The macroeconomic costs and benefits of the Economic and Monetary Union

Roel Beetsma, Massimo Giuliodori 27 November 2009



More than ten years since its start, the costs and benefits of the Economic and Monetary Union (EMU) in Europe continue to be debated. “Technically”, the EMU has been a success. There have been no disruptions in the financial markets as a result of the monetary unification, nor has there been economic chaos otherwise. The euro is accepted everywhere Overall, the ECB has fulfilled its obligations by keeping the area-wide inflation rate close to its target. However, the union has had to withstand substantial divergences in the business cycles of its member states. During most of the EMU’s existence, the economies of the largest members were lagging behind those of the smaller members, thereby creating a policy dilemma for the ECB. There have also been repeated public pressures on the ECB to relax its policy stance.

Friends in need are friends indeed

The recent financial and economic crisis has shown the value of being part of the EMU1 and has led to increased support for joining the EMU in those countries not (yet) part of it. In particular, currencies from countries outside the area have come under pressure. For example, Denmark tries to keep its krone stable against the euro, but it pays a premium on its interest rate. Motivated by low interest rates, the private sectors in some Eastern European countries, which borrowed heavily in euros before the crisis, are now facing the prospect of substantial increases in their real debt burdens due to pressure on their currencies. Iceland has begun a discussion about the desirability of EMU membership. EMU membership has likely protected countries from the detrimental effects of competitive devaluations that plagued Europe in the early 1990s when the European Monetary System collapsed. During the current crisis, international trade and domestic demand have taken abrupt and large hits that would have given countries an incentive to “steal” business from each other through currency devaluations had they still been able to follow their own monetary policy.2 Monetary unification avoids those mutually detrimental actions. This argument also shows the danger of having an internal market in which not all members share the same currency, a situation that may not be sustainable in the longer run.

Mundellian approach

The starting point of all analysis of monetary unification was the path-breaking and Nobel-prize winning article by Mundell (1961). He showed that countries form a so-called optimum currency area when the gains from reduced currency exchange costs under a monetary union outweigh the costs associated with imperfect macro-economic stabilisation because real wages are slow to adjust in response to changes in local labour market circumstances.

While Mundell’s contribution was followed by other seminal works in the 1960s, research on optimum currency areas went out of fashion until it was revived by the plans for an EMU in the beginning of the 1990s. This more recent work goes beyond the “traditional” literature in emphasising other aspects in the trade-off between unification and monetary autonomy.

In Beetsma and Giuliodori (2009), we review this recent literature. Starting from the observation that giving up monetary autonomy entails the loss of a policy instrument to stabilise national economic shocks, any net economic benefit must derive from institutional, political, and other considerations that limit the scope for attaining an optimal allocation under autonomy. One example concerns the incentive for competitive devaluations. A second example concerns the benefit of lower inflation for countries with weak institutions. In the debate about the design of the macroeconomic framework under EMU, substantial attention has been devoted to fiscal policy arrangements. The EMU has created several complications for fiscal policymaking. One is that governments generally pursue different macroeconomic objectives than the ECB. The latter is concerned with stabilising inflation at a low level, while the former aims at achieving a high and stable level of activity. Dixit and Lambertini (2001, 2003) show that the strategic interactions among the monetary and fiscal authorities may lead to extreme outcomes that make everyone worse off and provide a rationale for imposing fiscal restrictions.

Another complication is that monetary unification may exacerbate or create new negative cross-border spillovers of fiscal policy. For instance, a national fiscal expansion raises the demand for savings, ceteris paribus pushing up the long-run interest rate and discouraging investment. In an integrated capital market strengthened by monetary unification, this effect will spread to other countries, imposing a negative externality. A monetary union may also generate new negative spillovers. An increase in domestic government purchases, in affecting the demand for domestic products, raises local inflation, thereby pushing up average euro-area inflation and forcing the ECB to contract monetary policy for the entire area. Further, a national fiscal expansion may cause an appreciation of the euro, thereby undermining the external competitive position of all union members.

Negative spillovers of expansive fiscal policies create a rationale for constraining fiscal policy in a monetary union, in particular if financial markets are not able to prevent fiscal profligacy. However, even when financial markets work properly, monetary unification may provide a rationale for fiscal constraints. Chari and Kehoe (2007) show that a lack of commitment on the side of a union’s central bank leads countries to free-ride on each other in setting fiscal policy. Knowing that the consequences of a national fiscal expansion in terms of higher inflation and nominal interest rates in a union are diluted, each country has an incentive to issue too much debt, leading to an over-accumulation of debt at the union level. Fiscal coordination eliminates the free-riding problem, although in the absence of monetary commitment, outcomes will still be suboptimal. Fiscal coordination is not always desirable in a monetary union, though. It strengthens the strategic position of the fiscal authorities against the central bank, possibly forcing the latter into a more lax stance than would be optimal. Hence, fiscal coordination is not a substitute for fiscal constraints. In fact, the latter may even be more desirable under fiscal coordination.

