marco - the economics of the monetary union and the eurozone crisis (2014)

SPRINGER BRIEFS IN ECONOMICS
Manuel Sanchis i Marco
The Economics
of the Monetary
Union and the
Eurozone Crisis
SpringerBriefs in Economics
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The Economics of
the Monetary Union
and the Eurozone Crisis
Manuel Sanchis i Marco
Faculty of Economics
University of Valencia
Valencia
Spain
© The Author(s) 2014
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ISSN 2191-5504 ISSN 2191-5512 (electronic)
ISBN 978-3-319-00019-0 ISBN 978-3-319-00020-6 (eBook)
DOI 10.1007/978-3-319-00020-6
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For Yvonne, my beloved wife
vii
The ECB decided in September 2012 to act as a lender of last resort in the government
bond markets of the Eurozone. In doing so, it prevented panic from undermining the
stability of the Eurozone. It was a necessary move to eliminate the existential fear that
was destroying the Eurozone.
While necessary, the ECB decision is insufficient to save the euro in the longer
run. The greatest threat for the Eurozone today does not come from financial
instability, but from the potential social and political instability resulting from the
economic depression Southern European countries have been pushed into and that
has led to increases in unemployment not seen since the Great Depression. This
state of affairs is the result of a dramatic failure of macroeconomic management in
the Eurozone.
Under the leadership of the European Commission and the ECB, tight austerity
was imposed on the debtor countries while the creditor countries continued to follow
policies aimed at balancing the budget. This has led to an asymmetric adjustment
process where most of the adjustment has been done by the debtor nations. The lat-

ter countries have been forced to reduce wages and prices relative to the creditor
countries (an “internal devaluation”) without compensating wage and price increases
in the creditor countries (“internal revaluations”).
These internal devaluations have come at a great cost in terms of lost output
and employment in the debtor countries. As these internal devaluations are not yet
completed (except possibly in Ireland), more losses in output and employment are
to be expected.
Thus, the burden of the adjustments to the imbalances in the Eurozone between
the surplus and the deficit countries is borne almost exclusively by the deficit
countries in the periphery. This creates a deflationary bias that explains why 5
years after the start of the financial crisis the Eurozone still has not recovered and
threatens to return into a recession.
The risk is real that citizens in Southern European countries that are subjected
to prolonged deep economic downturns revolt and reject a system that was prom-
ised to them to be economic heaven.
In order to understand these dramatic economic developments that grip the
Eurozone, the book of Manuel Sanchis i Marco is the right one coming at the right
Foreword
Foreword
viii
time. The theory of optimal currency areas remains the essential framework to
understand the design failures of the Eurozone. Professor Sanchis i Marco does a
superb job in explaining this theory and in making it relevant for our understand-
ing of the problems faced by the Eurozone.
The last two chapters of the book turn towards an analysis of the crisis of the
euro and how to get out of this crisis. Spain is used as the prototype country to
explain how the crisis unfolded. This is the country that in the beginning of the
Eurozone seemed to do everything right. Few saw how the imbalances were build-
ing up; even fewer predicted that this would lead to disaster. This book produces
the best analysis I have seen of why things have gone wrong so badly in Spain. By

suggesting a path out of the crisis, Professor Sanchis i Marco leaves us with some
hope for the future for Spain and other Eurozone countries.
Paul De Grauwe
London School of Economics
January 2013
ix
Early in July 2012, Professors Esther Versluis, Director of Studies of the MA in
European Public Affairs of the University of Maastricht, and Christine Arnold
from the Department of Political Science of that University, invited me to partici-
pate in the MA programme on European Studies as a Guest Speaker. They pro-
posed that in autumn I give a set of six Guest Lectures on The Economics of the
Monetary Union and the Eurozone Crisis.
Over the summer, I was very engaged with the preparation of the teaching
material for this set of six lectures, now transformed into the six chapters of this
book. It was a great honour to participate in the University of Maastricht‘s MA
program on European Studies, and I would like to thank both professors for giv-
ing me the opportunity to do so. I also wish to thank Professor Vicent Almenar
who assisted me in the preparation of the graphs and tables. Thanks are also due to
Sallie Russell, responsible for the final version of the text in English.
Finally, I would like to express my gratitude to my beloved wife, Yvonne, who
as always, showed exceptional patience and indulgence with me during the long
summer days when I was typing the manuscript.
La Canyada, January 2013 Manuel Sanchis i Marco
Preface
Disclaimer: The author asserts that the views expressed in this book are his own
and do not represent the official position of the European Commission or any of
the European Institutions.
xi
1 The Economics of Monetary Union: The Theory of Optimum
Currency Areas 1

