Abstract
We take stock of the history of the European Monetary Union and pegged exchange-rate regimes in recent decades. The post-Bretton Woods greater financial integration and under-regulated financial intermediation have increased the cost of sustaining a currency area and other forms of fixed exchange-rate regimes. Financial crises illustrated that fast-moving asymmetric financial shocks interacting with real distortions pose a grave threat to the stability of currency areas and fixed exchange-rate regimes. Members of a currency union with closer financial links may accumulate asymmetric balance-sheet exposure over time, becoming more susceptible to sudden-stop crises. In a phase of deepening financial ties, countries may end up with more correlated business cycles. Down the road, debtor countries that rely on financial inflows to fund structural imbalances may be exposed to devastating sudden-stop crises, subsequently reducing the correlation of business cycles between currency area’s members, possibly ceasing the gains from membership in a currency union. A currency union of developing countries anchored to a leading global currency stabilizes inflation at a cost of inhibiting the use of monetary policy to deal with real and financial shocks. Currency unions with low financial depth and low financial integration of its members may be more stable at a cost of inhibiting the growth of sectors depending on bank funding.
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Notes
Glick and Rose (2002) also supported this argument, finding a large impact on the growth of trade of a currency union among its members. Revisiting this issue, Glick and Rose (2015) found a more modest impact of the EMU on trade among its members and noted that switches and reversals across methodologies do not make allowances for any bold statements. Rose (2017) provides an update of the empirical evidence.
Aizenmanet al. (2010) quantified the three-trilemma indexes for more than 170 countries during recent decades. The monetary independence index depends negatively on the correlation of a country’s interest rates with the base country’s interest rate, the exchange rate stability index depends negatively on exchange rate volatility, and the degree of financial integration is the Chinn-Ito capital controls index. For further details, see http://web.pdx.edu/~ito/trilemma_indexes.htm.
Note that this argument holds only if the central bank of the country in question is credible and the sovereign issues debt that is denominated in the local currency. Clearly, these conditions would not hold for many countries, including those that experienced crises in the Eurozone.
Among the fundamental factors of each of the individual crisis countries in the Eurozone was the build-up of external and internal debts -- whether public debt, or private debt. In these circumstances, the straight-jacket imposed by the Eurozone membership precludes country specific depreciations, magnifying recessionary forces during the adjustment.
The GDP/capital growth rate decline during the GFC [2006 to 2008] was about 4% in Poland, which was half of the decline experienced by Germany and Spain. Remarkably, the public debt/GDP of Poland increased mildly from 45% in 2007 to 57% in 2013, while that of Spain almost tripled during that period, rising from 37% to 94%. The Zloty/Euro rate depreciated by 44% during the GFC [rising from 3.21 zloty/euro in 6/30/2008 to 4.64 zloty/euro in 2/1/2009], thus mitigating the recessionary impact of the crisis. These considerations are reflected in the attitude of Beata Szydlo, the new Polish Premier elected in 2015, who described the euro as a bad idea that would make Poland a “second Greece.” [Financial Times, “ECB alarmed at UK push to rebrand Union” 12/5/2015].
The U.K.’s expansionary monetary policy induced the depreciation of the British pound by a third of its value (from 2.1 dollar/lb in Nov. 7, 2007, to 1.38 dollar/lb in January 22, 2009), thus facilitating a faster recovery. In contrast, Spain stagnated. The sharp increase in the sovereign spread of Spain in 2010 and 2011 and its stagnating growth implied that, despite entering the crisis with lower public debt/GDP than the U.K., Spain resumed anemic growth in 2014 with a sizably larger public debt/GDP than the U.K.
Kazakhstan’s fixed exchange rate regime was one of the latest victims of the declining commodity prices, moving to a floating exchange rate in August 2015. Plummeting oil prices and devaluations by Russia and China increased exponentially the cost of defending the currency against the dollar. Azerbaijan followed Kazakhstan in moving to a floating currency in December 2015, after a devaluation of about 25% in February 2015. In both cases, growing exchange market pressure and declining international reserves induced exchange rate regime changes.
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Acknowledgements
I gratefully acknowledge the discussion and comments at the March 8-9 2016 ATI-IMF seminar on “The Future of Monetary Integration,” Mauritius, and the insightful comments of George Tavlas.
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Aizenman, J. Optimal Currency Area: A twentieth Century Idea for the twenty-first Century?. Open Econ Rev 29, 373–382 (2018). https://doi.org/10.1007/s11079-017-9455-y
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DOI: https://doi.org/10.1007/s11079-017-9455-y