Pelgidis mitsopoulos whos to blame for greece; austerity in charge of saving a broken economy (2016)

Who’s to Blame for Greece?


Who’s to Blame for Greece?
Austerity in Charge of Saving
a Broken Economy
Theodore Pelagidis
NR Senior Fellow, Brookings Institution, USA and Professor of Economics,
University of Piraeus, Greece

and

Michael Mitsopoulos


© Theodore Pelagidis and Michael Mitsopoulos 2016
Softcover reprint of the hardcover 1st edition 2016 978-1-137-54919-8
All rights reserved. No reproduction, copy or transmission of this
publication may be made without written permission.
No portion of this publication may be reproduced, copied or transmitted
save with written permission or in accordance with the provisions of the
Copyright, Designs and Patents Act 1988, or under the terms of any licence
permitting limited copying issued by the Copyright Licensing Agency,
Saffron House, 6–10 Kirby Street, London EC1N 8TS.
Any person who does any unauthorized act in relation to this publication
may be liable to criminal prosecution and civil claims for damages.
The authors have asserted their rights to be identified as the authors of this
work in accordance with the Copyright, Designs and Patents Act 1988.
First published 2016 by
PALGRAVE MACMILLAN

Palgrave Macmillan in the UK is an imprint of Macmillan Publishers Limited,
registered in England, company number 785998, of Houndmills, Basingstoke,
Hampshire RG21 6XS.
Palgrave Macmillan in the US is a division of St Martin’s Press LLC,
175 Fifth Avenue, New York, NY 10010.
Palgrave Macmillan is the global academic imprint of the above companies
and has companies and representatives throughout the world.
Palgrave® and Macmillan® are registered trademarks in the United States,
the United Kingdom, Europe and other countries.

ISBN 978-1-349-58058-3 ISBN 978-1-137-54920-4 (eBook)
DOI 10.1057/9781137549204
This book is printed on paper suitable for recycling and made from fully
managed and sustained forest sources. Logging, pulping and manufacturing
processes are expected to conform to the environmental regulations of the
country of origin.
A catalogue record for this book is available from the British Library.
A catalog record for this book is available from the Library of Congress.
Typeset by MPS Limited, Chennai, India.


To Elli, Mark and the new baby boy who has arrived the same
month as the book! (T.P.)
To Georgia and our daughter Veronica (M.M.)


Contents
List of Figures and Tables

xi

About the Authors

xv

1 Introduction

1

Part I The “Party Period” before the Crisis
2 The Costs and Benefits for Joining a Common
Currency with Emphasis on Weaker Member States:
The Pre-Crisis Debate
2.1 Potential sources of conflicts/costs:
de-synchronization of business cycles
2.2 Demand disturbances and trade
2.3 Responses to labor market rigidities
2.4 Shortage of money stocks for the peripheral countries
2.5 External imbalances
2.6 The effect of a monetary union on trade
between member states
2.7 Ten years of EMU (2000–2009):
convergence or divergence prevailed?
3 Greece before the Crisis: The Critical Years
in Domestic Politics
3.1 The discussion in the Greek Parliament ahead of the
ratification of the Maastricht Treaty
3.1.1 References to the strategic advantages of EMU
membership and issues that relate to the common
currency area and the chances of success of the

country in it
3.1.2 References to the impact on employment
3.1.3 References to the impact on the macro-environment
3.1.4 References with regard to institutions, structural
reforms and the role of the state in the economy
3.1.5 References with regard to tax evasion
and tax reforms
3.1.6 References with regard to the issue of fiscal
consolidation
vii

7
7
10
11
14
15
16
18
25
26

28
31
31
31
34
34

viii Contents

3.2 Various other debates and key speeches in the Greek
Parliament during the term of the government that
brought the Maastricht Treaty for ratification
by the Greek Parliament
3.2.1 The role of Greece in Europe and the chances
of success
3.2.2 Employment and education
3.2.3 Growth enhancing structural reforms, privatizations,
and infrastructure projects and the role of the state
in the economy
3.2.4 Fiscal stabilization
4 IMF and EU Reports on Greece
4.1 IMF reports during the accession period (’90s) and
the 2000–2009 “golden years”
4.1.1 Assessment of the EMU accession
4.1.2 References to labor market policies
4.1.3 Recommendations for structural reforms
in product markets and professional services
and the content of these
4.1.4 References with regard to fiscal consolidation
and the content of the related initiatives
4.1.5 References to the reliability of statistics/extrabudgetary expenditure items
4.2 The implementation of the conditionality program:
fiscal consolidation and the issue of spending cuts
vs revenue increases
4.2.1 Research with regard to the policy mix
of fiscal adjustments
4.2.2 IMF progress reports on the Greek

