalism does not actually exist in the EMU; the implementations of the EFSF and the ESM are insufficient. The EU budget represents only 1% of EU GNP (about 130 billion). _ by increasing coordination between members, more political integration leads to less asymmetry and increases the areas long term stability. However evidence suggests that as more countries join the EMU, coordination becomes more difficult. One important condition for an optimum currency area is enough symmetry in macroeconomic shocks affecting its members so that uniform policies can be implemented. This is certainly not the case for the EMU as the following large discrepancies in current account figures for 2008 illustrate: -14.6% of GDP for Greece, -3.4% for Italy and +6.7% for Germany. Such contrasting economic performances under a uniform monetary policy suggest that EMU members are subject to asymmetric shocks. Indeed a divergence in real exchange rates happened since 1999 because of differences in inflation rates. For e.g. in 2006 the real effective exchange rate was 90 in Germany compared to 110 for Italy and Greece (1999=100 for all countries). Different inflation rates occurred because poorer EMU countries experienced higher productivity growth rates while catching-up (Balassa - Samuelson effect), rising living standards, higher demand levels (e.g. housing booms). Wages were also growing by about 3% p.a., while Germany was implementing wage moderation policies. Finally flexibility in factor markets is essential in the process of adjustment to macroeconomic shocks. However, evidence suggests that labour mobility is limited not only at the European level, but also within countries. For instance the percentage of total population changing residence in a given year is 3.1% in the US, but only 1.1% in Germany and 0.5% in Italy. (P. Huber, 2003). Capital flexibility has been enhanced by the introduction of the euro, but it is questionable whether or not this has enhanced economic integration. Capital can now flee abroad more easily in case of an adverse shock which will further depress the country in difficulty. Moreover, since the income share of labour is two thirds, labour mobility is a far more important factor in adjustments to shocks.