1.1 Introduction to the Analytical Framework 2
1.2 The Theory of OCAs: The Costs of Having a Common Currency 3
1.2.1 Mundell: Factor Mobility 3
1.2.2 McKinnon: Openness of the Economy 5
1.2.3 Kenen: Product Diversification 6
1.2.4 Magnifico: “National Propensity to Inflation” 7
1.2.5 Ingram: Degree of Financial Integration 7
1.2.6 Vaubel: Real Exchange-Rate Changes 8
1.3 The Benefits and Costs of a Common Currency 9
1.3.1 Benefits 9
1.3.2 Costs 11
References 11
2 The Economic Rationale of Fiscal Rules in OCAs: The Stability
and Growth Pact and the Excessive Deficit Procedure 13
2.1 Why Don’t Regions Leave Currency Areas When they
Experience Asymmetric Shocks? 13
2.2 The Economic Rationale of Fiscal Rules in a Monetary Union 18
2.3 The Stability and Growth Pact 20
2.3.1 The Preventive Arm 20
2.3.2 The Dissuasive Arm: The Excessive Deficit Procedure 20
2.3.3 The Long-Term Sustainability of Public Finances 23
2.4 An Assessment of the Revised Stability and Growth Pact 25
2.5 The Six Pack: Scoreboard for the Surveillance of Macroeconomic
Imbalance Procedure 27
References 28
Contents
Contents
xii
3 Coping with Asymmetric Shocks in the EMU:
The Role of Labour Market Flexibility 29

3.1 Conditions for Success 30
3.2 Nominal and Real Wage Growth: The Experience from
the 1970–1997 Period 31
3.3 Coping with Asymmetric Trans-European Shocks 33
3.4 Adjustment to Shocks 35
3.5 Behavioural Changes of Economic Agents and Institutions 36
3.6 Wage Negotiations Within Member States from a European
Perspective 37
3.7 Price Setting and Wage Bargaining Behaviour 38
References 40
4 The Concept of Labour Market Flexicurity in the Eurozone 41
4.1 A Tentative Proposal for the Concept of Flexicurity 41
4.2 The Concept of Labour Market Flexibility 43
4.3 The EU Policy Approach to the Flexibility-Security Nexus 43
4.4 Definition of Labour Market Adaptability 44
4.5 How the European Commission Understands Flexicurity 46
4.6 Wilthagen’s Definition of Flexicurity: The Dutch Approach 47
4.7 Madsen’s Definition of Flexicurity: The Danish Approach 48
4.8 The Flexicurity Approach in Austria 50
4.9 The Flexicurity Approach in Spain 50
4.9.1 Elements of Flexicurity in the Spanish Labour Market
Reforms (1984–1997). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51
4.9.2 New Reforms During the 1997–06 Period 51
4.9.3 Latest Reforms During the 2010–12 Period 52
References 53
5 The Spanish Case: The Housing Market Bubble and External
Disequilibria. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55
5.1 Gliding Economics Did Not Solve the Spanish Meltdown 56
5.2 Spain’s Major Macroeconomic Imbalances and Weaknesses 60
5.3 A Huge Current Account Deficit, Though Now Close to Balance 61

5.4 Over-Dimensioned Sectors and Structural Reforms 62
5.4.1 The Housing Market 62
5.4.2 The Financial Sector 69
5.4.3 Labour Market Reforms 70
5.4.4 Changes in the Fiscal and Budgetary Scenarios 71
5.5 Is Spain a Heavily Indebted Economy? 71
References 74
Contents xiii
6 The Global Crisis and Alternative Scenarios to Save the Euro:
A Spanish Perspective 75
6.1 Origins of the Great Recession 76
6.2 Lessons That Can be Learned 78
6.3 How the European Union Reacted 80
6.4 From Financial to Debt Crisis: The Weaknesses of the Euro
at Sight 83
6.5 Some Institutional Responses 87
6.6 The Euro Project: The Economic and Political Rationales
are Conflicting 90
6.7 What Does Fiscal Union Mean So Far? 92
6.8 Alternative Scenarios to Save the Euro 95
6.9 The January 2012 European Summit: The Need for a European
Approach 96
6.10 A Sort of Epilogue: The EU at the Crossroads 100
References 102
Appendix: Ideology and Economics in the Failure of Lehman Brothers 105
1
Abstract In the 1960s, the theory of Optimum Currency Areas (OCAs) emerged
as a by-product of the theoretical debate between fixed and flexible exchange
rates. The OCAs approach singles out an economic characteristic to define
an economic domain where there is exchange rate fixity erga intra, while there