Conditionality Program
4.3 European Union bodies’ reports and decisions
4.3.1 Annual country specific recommendations
by the Council, and European Commission
recommendations to the Council
4.3.2 The decision to admit Greece to the euro area

35
38
40

40
45
56
56
59
60

62
64
68

68
74
77
80

81
85

Part II Greece’s Free Fall 2010–2013
5 The Troika Period Reconsidered
5.1 The Greek public finances and debt: a brief overview

93
93


Contents ix

5.2 The run up to the memorandum
5.3 What the memorandum initially provided
5.4 Implementing the memorandum as of
September 2011 and the Medium Term Fiscal Strategy
5.5 Incentives and unraveling the impasse
Appendix to Chapter 5: OECD structural indicators in
key network industries
6 Assessing the Intentions of the Government(s) since the
Ratification of the Maastricht Treaty
6.1 The 1990–1993 program, design, and implementation
6.2 The 2010 program: design, implementation,
and comparison with the 1990–1993 approach
6.3 The “internal devaluation” fallacy of 2010–2012
6.4 The other side of the internal devaluation
fallacy – the approach to the labor market
deregulation during 2010–2012
6.5 The lack of a strategy to enhance growth – in Greece
and in Europe
6.6 The private sector death-trap: undermining the
financial sector, jeopardizing macroeconomic stability,

and questioning the European future of the country
6.6.1 The Private Sector Involvement (PSI)
6.6.2 Euro area exit

101
101
103
107
110

117
117
118
123

127
136

139
140
145

Part III Looking Ahead
7 Greece: Why Did the Forceful Internal Devaluation
Fail to Kick-start an Export-Led Growth?
7.1 Introduction
7.2 Employment
7.3 Wages and earnings
7.4 Labor cost indexes and exports
7.5 Conclusions and further remarks

155
155
156
159
181
192

8

Giving Greece a Chance to Succeed

195

9

How to Design a Closer and More Democratic Union
9.1 The compromise of the euro area: common monetary,
national fiscal, and structural policies
9.2 Evaluating the current structure of powers and
democratic mandates

205
205
206


x Contents

10

9.3 How changes in the structure of the democratic
mandates can secure a “closer and more
democratic” Union
9.4 The role of European parties

209
215

Conclusions

218

Afterword
The Greek Bail-out Drama: Is This Time Different?

225
225

Author Index

228

Subject Index

230


List of Figures and Tables
Figures

2.1

McKinsey presentation of lack of adjustment
mechanism in euro area

12

2.2

Labor migration in key economic areas

13

2.3

Intra-EU and intra-euro area shares of export on
total export of the two groups respectively

17

2.4

Divergence of current accounts within the EMU

19

5.1

Net revenue, primary expenditure, and interest expenditure
of Greek central government budget

94

5.2

“Interest cover” of Greek general government

96

5.3

OECD structural indicators in key network industries

114

5.4

OECD PMR indicator: Greece and average of
euro area countries that are also OECD members

115

6.1

Public and private sector employment to
population ratio, 2013

125

6.2

Tax wedge in Greece, 2014

128

6.3

Self-employed to employees ratio, 2014

130

6.4

Compensation per employee, 2014: gross compensation,
including all Social Security Contributions and value
of benefits, thousands of euro per year

131

Annual gross compensation per employee, including
all Social Security Contributions and benefits: thousands
of euros per year, 2013

132

Personal income tax (PIT) and Social Security
Contribution (SSC) revenue as % of GDP, 2012

133

6.7

Share of employment by company size class, 2013

134

6.8

Gross monthly basic wage per employee (including only
employee Social Security Contribution) per company size
class, euros per month

134

6.5

6.6

xi


xii List of Figures and Tables

6.9

Full-time employees, employed per company size class

135

6.10

Public finances structure: key revenue and expenditure
items 2013 General Government budget (billion euros)

137

7.1

Employment and unemployment (thousand of persons)

