Euro 20/20: Twenty papers to better understand the single currency

Nauro Campos, Fabrizio Coricelli 08 July 2019

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Never let a good anniversary go to waste, we think. In 2019 we have had the 20th anniversary of the official introduction of the European single currency. The 1992 Maastricht Treaty laid down a roadmap for the creation of the euro. The roadmap led first to the establishment of the Economic and Monetary Union in January 1999 and then, three years later, to the introduction of physical euro notes and coins. 

From the beginning, the road was bumpy and it has been a controversial journey. The oil shock in 2000, 9/11, and the bursting of the dot-com bubble were not a smooth start. The single currency was less than ten years old when the Global Crisis erupted in 2008, severely affecting European economies. In some countries it escalated into a sovereign debt crisis around 2011, from which not all have fully recovered.  

We expected the 20th anniversary of the single currency would coincide with a revival of the academic debate around it. We thought this debate would try to take stock of the accomplishments and disillusionments so far, and discuss the ways to improve functioning of the euro in future. We are disappointed by what we see. 

So, instead, we have selected, and will briefly discuss, the euro 20/20. That is, 20 papers that we think every economist and policymaker should read, re-read, and reflect upon on this 20th anniversary. Note that we have restricted ourselves to academic papers published in refereed journals, and in so doing deliberately excluded various influential books and reports that have already achieved 'classic' status (work by Baldwin, De Grauwe, Eichengreen, James and Wyplosz, to name a few). 

Why is the euro effect so hard to detect?

History matters. To understand how difficult it is to find a clear-cut effect of the single currency, we need to appreciate how the euro was created. The euro is the outcome of a gradual process that started in 1969, when European leaders realised the Bretton Woods system was faltering (James 2013). The process continued in the 1970s with the 'snake in the tunnel' system which was further structured with the 1979 Exchange Rate Mechanism (ERM). 

Although symmetric in principle, the ERM became increasingly centred around the deutschmark in the 1980s. The (common) use of a dummy variable to capture the euro from 1999 suggests the fixing of exchange rates in Europe took place abruptly, though many were pegged to the deutschmark and ECU since 1993, and even before that for some country pairs. 

This is maybe one reason why the euro effect remains elusive, especially after 1999. Another is that the European single market emerged at the same time: it was agreed in 1985, completed in 1992 and in full swing by the late 1990s. It remains a pressing task to disentangle these effects.  

The creation of the euro has traditionally been viewed critically by academic economists in the US. Jonung and Drea (2010) reviewed this large body of literature, organising the papers in chronological order and discussing their main views. It contains well-known radical criticisms by Feldstein, less-radical criticism by Eichengreen and co-authors, but also lesser-known views – such as, for instance, those of Tobin. 

It is remarkable that these critics covered a broad range of topics, from business cycle asymmetries to political economy issues. But if we search for a similar analysis by those who supported the euro, or even viewed it less critically, we would be disappointed. 

The loss of monetary independence, or the myth of it

The adoption of the euro implied the loss of national monetary policy independence. Most of the assessments on the costs and benefits of this refer to the classic contribution by Mundell (1961) on optimal currency areas. He argued that heterogeneity in economic structures, and thus exposure to idiosyncratic shocks, would undermine a currency area unless there was a high degree of inter-country labour mobility. Consistent with this approach, euro critics stressed the heterogeneity of member states and the need for the exchange rate as an adjustment mechanism.

But McKinnon (2004) has argued that economists neglected subsequent work by Mundell, which he called 'Mundell II'. According to this, the benefits of a currency area were relevant for heterogeneous countries, and such benefits would derive from the higher financial integration brought about by sharing the same currency. In turn, higher financial integration would increase the effectiveness of risk-sharing among member countries.  In short, the key, overlooked, contribution of Mundell II was the central role of financial markets, rather than labour markets.

This emphasis has led to new insights in work not directly linked to the euro, but more generally to the implications of financial market integration on national monetary independence, even in flexible exchange rate regimes. Calvo and Reinhart (2002) found that countries that defined themselves as having free-floating regimes in fact intervened in the exchange rate market. Indeed, there was what they called a “fear of floating", and “the so-called demise of fixed exchange rates is a myth”. 

Kareken and Wallace (1981) is still a fundamental paper for discussing exchange rate regimes in a world of high capital mobility, and potentially a high degree of currency substitution. It established the indeterminacy of a free-floating exchange rate. This theoretical result serves as a caution for those who believe that flexible exchange rate can help economies achieve a better real equilibrium, because exchange rates may be highly erratic and disconnected from economic fundamentals. 

What is the euro for? 

Lane (2006) reviewed the real effects of European monetary union in its first decade. He focused on five main aspects: financial and trade integration, labour mobility, fiscal policy and the political viability of the euro. 

1. Trade and financial integration

Rose (2000) found a large positive effect of currency union on international trade, and a small negative effect of exchange rate volatility. These statistically significant effects imply that two countries sharing a currency trade three times as much as they would if they did not. Currency unions, like the EMU, lead to a large increase in international trade.

Berger and Nitsch (2008) was one of the first pieces of work to challenge these results. It did so by accounting for the introduction of the single market.  

The euro has also had large effects on financial integration in Europe which, it needs saying, was low even in the late 1990s (Portes and Rey 1998). Kalemli-Ozcan et al. (2010) documented the nature, size and dynamics of these effect, and investigated their underlying mechanisms. They concluded that the euro's impact on financial integration was not through trade in goods but instead "primarily driven by eliminating the currency risk. Legislative–regulatory convergence has also contributed to the spur of cross-border financial transactions." 

