Monday, June 30, 2008

The euro@10: One currency, fifteen soccer teams

I found myself at a beach in Portugal over the weekend, eating sardines and watching the Eurocup final. For those who don’t know what I’m talking about, that’s the European soccer championship—a tournament that, every four years, ignites passions the world over, with the exception of America and, possibly, Tuvalu.

“Underdog” Spain staged an impressive victory over three-times-champion Germany though, for me, far more interesting was the set up: A sandy beach, beer and sangrias, and a bunch of Europeans—Germans, Spaniards, Portuguese, Austrians—cheering passionately for their chosen favorite.

As I was watching, a thought sprang to mind: Is it remotely conceivable that anyone in the group would ever give up their national soccer team for a pan-European one? I mean, think of the efficiencies: Portugal’s Ronaldo for forward, Germany’s Ballack for midfield, Spain’s Ramos for defense, Italy’s Buffon as goalkeeper… A dream team with far better chances of beating the likes of Brazil at the World Cup.

Unthinkable? Perhaps. But if that’s so, why, when it came to their national currencies, European countries did precisely that?

Coincidentally, year 2008 also marks the 10th anniversary since the inception of the euro—Europe’s single currency. And with 10 being a nice round number, it was inevitable that some stock-taking was conducted to assess whether the euro was a good idea after all. So what’s the verdict?

The wedlock: Think of a currency union (CU) like a marriage—both with their costs and benefits. In the case of marriage, the cost boils down to the loss of one’s independence. When it comes to the benefits, well… you tell me! But at (the very) least, you get economic synergies from paying a single rent and buying napkins in bulk.

Thankfully in the case of a CU the benefits are easier to pinpoint, at least in theory. The CU means the elimination of exchange rate risk among its members, which, in turn, reduces the costs of cross-border trade and investment, fosters price and output stability and encourages a more productive allocation of resources within the CU area. By implication, the more countries trade with, and invest in, each other (i.e. the more “integrated” they are) the higher the benefits they will likely draw from sharing a common currency.

Sharing the same roof: What about the costs? Similarly to a marriage, they have to do with the loss of a country’s “independence”, only the monetary policy kind: As a result of a CU, countries give up their ability to set interest rates as they see fit for their own economic circumstances, for a reason dubbed as “the impossible trinity” (nothing to do with “triangles” here). The one difference with marriage is that not all economists agree that this is a bad thing.

Those who say it’s bad argue that different economies often face shocks at different times and, therefore, must maintain the ability to adjust rates independently in order to facilitate their transition back towards potential output growth and “full” employment. But some disagree, arguing that monetary policy should not (and cannot) target “real” stuff, like how many goods we produce or how many people are employed—instead, a Central Bank should contain its mandate to “nominal” stuff like price stability.

Debate aside, let’s assume here for the sake of argument that there is a role of monetary policy beyond the realm of the “nominal” and that, hence, giving up monetary policy independence is costly. By implication, the costs of entering into a CU are higher the more asynchronous the economies are—i.e. the more their business cycles move out of sync.

Passion or reason? So when is a single currency a good idea? Think marriage again. However strong the initial passion, success is more likely when the parties involved are sufficiently compatible. I mean, what if she can’t live without a pet while you shudder with horror each time the poochy poo rushes to lick your feet? Or (worse?!) what if you, an ardent fan of Germany, are asked to tolerate her (sooo inconsiderate) loud cheering of Spain’s victory? Put it plainly, success requires that the benefits exceed the costs; and compatibility is, if not a sufficient condition, at least a good start.

Same in currencies—however solid the political will, economic compatibility is pretty important. To throw a bit of jargon, the countries contemplating a CU should ideally meet the criteria for an “optimal currency area” (or OCA). For example, are they sufficiently integrated? Are their economies synchronized? Are they flexible enough to be able to adjust to idiosyncratic shocks without the “luxury” of their own interest rates? And, going back to our original question, how does the eurozone fare against these measures?

Let's look at a couple of basic metrics: When it comes to the synchronicity of business cycles, it varies—for example, countries such as Austria, France or the Netherlands tend to have a higher correlation with Germany (the eurozone’s largest economy) than their Mediterranean peers /1. When it comes to trade integration, about half of the eurozone’s total trade is conducted within its membership. Is that “sufficient”? Well, it depends on whether you want to see the glass as half full or half empty. But… does it matter that much?

Love is endogenous: Some argue it might not. Their premise is that, once stuck into the wedlock, “things just happen”… You begin to like the poochy poo, you miss it when you’re gone, and you might even wake up one day to find you support Spain!

Similarly, in a CU things are supposed to happen, "endogenously"—meaning on their own, without the interference of external factors: Trade between the countries increases, financial markets become more integrated, interest rates converge, business cycles begin to move more in sync. As a result, the costs of a CU fall and the benefits rise, bringing the CU members closer and closer to the OCA benchmark.

Indeed, in the case of the eurozone, such a convergence and integration did occur—only that the euro on its own was not exactly the reason. According to a recent report by the European Commission /2, the rise in synchronicity was likely the result of the removal of barriers to trade and capital in the context of the establishment of the European Single Market in 1992 and the subsequent reforms in the run-up of to the euro’s adoption.

Fans of the “endogeneity” theory for OCAs may still read the eurozone’s business cycle convergence as a validation of their premise that “things just happen.” Yet, some other “things” have yet to happen: For example CUs are envisaged to provide incentives for structural reforms to improve their members’ competitiveness. These include, among others, reforms to make wages and prices more responsive to output or productivity shocks, make employment more flexible and more mobile across borders, or encourage research and development to better compete in global markets.

Progress in this area has clearly fallen short. The result being that countries like Italy are seeing their competitiveness on a steady downward spiral, or others such as Greece or Spain building external imbalances of a scale that, one day, might raise questions of sustainability.

Honeymoon is over: With the honeymoon passion over, could eurozone members be entering a phase of wedlock fatigue? And, if the first 10 years were hard enough, how about the next 10, which promise high commodity prices, the eventual unwinding of global imbalances and the admission to the euroclub of numerous more countries that are arguably less “compatible” than the club’s original members? Will countries strive to work things out or could they (as the pessimists like to entertain)… file for a divorce?!

Whatever answer I try to give, at this stage it remains a highly subjective one. All I'll say is that I’d like to believe the divorce option is at least as unthinkable as a pan-European soccer team!

Glossary: optimal currency area, currency union, single market, impossible trinity, real vs. nominal, endogenous vs. exogenous, soccer vs. football

Interesting Reads:
Not so unthinkable? See here: "Betting on the possibility of breaking up the eurozone", in the Financial Times

1 See "Optimal Currency Areas And The European Experience", by the Chair of International Finance

2 See


Frances said...

This game would definitely be more enjoyable if those with you in the audience knows some soccer glossary so that they could follow its technicalities.

Serge said...

Once you get to learn a lot more about various jargon in soccer, you could appreciate the game even more.