156

7.2

Total employment to population ratio: euro area and Greece

157

7.3

Employment in government and pensioners/former
government employees: 1,000 employees/pensioners

158

Compensation of employees for total economy
(% of GDP)

159

7.5

Compensation of employees, corporations (% of GDP)

160

7.6

Compensation of employees, Greece (% of GDP)

160

7.7

Compensation of employees (% of GDP, total economy
minus corporations)

161

7.8

Average gross wage per day, euros

163

7.9

Average gross wage per day (% YoY change)

164

7.10

Number of employees

165

7.11

Employment and basic salary (% YoY change)

166

7.12

Labor cost index: market activities

168

7.13

Nominal compensation per employee (thousands of
euros annually)

169

7.14

Administrative cost and gross wages and salaries of
private sector (% of GDP, 2003)

171

7.15

Regulation of product markets and corporate wage bill
(% of GDP, 2013)

172

Profit before tax to sales: non-financial corporations –
limited companies and partnerships or equivalent
legal form, 2008

173

Profit before tax to total assets: non-financial
corporations – limited companies and partnerships or
equivalent legal form, 2008

173

Distribution of employees insured at IKA per bracket
of gross monthly wage. Companies with up to 24 insured.
Full-time employment only

176

Distribution of employees insured at IKA per bracket
of gross monthly wage. Companies with 25–249 insured.

Full-time employment only

177

7.4

7.16

7.17

7.18

7.19


List of Figures and Tables xiii

7.20

Distribution of employees insured at IKA per bracket of
gross monthly wage. Companies with over 250 insured
employees. Full-time employment only

177

7.21

Distribution of employees insured at IKA per bracket
of gross monthly wage. Companies with up to 49 insured
employees. Part-time employment only

178

7.22

Deviation of pay in sector and provisions of sectorial wage
agreements in Greece for the year 2009. Difference of sector
minimum wage from basic national agreement. Euros
180

7.23

Real unit labor cost. Total economy, performance relative
to the rest of former EU-15

181

Stock to sales and road haulage regulation, 2008.
Non-financial sector private and public limited companies

182

Journeys and regulation of road freight haulage.
National transport, all own account and for hire trucks

183

7.26

Taxes on electricity for industrial use. Consumption “C”

in the 20,000 MWh
184

7.27

Excise tax. Euro per unit. 2014. Consumption for
industrial use

185

Labor and energy costs as % of all costs for key energy
intensive industries

185

Exports of energy intensive and non-energy
intensive goods, Greece. Quarterly data

186

Exports of energy intensive and non-energy
intensive goods, Greece. Quarterly data

187

7.31

Exports of iron and steel products, Greece and Portugal

188

7.32

Exports except mineral fuels for Greece and Portugal.
Quarterly data

189

7.33

Exports of textiles, yarn, fabrics, apparel, clothing,
and accessories. Greece and Portugal

190

Interest rates, national difference with euro area average.
Loans to non-financial corporations

191

8.1

Deposits and financing from Greek MFIs

196

8.2

Interest rates on Greek government debt and on corporate

loans, non-financial corporations (NFC), 2009–2014

198

Debt to GDP ratio. Euro area countries, 2014. Loans
issued by MFIs and government debt

199

7.24
7.25

7.28
7.29
7.30

7.34

8.3


xiv List of Figures and Tables

8.4

Non-performing loans as a % of all loans and
unemployment, Greece

200

8.5

Accumulated provisions by Greek main
financial institutions

201

9.1

Mandates and powers of European bodies.
Current state of 2012, does not include co-decision

207

9.2

Moving in parallel mandates and powers

209

9.3

Mandates and powers of European bodies.
Proposed structure

211

Tables
4.1

Fiscal measures foreseen by the MoU and actually
implemented, according to budgeted numbers, by
the Greek government. Mid-April 2010

70

Fiscal measures foreseen in 2011 Medium Term
Fiscal Strategy (MTFS) for Greece, June 2011,
and item-by-item sum of measures immediately
legislated for implementation

71

4.3

Indicative 2011–2012 statements by officials and opinion
leaders that may have contributed to the fear of markets
about an impeding exit of Greece from the euro area