is exchange rate flexibility erga extra. In an optimum currency area, exchange
rates fixity prevails internally without any type of internal or external disequilib-
rium. Each single characteristic ensures that floating or regular adjustments in
nominal exchange rates are neither necessary, efficient nor desirable for stabili-
sation purposes. The literature proposes several economic criteria: factor mobil-
ity (Mundell); openness of the economy (McKinnon); product diversification
(Kenen); national propensity to inflate (Magnifico); financial integration (Ingram);
real exchange-rate changes (Vaubel). While the cost-benefit approach considers
OCAs criteria for guaranteeing long-term equilibrium, this approach is operational
and focuses on the political commitment of countries to form a monetary union
assessing the resulting costs and benefits. Benefits are associated with efficiency
and price stability gains, reduction of risks arising from exchange rate uncertainty,
and gains from using the euro as a reserve currency; while costs relate to the loss
of monetary independence, diverging preferences in national inflation-unemploy-
ment relationships, and worsening regional disequilibrium.
Keywords  Optimum  currency  area  •  OCAs  •  Monetary  union  •  Monetary 
integration  •  Cost-benet approach  •  One money, one market  •  Exchange rate xity  •
Exchange rate flexibility
Chapter 1
The Economics of Monetary Union: The
Theory of Optimum Currency Areas
M. Sanchis i Marco, The Economics of the Monetary Union and the Eurozone Crisis,
SpringerBriefs in Economics, DOI: 10.1007/978-3-319-00020-6_1, © The Author(s) 2014
2
1 The Economics of Monetary Union: The Theory of Optimum Currency Areas
1.1 Introduction to the Analytical Framework
The theory of optimum currency areas
1
(OCAs) emerged in the early 1960s, as a
by-product of the theoretical debate between those who favoured fixed and those

who favoured flexible exchange rates. According to this theory, we understand a
currency area as a “domain within which exchange rates are fixed” (Mundell
1961). This means that a currency area is a territory, composed by either regional
or national entities, with one or several currencies whose values are permanently
fixed, but whose external value is determined in markets free from official inter-
ventions (Grubel 1970, p. 318).
A problem arises when defining the domain within which exchange rates are
fixed, and when selecting the economic criteria that would qualify a domain as
optimum to form a currency area. What would be the single economic character-
istic that would define the appropriate domain of a currency area? It is important
to keep in mind that, in this context, the boundaries of a national currency area
do not necessarily correspond with those of so-called optimum currency areas. In
other words, if Europeans assumed that EU Member States would increase their
welfare when they abolished their currencies and adopted a single one of a wider
area, the issue at stake would be “What is the appropriate domain of a currency
areas?” (Ishiyama 1975, p. 344), or “Where do they stop then? Should they have
one money for the Benelux, or for the EC, or for the whole of Europe, or maybe
for the whole world? This problem leads us to raise the question of what consti-
tutes an optimal currency area” (De Grauwe 1997).
There are two main approaches to answering these questions. First, the tradi-
tional approach, called optimum currency areas (OCAs)—which may not nec-
essarily correspond with national boundaries—tries to single out one economic
or financial characteristic that an economic region or space has to fulfil in order
to draw a line within which fixed exchange rates could be maintained internally
without tension. Each single characteristic has to ensure that floating or discreet
adjustments in nominal exchange rates are neither necessary nor efficient nor
desirable for stabilisation purposes. The alternative approach is called the cost
benefit approach. It takes a more realistic and useful view as it tries to evaluate
the costs and benefits of partner countries, which have taken a political decision
to participate in a currency union. Although this approach takes into considera-

tion the previous single criteria of OCAs for guaranteeing long-term equilibrium,
it focuses on the political commitment of a group of countries, which find it desir-
able to form a currency area when the final balance of costs and benefits favours
participation in the institutional frame of such a currency unification.
1
For surveys on this issue see Tower and Willet (1970), Fernández de Castro (1973), Ishiyama
(1975), Presley and Dennis (1976), Molina (1982), and Sanchis i Marco (1984a, b, 1988a, and b).
3
1.2 The Theory of OCAs: The Costs of Having a Common Currency
1.2 The Theory of OCAs: The Costs of Having a Common
Currency
1.2.1 Mundell: Factor Mobility
Robert Mundell, inspired by the Ricardian assumption that factors of production
are mobile internally but immobile internationally, proposed the concept of factor
mobility. By this he meant that the free movement of labour and capital are the
key conditions to define a geographic area as an optimum currency area (Mundell
1961). Optimality in Mundell’s article means the ability to stabilise national
employment and price levels. Mundell's definition of an optimum currency area
consists of a geographical region that exhibits characteristics, which lead to an
automatic removal of unemployment and balance-of-payments disequilibria. In his
seminal paper automatic means that no intervention from fiscal or monetary poli-
cies is required to restore both internal and external equilibrium.
Mundell considered a simple model of two entities, whether regions or coun-
tries, and assumed that such entities pursue both internal and external balance,
that is, full employment and payments equilibrium. These entities were initially
in full employment and balance-of-payments equilibrium. He also assumed that
money wages and prices were rigid in the short run, so we could not reduce
them without producing output forgone and job losses and that monetary author-
ities would react to prevent inflation. Then, he supposed that both entities,
whether regions or countries, were unexpectedly disturbed by a shift in aggre-