Bekaert et al. (2013) continued this analysis by showing the difficulties in disentangling the effect of the single market from EU membership, and from the euro.  

De Sousa and Lochard (2011) found that the euro increased intra-EMU FDI stocks on average by around 30%. This effect varied over time and across EMU members, and was larger for the outward investments of less-developed EMU members.

2. The euro and structural reforms

Alesina et al. (2011) argued not only that the euro has a substantial effect in driving structural reforms in Europe but that it had a bigger effect than the single market. In contrast, Férnandez-Villaverde et al. (2013) argued that membership in the euro, by reducing interest rates and exchange rate risk, induced large capital inflows in southern Europe that sharply reduced incentives for structural reforms. 

3. Core and periphery

Bayoumi and Eichengreen (1993) highlighted the existence of a core–periphery pattern in the run-up to the EMU. If persistent, this pattern would have been detrimental to the euro project. Using pre-EMU data to estimate the degree of synchronisation, they argued that there was a core for which (supply) shocks were highly correlated, and a periphery in which synchronisation was significantly lower. We still lack an authoritative study about convergence post-euro, especially one that considers the role of institutions and greater competition (Philippon and Gutiérrez 2018).

4. The euro and the Great Recession     

We still need a serious medium-term assessment to grapple with the implications for the euro of the crisis (Martin and Philippon 2017), of populism (Guiso et al. 2019), and of Brexit (Dhingra et al. 2017), because there are close links between these factors. 

Closing remarks  

So far, we haven’t seen as much debate in this milestone year as we think the euro deserves – and needs. The euro has survived its first 20 years, and will survive at least the next 20. So, if it is here to stay, we need to find ways to make it work better. We need a candid and detailed dialogue. Picking 20 papers is arbitrary, and our choice will probably be controversial. It is not easy to explain them (or to justify our choice) in 1,500 words, but we hope this column helps inspire the revival of this academic debate. 

References

Alberto, A, S Ardagna and V Galasso (2011), “The Euro and Structural Reforms”, Review of Economics and Institutions 2(1): 1-35.  

Bayoumi, T and B Eichengreen (1993), “Shocking Aspects of European Monetary Integration”, in F Torres, F Giavazzi (eds.), Adjustment and Growth in the European Monetary Union, Cambridge University Press.

Bekaert, G, C Harvey, C Lundblad, and S Siegel (2013), “The European Union, the Euro, and Equity Market Integration”, Journal of Financial Economics 109(3): 583-603.

Berger, H and V Nitsch (2008), “Zooming Out: The Trade Effect of the Euro in Historical Perspective”, Journal of International Money and Finance 27(6): 1244–1260

Calvo, G and C Reinhart (2002), “Fear of Floating”, Quarterly Journal of Economics 117(2): 379-408. 

De Sousa, J and J Lochard (2011), “Does the Single Currency affect Foreign Direct Investment?” Scandinavian Journal of Economics 113(3): 553-578.

Dhingra, S, H Huang, G Ottaviano, J Pessoa, T Sampson and J Van Reenen (2017), “The Costs and Benefits of Leaving the EU: Trade Effects”, Economic Policy 32(92): 651–705.

Fernández-Villaverde, J, L Garicano, and T Santos (2013), “Political Credit Cycles: The Case of the Eurozone”, Journal of Economic Perspectives 27(3): 145–166.

Guiso, L, H Herrera, M Morelli and T Sonno (2019), “Global Crises and Populism: The Role of Eurozone Institutions”, Economic Policy 34(97): 95-139.

James, H (2013), “Designing a Central Bank in the Run-up to Maastricht”, Journal of European Integration History 19(1): 105-122.

Jonung, L and E Drea (2010), “It Can’t Happen, It’s a Bad Idea, It Won’t Last: U.S. Economists on the EMU and the Euro, 1989-2002”, Econ Journal Watch 7(1): 4-52

Kalemli-Ozcan, S, E Papaioannou, and J-L Peydró (2010), “What Lies Beneath the Euro's Effect on Financial Integration?” Journal of International Economics 81(1): 75-88.

Kareken, J and N Wallace (1981), “On the Indeterminacy of Equilibrium Exchange Rates”, Quarterly Journal of Economics 96(2): 207-222.

Lane, P (2006), “The Real Effects of European Monetary Union”, Journal of Economic Perspectives 20(4): 47-66.

Martin, P and T Philippon (2017), “Inspecting the Mechanism: Leverage and the Great Recession in the Eurozone”, American Economic Review 107(7): 1904-1937. 

McKinnon, R (2004), “Optimum Currency Areas and Key Currencies: Mundell I versus Mundell II”, Journal of Common Market Studies 42(4): 689–715.

Mundell, R (1961), “A Theory of Optimum Currency Areas”, American Economic Review 51 (7): 509-517.

Philippon, T and G Gutiérrez (2018), “How EU Markets Became More Competitive Than US Markets: A Study of Institutional Drift”, NBER working paper 24700. 

Portes, R and H Rey (1998), “The Emergence of the Euro as an International Currency”, Economic Policy 13(26): 306-343.

Rose, A (2000), “One Money, One Market: Estimating the Effect of Common Currencies on Trade”, Economic Policy 15(30): 9-45.

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Topics:  EU institutions EU policies

Tags:  euro, single currency, ERM, EMU, monetary union

Professor of Economics, University College London and Research Professor at ETH-Zürich

Professor of Economics at Paris School of Economics, Université Paris 1 Panthéon-Sorbonne; and CEPR Research Fellow

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