73

5.1

Macroeconomic indicators, billions of euros

95

5.2

Finances of general government

98

4.2


About the Authors
Theodore Pelagidis is a non-resident senior fellow at the Brookings
Institution, USA, and Professor of Economics at the University of Piraeus,
Greece. He has also been a NATO scholar at the Center for European
Studies at Harvard University, USA; an NBG fellow at the London School
of Economics, UK; and a Fulbright professorial fellow at Columbia
University, USA. He has also served as an advisor to the International
Monetary Fund in the Independent Evaluation Office, USA.
Michael Mitsopoulos holds a PhD in Economics from Boston University,
USA. He is an economist at the Hellenic Federation of Enterprises,
Greece, and has taught at the University of Piraeus and the Economic
University of Athens, Greece. He has published in academic journals and
is the co-author with Pelagidis of Understanding the Crisis in Greece: From
Boom to Bust (2011) and of Greece: From Exit to Recovery? (2014).

xv


1
Introduction

The strategic failures in the approach to deal with the problems of the
Greek economy, namely the disproportionate internal devaluation of
the private sector and the tax base with respect to the milder internal

devaluation of the government expenditure, has certainly taken place
in the context of a country that was asked to undertake one of the most
difficult adjustments made by any country and through a deal that
appeared to be ignoring important warning signs (Mitsopoulos and
Pelagidis, 2011, 2012; Pelagidis and Mitsopoulos, 2014). Essentially,
the 2010 and onward sequential deals amounted to agreeing with the
political leadership and the administration of an economy that has
been turned by the former into a quasi-soviet economy at the fringes
of free markets that they will tear down the bureaucracy that has been
established for over 30 years, while being offered the cash and support
to keep operating largely in a “business as usual” environment.
It is within such a context that there were few apparent efforts to shift
the balances in favor of the productive sector of the economy as a necessary precondition for success. The lack of such an effort has been paired,
after 2010, with a number of other unfortunate policy choices, both
by the Greek government and by the creditors – the IMF, ECB, and the
European Commission. These have further burdened the prospects of
the private sector even as they kept the profligate state on life-support for
at least three years. In particular, these are (a) the gradual entrenchment
of macroeconomic imbalances as a permanent situation, (b) the delayed
PSI, and the large PSI of October 2011, as outlined in the respective
Euro Area Summits statements, and (c) the uncertainty that stems from
tying the European prospects of the whole of Greece with the insufficient willingness of the government to implement the agreed program.
Overall, the above have managed to add to the private sector of the
1


2 Who’s to Blame for Greece?

economy, in addition to the burden of persisting fiscal problems and
competitiveness deficit, the impact of a full-blown liquidity crisis. So,

the question that springs in mind after all this policy failure is identical with the title of this book: Who’s to Blame for Greece, and, more
importantly, what lessons for the future can we learn from the failures
of the past?
In this context, the first part of the book sets the theoretical context in which Greek policymakers, politicians, and the public opinion
matured the decision to adhere to the single currency. In this setting,
in Chapter 2, we briefly present the relevant debate in the literature
concerning the costs and benefits of joining a currency union. This is
necessary to examine the impact of the fundamental discussion that
took place 20 years ago in the country, on the costs and benefits of getting rid of the drachma and join the euro area as well as to understand
both the constraints and the opportunities that Greece’s economy has
faced since 2010.
In Chapter 3, we elaborate and analyze for the very first time in the
relevant literature, material that reviews what economic theories and
narrative shaped the understanding of Greek policymakers and politicians about costs and benefits for Greece to join the single currency.
We then match this narrative with the declared policy strategy, and its
implementation, by the government that introduced the Maastricht
Treaty for ratification, in order to investigate the extent to which its
conviction that Greece could succeed to enter on equal terms as a constructive member country was well-founded.
In Chapter 4, we examine the IMF Director’s, and supporting staff,
reports on Greece from 1990 on, as well as the European Council
recommendations to Greece and the preceding European Commission
recommendations to the Council. We present these in order to place
them in context with the key issues raised in Chapter 3, as well as with
the recent developments in Europe and the country.
The central aim of the second part and originally of Chapter 5 is
to reconsider the troika period, focusing especially on the first three
years of the program, where the adopted policy is supposed either to
have failed or/and faced significant headwinds. We initially focus on
the Greek public finances and debt. We analyze conditions that led
to the first Memorandum of Understanding (MoU) and we present an

analysis on what it initially provided. We follow the implementation of
the MoU and the fiscal strategy involved in it. We focus in particular
on the equilibrium between the opposition to reform and the nexus of
state sponsored privileges in the country. In the end, this analysis, and