gate demand from B to A, that is, a fall in the demand for goods in entity B, and
an increase in the demand for goods in entity A. In this case he proposed three
alternative scenarios.
1.2.1.1 Scenario A: Countries with National Currencies
A shift in demand from country B to country A, provided import and export
demands are sufficiently elastic, will cause in B an increase in unemployment and
a balance-of-payments deficit; whereas, it will cause in A an over full-employment
situation, inflation and a balance of payments surplus. As long as country A does
not resist the price increase, price pressures in A will translate into a change into
the terms-of-trade and will introduce some relief in B, so the burden of adjustment
will be distributed between B and A. However, if country A tightens monetary pol-
icy to prevent prices from rising, then B will suffer the entire adjustment burden
(Mundell 1961, p. 658).
Country B needs to reduce its real income level. However, if this cannot be
done through a change in the terms-of-trade—because B cannot lower money
wages and prices in the short run, while A cannot raise prices because of credit
restrictions—then the reduction of country B’s real income will take place through
output forgone and job losses. The latter would imply higher unemployment levels
4
1 The Economics of Monetary Union: The Theory of Optimum Currency Areas
in order to reduce the demand for imports from A, and to divert production to
exports and to stabilise or reduce prices to improve the foreign trade balance or
make it more balanced.
Therefore, under a fixed exchange rates regime or a common currency, a
restrictive monetary policy in A (the surplus country) to contain price pressures,
will cause a deflationary bias, or recessive pressure, in B (the deficit country).
In other words, in the absence of exchange rate adjustments, disequilibria would
require deflation (internal devaluation) in B and reflation (internal revaluation) in
A. As said above, if we allow prices to rise in country A, then the terms of trade
will improve for B and will relieve B for some of the adjustment burdens. In addi-

tion, if the deflationary bias works, prices will fall in B and we will restore the
balance-of-payments equilibrium.
To avoid a deflationary bias—and the resulting recession—and restore both the
external and the internal equilibrium, there must be a free-floating exchange rate
regime between the two countries B and A. In this case, the exchange rate would
depreciate in the deficit country with respect to the surplus country or, conversely,
the exchange rate in the surplus country would appreciate with respect to the deficit
country.
1.2.1.2 Scenario B: Regions with a Common Currency
In contrast with the previous situation, consider now a closed economy with
regions that share a common currency, and assume that the government pur-
sues a full employment policy. In this context, the shift in demand from B to A
causes unemployment and a balance-of-payments deficit in region B, and infla-
tionary pressures and a balance-of-payments surplus in region A. To correct for
the unemployment in B, the monetary authorities could expand the money stock.
This monetary expansion, however, would be at the expense of higher prices in A,
aggravating the inflationary pressure in A and turning the terms-of-trade against A.
Therefore, a monetary policy pursuing full employment in region B causes an
inflationary bias in the multiregional economy, or in the whole area sharing a com-
mon currency. Similarly, in a currency area made up of different countries with
national currencies, the willingness of surplus countries to inflate determines the pace
of employment in the deficit countries. However, in a currency area comprising many
regions and a single currency, the pace of inflation is set by the willingness of the
central bank to allow unemployment in deficit regions (Mundell 1961, pp. 658–659).
1.2.1.3 Scenario C: Regions of both Different Countries and Currencies
Mundell assumes that the whole world area consists of two countries, Canada and the
United States, with separate currencies, but also that this world is divided into two
separate regions, East and West, which do not correspond with the national bounda-
ries. The East produces cars and the West, lumber products. An increase in productiv-
ity in the car industry (in the East) will produce an excess supply of cars and an excess

5
1.2 The Theory of OCAs: The Costs of Having a Common Currency
demand for lumber products. As a result, this shift in demand will cause unemploy-
ment in the East and inflationary pressures in the West (Mundell 1961, p. 659).
Both central banks (North and South) will have to choose between relieving
unemployment in the East by relaxing their monetary policies; or, preventing infla-
tion in the West by tightening both monetary policies. Therefore, both countries
will share the burden of adjustment between East and West with some unemploy-
ment in the East and some inflation in the West. However, each single country has
to face both unemployment and inflation.
With flexible exchange rates the situation between the two countries will be cor-
rected, but not between the two regions. Therefore, it will be preferable for those
regions to have their own common currency or fixed exchange rates internally. This
would favour the use of regional currencies (Eastern and Western dollars, respec-
tively) and the abandonment of national ones (Canadian and US dollars).
To sum up, Mundell argued in favour of dividing the monetary world into cur-
rency areas. This is because the stabilization argument which favours flexible
exchange rates does not apply when the currency area has full factor mobility erga
intra and factor immobility erga extra, that is, “[…] If the world can be divided
into regions within each of which there is factor mobility and between which there
is factor immobility, then each of these regions should have a separate currency
which fluctuates relative to all other currencies” (Mundell 1961, p. 663). In these
cases, regional currency areas can be created because the use of flexible exchange
rates for stabilisation purposes becomes ineffective, unnecessary or undesirable.
To reorganise the world in such a way is not, however, very realistic since a
region is an economic entity, while a currency domain is mostly an expression of
national sovereignty. Therefore, it is not feasible to give up monetary sovereignty
unless the political domain coincides with the economic criteria of having both
internal factor mobility and external immobility. Otherwise, in these cases, cur-
rency flexibility will not fulfil its stabilisation function, and the result will be vary-