While fiscal constraints may be beneficial in the context of theoretical models, their practical design and implementation in the euro-area has provoked substantial criticism. The EU Stability and Growth Pact (SGP) restricts deficits to 3% of GDP. The format of this restriction is alleged to undermine macro-economic stabilisation in the presence of country-specific shocks, although empirical evidence does not seem to support this view (Gali and Perotti, 2003, and Wyplosz, 2006). However, the Pact has functioned less than perfectly given the number of times it has been violated, even at times when economic circumstances were not as harsh as they are now (see Table 1). The SGP’s most fundamental weakness is that its enforcement relies on finance ministers issuing negative verdicts against each other.

Table 1. Closed excessive deficit procedures

Source: European Commission.

Experience has clearly revealed that they are unwilling to do so, and this undermines the credibility of the 3% deficit limit, thereby weakening the incentives for improving structural budgets. Hence, if the SGP hampers fiscal stabilisation, this is the indirect consequence of its weak (expected) enforcement and not its specific design. Credible enforcement provides governments with incentives to improve their structural budgets, thereby also creating room for withstanding the budgetary effects of “normal” recessions. At present, most of the EU member states find themselves in (or are threatened with) an excessive deficit procedure for violating the 3% norm.

The European Commission, which does the preparatory work for the procedure, has indicated that, in view of the severity of the current crisis, it will treat the violators with leniency. Obviously, governments should not be forced to push their economies into an even deeper recession by contracting fiscal policy. However, the deadlines given to these countries for the correction of their deficits seem rather generous, potentially implying too little budgetary consolidation in case economic growth resumes more quickly than expected. Given that there is a possibility to revise those deadlines under unexpected adverse events, the current deadlines might have been set tighter.

Once economic growth has returned to a satisfactory pace, the Commission should actually become stricter than before the crisis in order to restore some of its lost confidence and to induce governments to reduce their swelling debt burdens. The latter is important both in view of the rising ageing costs and to preserve the support for the EMU. While a default on euro-zone public debt is not likely, it is also not inconceivable, as the substantial increases in interest spreads and credit default swaps have shown. This would certainly undermine the viability of the EMU (with or without a bailout, which under specific circumstances is allowed by the Treaty – see Münchau and Mundschenk, 2009).


1 We may think in particular of Ireland and Greece, countries that have seen substantial increases in the interest rates on their public debt but have avoided currency collapses or further interest rate rises associated with the defence of a national currency.

2 In crises, national interests trump common interests. Witness the recent rise in protectionism in Europe, which is aptly illustrated by Germany and France trying to protect their car industries at the cost of other EU members.


Beetsma, R. and M. Giuliodori (2009), The Macroeconomic Costs and Benefits of the EMU and other Monetary Unions: An Overview of Recent Research, Journal of Economic Literature, forthcoming.

Chari, V. and P.J. Kehoe (2007). On the Need for Fiscal Constraints in a Monetary Union, Journal of Monetary Economics, 54 (8), pp. 2399-2408.

Dixit, A.K. and L. Lambertini (2001). Monetary-Fiscal Policy Interactions and Commitment versus Discretion in a Monetary Union, European Economic Review, 45, pp. 977-987.

Dixit, A.K. and L. Lambertini (2003). Symbiosis of Monetary and Fiscal Policies in a Monetary Union, Journal of International Economics, 60 (2), pp. 235-247.

Galí, J. and R. Perotti (2003). Fiscal Policy and Monetary Integration in Europe, Economic Policy, 18, pp. 533-572.

Mundell, R.A. (1961) "A Theory of Optimum Currency Areas," American Economic Review, November, 51(4):657-665

Münchau, W. and S. Mundschenk (2009). Eurozone Meltdown: Eight Scenarios how the Unthinkable Might Happen

Wyplosz, C. (2006). European Monetary Union: the Dark Sides of a Major Success, Economic Policy, 22, pp. 207-61.



Topics:  EU institutions

Tags:  EMU, currency union, fiscal policy

MN Professor of Pension Economics and Vice-Dean of the Faculty of Economics and Business, University of Amsterdam, Member of the European Fiscal Board

Professor of Empirical Macroeconomics at the Amsterdam School of Economics (University of Amsterdam)


CEPR Policy Research