Introduction 3

the supporting facts, are contrasted with the criticalities emerging from
the ex post analysis of surveillance reports done by international organizations and the other material of Chapters 3–4.
In Chapter 6 we assess the intentions of the government that ratified
the Maastricht Treaty in view of the current developments and place the
developments in Greece within a broader context of European policies
and approaches. In particular, we assess the experience of Greece, and
other European countries, that implemented at the same time structural
and fiscal reforms, and compare them with the impact of the one-sided
implementation of the conditionality program in Greece after 2010. We
also attempt a preliminary assessment of where this one-sided implementation has led the country, and what can be done from now on.
In the third part of the book, Chapter 7 assesses the results on the
critical domain of exports. In particular it explains the reasons that the
internal devaluation failed to kick-start an export led growth. It focuses
on employment and wage earnings and reveals the real costs that made
exports to grow albeit at an insufficient pace.
Chapter 8 analyzes the financial conditions needed for Greece to
recover at a rate that would make not only the debt fraction to GDP
sustainable but also increase significantly employment. The section
deals with the financial sector and more specifically with the conditions
needed to finance the private sector.
Chapter 9 addresses the issue of institutional reforms for the euro
area itself, elaborating on the notion and a project for a closer and

more democratic union to heal economic asymmetries. This is critical
for the southern euro area member states and especially for the weakest
economy among them, Greece, if it is to get its economy back on track
and recover.
Finally, in Chapter 10, we conclude.
In Afterwords, we focus on the rise of Syriza to power and the consequences to the economy.

References
Mitsopoulos, M. and T. Pelagidis (2011), Understanding the Crisis in Greece,
London: Palgrave Macmillan.
Mitsopoulos, M. and T. Pelagidis (2012), Understanding the Crisis in Greece. From
Boom to Bust, London, Palgrave Macmillan, 2nd edition.
Pelagidis, T. and M. Mitsopoulos (2014), Greece. From Exit to Recovery?,
Washington, DC: Brookings Institution Publ.


Part I
The “Party Period” before
the Crisis


2
The Costs and Benefits for Joining a
Common Currency with Emphasis on
Weaker Member States: The Pre-Crisis
Debate

2.1 Potential sources of conflicts/costs:
de-synchronization of business cycles
Long before the crisis, the dominant theory of an Optimum Currency Area

(OCA) was that there are necessary conditions or properties for success
(Mundell, 1961; McKinnon, 1963; Kenen, 1969). The basic premise
was that the fundamental requirement for a successful currency area
is wage/price flexibility and mobility of factors of production as well as
harmonization of economic and political institutions. This injects sufficient flexibility in the system to hedge against the so-called “asymmetric
demand shocks/disturbances”. Asymmetric shocks are demand shocks
or disturbances that hit two or more regions or countries with a common
currency. When shocks are asymmetric, business cycles between two
countries – let us assume Greece and Germany – are de-synchronized.
De-synchronization of business cycles means that Greece experiences,
for example, a negative growth rate along with relatively low inflation,
while Germany experiences, at the same time, a high growth that goes
with low unemployment. Then, the two countries need different
monetary stabilization policies. Greece needs some accommodation
through decreasing interest rates in order to stimulate economic activity,
while Germany needs some contraction to fight an excessive inflation
rate. Then, the dilemma that the European Central Bank (ECB) faces has to
do with the diversified stabilization prescriptions the two aforementioned
economies require.
What it is important to recognize is that the incidence and magnitude
of demand shocks or disturbances ultimately depend on the output mix
and degree of specialization across countries and regions. These factors
can in turn undermine the OCA. The European Monetary Union (EMU)
7