ing rates of unemployment and prices in the different regions of the country. If
this is the case, why would the different regions in a country, which show diverg-
ing trends in unemployment, prices, and productivity, have an interest in sharing a
common currency? We will come back to this issue in Chap. 2.
1.2.2 McKinnon: Openness of the Economy
Ronald McKinnon proposed a second criteria for a group of countries or economic
regions to qualify for constituting a optimum currency area (McKinnon 1963).
For McKinnon for whom, as for Mundell, optimality is defined as the capacity to
achieve automatic internal and external balance, or, more precisely: “‘Optimum’ is
used here to describe a single area within which monetary-fiscal policy and flex-
ible external exchange rates can be used to give the best resolution of three (some-
times conflicting) objectives: (1) the maintenance of full employment; (2) the
maintenance of balanced international payments; (3) the maintenance of a stable
internal average price level” (McKinnon 1963, p. 717).
6
1 The Economics of Monetary Union: The Theory of Optimum Currency Areas
McKinnon proposes that a group of regions or countries could comply with
the definition of optimum currency area provided they are highly open econo-
mies, as for him “‘The ratio of tradable to non-tradable goods’ is a simplifying
concept which assumes all goods can be classified into those that could enter into
foreign trade and those that do not because transportation is not feasible for them”
(McKinnon 1963, p. 717). When a group of regions/countries forms an optimum
currency area, McKinnon puts more emphasis on the need to minimise the costs of
achieving these three objectives, than on the possible benefits of forming such an
area, on which there are few references.
McKinnon’s criteria rely implicitly on the so-called ‘vicious circle hypoth-
esis’ in such a way that the higher the degree of openness, the lesser the degree of
money illusion of a country, the less effective will be exchange rate depreciation to
lower real wages and restore the external equilibrium. The more open an economy
is, the less effective flexible exchange rates to both correct external imbalances

and stabilise prices will be because “[…] A devaluation would be associated with
a large domestic price-level increase and hence money illusion would not be much
help in getting labor to accept a cut in real wages” (McKinnon 1963, p. 723).
1.2.3 Kenen: Product Diversification
The third contribution to the theory of optimum currency areas is from Kenen who
proposed the degree of diversification of national production as the key economic
criterion which prompts a group of regions or countries to form a successful opti-
mum currency area (Kenen 1969). The more diversified a national economy is, the
fewer the variations in the terms of trade because variations in the prices of some
goods, produced by an external shock will be compensated for by variations in
others. In addition, this would maintain the exchange rate and the level of employ-
ment more steadily than in the case of a partially diversified economy.
Kenen states that “[…] diversity in a nation’s product mix, the number of
single-product regions contained in a single country, may be more relevant than
factor mobility” (Kenen 1969, p. 49), and makes three claims: “(1) That a well-
diversified national economy will not have to undergo changes in the terms of
trade as often as a single-product national economy. (2) That when, in fact, it does
confront a drop in the demand for its principal exports, unemployment will not
rise as sharply as it would in a less-diversified national economy. (3) That the links
between external and domestic demand, especially the link between exports and
investment, will be weaker in diversified economies” (Kenen 1969, p. 49).
McKinnon's and Kenen's approaches are contradictory as they use as starting
points different assumptions. For McKinnon domestic economic forces produce
the external disequilibrium; for Kenen the origin of the disturbance is external. For
McKinnon economies that are more open should maintain internal exchange rate
fixity but external flexibility. Surprisingly, if these more open economies joined in
a new currency area they would become more diversified. In this case, according
to Kenen's criteria, they should establish a regime of fixed exchange rates between
7
1.2 The Theory of OCAs: The Costs of Having a Common Currency

them, whereas, according to McKinnon, they should have exchange rate flexibility
between them. Furthermore, one would expect that the more diversified an economy
is the less it will rely on trade and, therefore, the smaller its external sector will be.
1.2.4 Magnifico: “National Propensity to Inflation”
Magnifico introduces the concept of “national propensity to inflation” as the relevant
criteria to determine whether a group of countries should form a currency area. An
optimum currency area is one that is formed by countries with similar national pro-
pensities to inflation. This “propensity” is a function of the inflation-unemployment
trade-off existing in each country, with some countries having a stronger preference
for inflation than others do. Assuming only two countries A and B, different prefer-
ences concerning inflation and unemployment imply that both countries will pay
a cost when forming a currency area. To maintain monetary union is costly for both
countries because both will have to choose a less preferred point in their respective
Phillips curves. Therefore, if country A had a higher preference for inflation it will be
subject to a deficit with country B, which has a lower preference for inflation.
Magnifico’s concept of “national propensity to inflation” opens many vistas
when compared to the concept of inflation rates, because it refers to a set of struc-
tural and institutional elements which constitute building blocks of national eco-
nomic sensibilities. From this perspective, the formation of a currency area is not
directly derived from maintaining equal inflation rates but, mostly, from the con-
vergence of the economic structures of the member countries, as well as from the
structural adjustments needed for these economies to converge.
In 1971, Magnifico stated that “[…] differences in the NPI would seem to
depend inter alia on historical and social factors, on the system of industrial rela-
tions and the militancy of trade unions, on the structure of industry and its regional
deployment, as well as, on the building into the general psychology of expecta-
tions of inflation or price stability generated by demand-management policies,
which in the past consistently may, or may not, have aimed at guaranteeing the
full-employment level of monetary demand, with little regard to changes in exter-
nal competitiveness and payments balance. In other words, historical patterns may

