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Euro Problems

Greece’s recent debt problem has many commentators wondering about the viability of the euro zone. It has also sent the euro reeling. Whether a country is better or worse off in a monetary union like the euro zone depends on whether the gains from giving up monetary-policy sovereignty exceed the costs of losing an important parameter for economic adjustment. Monetary unions are not one-size-fits-all arrangements.

Map of Countries Using the Euro

In January 1999, eleven of the 27 European Union countries adopted the euro as their currency. In doing so, they agreed to accept a common monetary policy, which the European Central Bank (ECB) would determine. A highlight of the ECB is its commitment to an inflation target of “below, but close to, 2 percent over the medium term.” Greece joined the euro zone in January 2001; Slovenia followed in January 2007; Cyprus and Malta climbed on board in January 2008, and Slovakia enlisted in January 2009. All European Union members are obligated to eventually adopt the euro except the United Kingdom, Denmark, and Sweden.

Foreign Exchange Rate of the Euro Over the Past Year

Having a common currency confers two key benefits on the euro-zone countries: First, those members that previously had less-than-stellar reputations for low inflation obtain an instant boost in their credibility. Such countries then face lower borrowing costs than otherwise would be the case, and their citizens can devote more resources to building wealth than to protecting the purchasing power of their existing wealth. Second, a common currency lowers the expense of cross-border euro-zone commerce by eliminating exchange-rate risk. The savings can be substantial for small economies that are heavily dependent on inter-Europe trade and investment.

Having a common currency, however, can also impose a serious cost: Member states have less latitude to adjust to specific types of economic shocks. When domestic wages and prices are inflexible or when international arbitrage is slow, flexible exchange rates can hasten a country’s adjustment to idiosyncratic economic disturbances by facilitating rapid changes in the price of a country’s exports relative to its imports. In the absence of exchange-rate movements, the necessary price adjustment must await changes in profit margins, or in wages and other input prices. Losing this flexibility is not a big deal if all of the countries in a monetary union experience similar and coincidental economic shocks. In that case, bilateral exchange-rate changes would not aid adjustment, and fixed exchange rates would seem ideal.

When economic shocks are dissimilar, however, fixed exchange rates are feasible only if other economic variables facilitate the adjustment process. If, for example, the individual countries within the monetary union have sufficiently well-diversified economies so that shocks are negatively correlated across the producing sectors of any single country, changes in exchange rates may not be necessary, since unemployed resources in one sector could be absorbed in other sectors. Likewise, exchange-rate changes may be unnecessary if factors of production are highly mobile across international borders within the monetary union. Absent factor mobility, fiscal transfers across countries could also ease the adjustment to temporary shocks without recourse to exchange-rate changes. Of course, when prices and wages are highly flexible, export prices can adjust quickly without a change in the nominal exchange rate.

Each country that joins a monetary union must consider the benefits and costs. That the cost has often dominated this calculation explains why monetary unions are rare and often fragile arrangements among sovereign nations. That said, the United States did it! (See herehere, and here.)

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