Creeping Eurozone fragmentation
In the mid-1990s before the creation of the euro, many economists analyzed whether the incipient European Monetary Union (EMU) was de facto an optimum currency area and whether it would make sense for a European country to join. Economists opined firmly, “it depends.”
Economic historian Barry Eichengreen concluded in a seminal paper in 1991, “Europe remains further than the US or Canada from the ideal of an optimum currency area. […] The extent of regional problems within existing currency and customs unions like the US underscores the need for regional shock absorbers, such as fiscal federalism, to accommodate asymmetrical disturbances.” Eight years before the introduction of the euro, this sounds in hindsight almost prophetic.
Most analyses in the 1990s assessing the optimality of what later became the Eurozone examined the business cycle correlation of the potential members. Higher was considered better because a single central bank addressing the business cycle for different countries could conduct uniform policy if those business cycles were in synch – more expansive monetary policy in business cycle contractions and a more restrictive policy during expansions.
Factors relating to business cycle synchronicity were also reviewed. A study by Jeffrey Frankel and Andrew Rose in 1996 focused on the trade integration that a monetary union would generate, arguing that while the sector specialization countries would face after entering a monetary union would lower business cycle synchronicity, on the other hand the sheer fact that the members of a currency union would become privileged trading partners of union member countries would lead to more synchronized business cycles.
Many studies also addressed the fact that a currency union would lead to more integrated financial markets, allowing better allocation of capital if barriers were lowered. This was also considered to promote business cycle synchronicity.
All in all the conclusions of such studies stated that over time, countries that entered a monetary union but were not considered optimal members at the outset would grow into it. As Frankel and Rose noted, “A country is more likely to satisfy the entry into a currency union ex post than ex ante.”
Almost 15 years since its creation and four years after the euro crisis started, the present Eurozone now shows signs that this conclusion is falling short of reality. Business cycles appear desynchronized, with Germany currently impressing again with hefty acceleration while Southern Europe continues to struggle with very low growth or contraction. Even worse, France emerged from recession in the second quarter 2013, and again posted contraction in the third. Given its large inventory buildup, this could extend in the fourth quarter, meaning that France could fall back into recession according to the layman’s definition of two consecutive quarters with a negative growth rate.
Looking at the intra-Eurozone trade flows since the introduction of the euro, we can also see fragmentation. German exports to the rest of the Eurozone amount to less than 40 % of its overall exports today, while in the mid-2000s, they made up 45%. The respective numbers for France are 47% versus 52%, for Italy 40% versus 48% and for Spain 50 % versus 62%.
Last but not least, since the beginning of the euro crisis there has been more financial fragmentation, as Southern European banks buy greater amounts of Southern European government debt. A recent study by the Deutsche Bundesbank reports that the Italian public debt held by Italian banks has increased by 73% since 2011 to EUR 415 billion. In Spain these figures are +81% to EUR 299 billion. Similar trends exist in Portugal and Ireland.
These trends do not forecast an optimal currency area in the longer run. Hopefully the banking union to be instituted in late 2014 will stop and even reverse this incipient Eurozone fragmentation.