not tell us what level of unemployment would be necessary for a given country to
attain the desired degree of price stability, but they would indicate that, in order
to prevent prices from rising faster than at a specified rate, higher unemployment
would be needed in certain countries, less of it in others.” (Magnifico 1971, p. 12).
1.2.5 Ingram: Degree of Financial Integration
The above four criteria focus on the real side of the economies, and leave little
room for the analysis of financial and monetary issues. Indeed, the models pro-
posed by Mundell, McKinnon, Kenen and Magnifico put the stress on real
8
1 The Economics of Monetary Union: The Theory of Optimum Currency Areas
variables, since prices are expressed in real terms of trade and the external adjust-
ment takes place on the current account, leaving aside the compensating financial
flows. Instead, Ingram considers that what matters to determine the optimum size
of a currency area are not the real but the financial characteristics of the concerned
economies (Ingram 1959).
The Ingram criterion to define a currency area considers that the higher the
degree of financial integration the lower the need for exchange rate changes
among partner countries, because changes in interest rates would provoke com-
pensating capital flows across national frontiers. In other words, “[…] Integration
of capital markets in the several partner countries, plus removal of restrictions on
the movements of claims, will enable equilibrating movements to perform their
vital role.” (Ingram 1959, p. 631).
1.2.6 Vaubel: Real Exchange-Rate Changes
Roland Vaubel states that a group of EC countries should form a monetary union
when they have no need to modify their real exchange rates through changes in
nominal exchange rates. Vaubel looks for “[…] a comprehensive and operational
criterion for the desirability of currency unification [and] it is the thesis of [his]
paper that the concept of real exchange rate variation can fill the gap”. (Vaubel
1976, p. 440). Vaubel starts with the existence of a group of specific nations,
which show both the political will and the commitment to merge into a separate

currency area. Consequently, he raises the following question: “Is the European
Community (already) a desirable ‘currency area’?” (Vaubel 1976, p. 432).
Vaubel explores the two reasons why it may not be. The first reason is that
“national propensities to inflate”, the term coined by Magnifico, might be too
different within the EC to allow for the abandonment of nominal exchange rate
changes as a tool to correct the external imbalances. While the first argument is
essentially political in nature, the second reason is of purely economic nature, as it
is concerned with the need for real exchange-rate changes. The EC members may
be willing and able to agree to a common rate of inflation for the whole monetary
union, but still find it harmful to adjust if diverging economic structures between
them require major real exchange rate adjustments.
Indeed, real exchange rates change when the commodity ‘terms of trade’ or the
financial ‘terms of finance’ change. The terms of trade shift when supply condi-
tions, notably labour costs and productivity increases, and/or demand condi-
tions change between members countries. The terms of finance shift in response
to changes in currency preferences and in risk, which may affect expected asset
yields (e.g. default risk). Therefore, as Vaubel states “[…] while the formation of
a currency union […] puts an end to all shifts of currency preferences within the
union, changes in the terms of trade and in lending risk will continue to occur and
produce real exchange-rate changes between the members of the union.” (Vaubel
1976, p. 434).
9
1.2 The Theory of OCAs: The Costs of Having a Common Currency
Therefore, a group of countries may prefer not to form a monetary union
because: (i) if flexibility in nominal exchange rates is not allowed, adjustment will
take the form of inflation or deflation between member countries; and (ii) if, for
example, productivity increases are faster in central areas than in the peripheral
ones, but trade unions of peripheral areas claim and obtain increases in wages
equal to those of the central areas, the monetary union (equivalent to rigidity in
nominal exchange rates) will lead to a rise in unemployment in peripheral areas.

As Vaubel clearly states, “If trade unions do not allow […] for the rise in import
prices which currency depreciation would produce, nominal exchange-rate adjust-
ment may be an effective means of bringing about a real exchange-rate depreciation
and hence of reducing real wages without a cut in nominal wages. The outcome
depends largely on the existence of exchange rate illusion […]. But even if labour
is fully aware of the purchasing power of its wages, exchange-rate depreciation is
likely to be a more effective means of inducing labour to accept downward adjust-
ments of real wages and of real wage increases for the sake of reductions in unem-
ployment than contractive demand management (and incomes policy) because
exchange-rate adjustment—unlike domestic demand management—does not
require transitory changes in relative wage positions of different trades and profes-
sions as successive wage bargains are concluded.” (Vaubel 1976, pp. 435–436).
Finally, Vaubel puts forward a summary of the main costs and benefits which
could be derived from currency unification, because it “[…] is likely to reduce the
monetary efficiency of domestic transactions, but it will increase the monetary effi-
ciency of international intra-union transactions by eliminating exchange rate risk,
exchange control risk, the cost of money changing and the cost of information about
foreign prices, exchange market conditions and foreign-exchange regulations. Since
real exchange-rate changes reflect the degree of openness they will—indirectly—
also indicate the efficiency gains or losses to be had from currency unification.”
(Vaubel 1976, p. 439). This brings us to the following point.
1.3 The Benefits and Costs of a Common Currency
1.3.1 Benefits
The economic literature on both the traditional and the alternative approaches to
optimum currency areas has singled out the above six main economic criteria by
means of which a group of regions can minimise the costs of maintaining inter-
nally fixed exchange rates or a common currency. Of course, there are others but
they can be included, to some extent, in the previous ones. As seen above, the opti-
mum currency areas approach puts the stress on the macroeconomic costs, which
a group of countries (or regions) has to face when abandoning the use of nominal

exchange rate changes to restore external disequilibria. Little attention has been
paid, however, to the advantages—mostly of a microeconomic nature—of having
a common currency. This is one of its major drawbacks.
10
1 The Economics of Monetary Union: The Theory of Optimum Currency Areas
Bearing in mind all the above, the European Commission launched a study
(European Commission 1990) to assess the potential costs and benefits of hav-
ing currency unification within member states in the context of the 1992 Single
Market Programme (SMP). From this study and other economic literature, we can
distinguish at least seven main benefits:
(i) reduction or suppression of risks associated with both the volatility and the
uncertainty of unexpected movements in nominal exchange rates. Indeed,
when the variability of exchange rates is not perfectly foreseeable and the
cost of covering the risks of unexpected exchange rate movements is high,
the maintenance of separate currencies, and the associated variability, is an
obstacle to reaping the efficiency gains arising from a better allocation of
resources in a single market;
(ii) efficiency gains. Highlighted by the European Commission (Emerson
1992), but somewhat oversold as most studies show a relatively weak
impact of the reduction of exchange rate volatility on the rates of invest-
ment, trade and economic growth. Moreover, lower exchange rate uncer-
tainty does not necessarily reduce systemic risks, as it may be compensated
for by higher uncertainty on sovereign debt, for instance, and therefore
induce higher risk premiums, as is the case today in the Eurozone
(iii) direct and indirect efficiency gains obtained from the elimination of the
transaction costs related to money changing and costs associated with
information on foreign prices, and foreign-exchange market conditions and
regulations. The use of a common currency as the medium of exchange is
directly proportional to the size of the monetary area to which it applies.
Therefore, the saving of resources resulting from this efficiency gain would

be devoted to uses that are more productive. Furthermore, the suppression
of transaction costs will benefit EU consumers as it will increase mar-
ket transparency, thus, increasing the difficulties for price discrimination
between national markets;
(iv) benefits of price stability. The adoption of a common currency could con-
tribute to maintaining inflation under control, provided the monetary
authorities build up a reputation and credibility by means of an independent
central bank (De Grauwe 1997);
(v) reduction of uncertainty positively influences capital movements, foreign
direct investments, trade and growth. Consumption, saving and investment
decisions might be distorted because the economic agents cannot fully
exploit the advantages of having access to the single market as the exist-
ence of several currencies acts as a barrier to access to the market and cre-
ates segmentation in economic and financial transactions. Further, there are
potential indirect and dynamic efficiency gains arising from the positive
impact that direct productivity gains might have on the increase of the stock
of capital over time, in response to efficiency gains;
(vi) economic gains from the use of the euro as a reserve and vehicle currency
for payments in international trade. A source of potential benefits arises
11
1.3 The Benefits and Costs of a Common Currency
from the demand for euros as a reserve currency (Wyplosz 1997). This,
together with the possibility to denominate payments in euros, eliminates
the uncertainty of future payments denominated in US dollars, or other
reserves or vehicle currencies for Eurozone countries. Achieving this will
rely heavily on the political will of more international hegemony for the EU
because “[…] the impact of EMU in the world cannot be fully understood
outside the framework of international political considerations. The ques-
tion of size is all-important in international monetary relations. Big powers
with stable currencies lead or dominate their currency areas. Great powers

have great currencies.” (Mundell 1993, p. 10). This puts the political ration-
ale of monetary union on the spot; and,
(vii) foster political integration within the EU countries, since monetary union
was conceived and launched as a step forward in the building of Europe.
1.3.2 Costs
Most of the costs are implicit in the macroeconomic analysis of optimum currency
areas discussed above, and can be summarised as follows:
(i) loss of autonomy of a country's monetary policy, both in terms of domestic
(interest rate) and external (exchange rate) aspects, which limits the capacity
of these instruments to correct external desequilibria when facing asymmetric
macroeconomic shocks.
(ii) reduced possibility to use seigniorage (or the inflation tax), something that
despite its inflationary consequences is very effective to escape from exces-
sive debt problems;
(iii) diverging country preferences on the inflation-unemployment relationship (or
Phillips curve). As Corden (1972) and Giersch (1973) pointed out, the main
characteristic of a monetary union is the setting of a common monetary policy
and, therefore, the convergence in inflation rates of member countries; and,
(iv) worsening of regional disequilibria, as there is the risk that the implemen-
tation of the 1992 Single Market Programme (SMP) would exacerbate eco-
nomic activity and would concentrate investment in the already affluent areas
of the EU. Consequently, the EU regional imbalances would deteriorate as the
material conditions of production in the less productive areas would worsen in
relative terms (Krugman 1991).
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13
Abstract This chapter examines the case of different regions within a single coun-
try that wish to share a common currency, even though they have divergent trends
in unemployment, inflation, wages, non-wage costs and productivity. This situation
compares with the case of a group of EU countries, each with its own decentralised
national budget, that have established a monetary union and that are facing asymmet-
ric shocks. As such an economic context requires fiscal commitments from national
governments, we analyse the economic rationale of setting fiscal rules for a common
currency area and the resulting EU institutional frame for the Stability and Growth
Pact (SGP) and the Excessive Deficit Procedure (EDP). We discuss the legal basis for
the EDP and the relevant accounting definitions. We also provide the initial settings
of the SGP, as well as a summary of the contents and the related assessment of the
revised SPG in March 2005. The chapter concludes with a brief comment on the so-
called “Six Pack” adopted by the EU in December 2011, which provides a wide range
of macroeconomic indicators to improve the governance of EMU within Eurozone

countries, through the Surveillance of Macroeconomic Imbalance Procedure.
Keywords  Fiscal federalism  •  Fiscal rules  •  Excessive Decit Procedure (EDP)  •
Stability  and  Growth  Pact  (SGP)  •  Six  Pack  •  Surveillance  of  Macroeconomic   
Imbalance Procedure
2.1 Why Don’t Regions Leave Currency Areas When they
Experience Asymmetric Shocks?
We have presented above an overview of the economic rationale for a group of
countries to share a common currency. I would like to start this second chapter
by examining the case of regions that in spite of showing diverging trends in
both unemployment and inflation rates, as well as in wages, non-wages costs and
productivity, still consider it advantageous to be part of a wider country with a
common currency.
Chapter 2
The Economic Rationale of Fiscal Rules in
OCAs: The Stability and Growth Pact and
the Excessive Deficit Procedure
M. Sanchis i Marco, The Economics of the Monetary Union and the Eurozone Crisis,
SpringerBriefs in Economics, DOI: 10.1007/978-3-319-00020-6_2, © The Author(s) 2014
14
Consider, for instance, the effect that the oil crisis of 1973–75 had on Spain. At
the time, the Spanish economy had embarked on a public investment programme
engineered through the National Institute for Industry (INI). In Leviathan fashion,
the government had decided to invest the bulk of Spain's national savings in the
shipyard and steel industries. It turns out that the State chose the wrong sectors, in
a situation that has been repeated today in the construction sector after it received
massive flows of private funds between 1999–2007.
What happened in 1973–75? Some regions in Spain like Cadiz or Valencia
suffered a negative productivity shock as their respective shipyards and steel
industries lost competitiveness. Subsequently, these regions experienced an
excess of productive capacity which resulted in a fall in industrial output and a

sharp increase in unemployment. Both regions undertook a process of industrial
restructuring which lasted nine years. The negative supply shock had an asymmet-
ric impact throughout the whole country, and the Bank of Spain implemented an
accommodating monetary policy to support growth. However, whereas some parts
of Spain were slowly recovering, the very lax monetary stance was unable to stim-
ulate the severely damaged areas of Cadiz and Valencia.
Had these depressed areas had the opportunity to separate from the monetary
union with the rest of Spain, they would have experienced a sharp devaluation,
which would have stimulated exports and fuelled a strong growth recovery in the
short-run. This was not, however, a politically feasible option. Why didn’t these
damaged regions choose to quit the currency area? Had these areas exited the
monetary union, they would have incurred huge losses as compared to short-term
competitive gains. What happened instead?
(i) investment opportunities remained in the chemical, textile, construction, and
other sectoral economic activities, which were concentrated in the north-
ern areas of Spain. As a result, physical capital flowed to areas in economic
expansion and absorbed the redundant employment, which was coming from
the depressed areas in the South (Cadiz) and the East (Valencia). Thanks to
factor mobility, workers from Cadiz and Valencia moved freely to those
Spanish areas which were experiencing both a moderate economic expansion,
and the corresponding increase in the demand for labour;
(ii) because most of these workers remained within the country, the savings that
Spanish society had previously used to invest in training and retraining this
human capital were not lost but fully exploited within Spain, thus contributing
to the financial sustainability of the Spanish pension system;
(iii) those workers who had fewer job opportunities in the Northern industries and those
who remained unemployed in the Southern/Eastern regions, received financial sup-
port from the national unemployment benefits schemes funded through the Spanish
national social security fund which, in turn, was mostly funded with the social
security contributions from people working in the North/Centre and North/East

areas in expansion;
(iv) to correct for the regional imbalances, which had been exacerbated by
the asymmetric negative shock, the central government set up a plan to
2 The Economic Rationale of Fiscal Rules in OCAs