8 Who’s to Blame for Greece?

process itself tends to create some convergence (Rose and Stanley, 2005)
but at the same time it also tends to, ironically, deepen the market integration that increases the degree of sector specialization and reinforces

differences in the structure of production and demand (Baldwin, 2006).
The greater the differences in the structure of production, the greater
will be the asymmetric incidence and magnitude of demand shocks
on individual countries and regions. Institutional divergences in wage
setting, for example, may lead in particular to divergent wages and
employment tendencies and worsen adjustment problems, and differences in economic and financial practices1 may also lead to the various
national financial markets working differently across the euro area.
Furthermore, the greater the difference in the structure of production,
the greater the incidence and the magnitude of the demand shocks
that individual countries and/or peripheries experience and, thus, the
lower their speed of adjustment, if any, in the case of the labor markets remaining rigid.2 Eichengreen (1997) provided evidence that the
countries at the center of the EMU (Germany, France, the Netherlands,
etc.) experience very different supply shocks from those affecting other
member states, such as Italy, Portugal, Spain, Ireland, and Greece.
In the case of multiple countries and currencies, governments are
able to use demand management policies to face idiosyncratic shocks,
namely succeed in adjustment by applying accommodating monetary
policies and using the exchange rate instrument to correct external
disequilibrium (amid inflationary pressures). Currency can depreciate to
lower relative prices and underpin demand or it can devalue. The greater
the asymmetric shock, the higher the option value of independent
domestic monetary and exchange rate policy. However, EMU, by definition, involves the sacrifice of the monetary autonomy, and in the euro
area authority for the implementation of a single and non-differentiated
monetary policy now belongs to the ECB. As economic integration
proceeds and diversity of production structures deepens across the euro
area, a negative aggregate demand shock is expected to have different,
heterogeneous impact on member states and regions. In this case, the
cost of adjustment within the euro area depends on the size and incidence of asymmetric real shocks, as well as on the efficacy of the alternative adjustment mechanisms, namely, labor market mobility/flexibility
and fiscal policies (Obstfeld, 1997). Otherwise, the country hit by shock
must deflate internally by lowering its wages through a policy of “internal devaluation,” accepting unemployment and economic recession.

Empirical evidence has shown that asymmetries in the EMU
between core and peripheral countries were persisting well before the


The Costs and Benefits for Joining a Common Currency 9

crisis (Bayoumi and Eichengreen, 1992a,b; Bordo and Jonung, 1999;
Krueger, 2000; Obstfeld, 2000; Dunn, 2001; Baldwin, 2006) and that
they coincide with non-synchronized business cycles among member
states. An assessment which culminated in 2003 of the case for the UK
joining the EMU by HM Treasury was in general agnostic. Regarding
the specific issue of business-cycle synchronization, however, the
assessment failed to uncover strong evidence in support of such synchronization. Therefore, as the asymmetry of demand shocks raises
regional unemployment by destroying industries and jobs, there is
a need for monetary accommodation (i.e., increase of money supply
and lower interest rates) to offset fluctuations and restore growth and
employment. For example, in the case where Greece suffers a permanent fall in GDP or in exports, output contracts and unemployment
rises as currency depreciation is excluded from policy tools, and wages
and prices are rarely flexible enough to react to economic slumps
without causing a severe rise in unemployment. The possible refusal
of ECB to implement an expansionary monetary policy in order to
avoid recession in Greece had some people being afraid that such an
attitude may cause continuing dissatisfaction among the Greeks and
other EMU public.
On the other hand, a decision by the ECB to implement monetary
accommodation by lowering the rate of interest may cause continuing
dissatisfaction among the anti-inflationary countries, such as Germany
(Feldstein, 1997). Economic disagreement over monetary policy may
then cause general environment distrust among member states and, as
a consequence, could very possibly bring about political disputes and

instability. The ECB, thus, may face pressures that cannot all be dealt
with (e.g., see Frieden, 1998).
The critical role of a central bank is also confirmed by Cooper and
Kempf (2004). In an economy with monetary policy alone, they confirm the presence of the Mandellian trade-off (between unification and
monetary autonomy) and find that, indeed, a monetary union will not
be welfare improving if the correlation of national shocks is too low.
However, the authors find that fiscal interventions by national governments, combined with a central bank that has the ability to commit to
monetary policy, overturn these results with welfare improving for any
correlation of shocks. Similarly, Beetsma and Giuliodori (2010) emphasize the complications that a monetary union poses for fiscal policymaking as governments policy objectives for a high and stable level
of economic activity may come at odds with ECB’s goal of stabilizing
inflation at a level below 2%. That, according to Dixit and Lambertini


10 Who’s to Blame for Greece?

(2001, 2003) may lead to extreme outcomes that make member states
worse off.
Therefore, in the case of the net real economic effect being negative, instead of increasing intra-EMU harmony, fostering stability and
promoting further integration, single currency may, according to some
authors (like Dixit and Lambertini 2001, 2003), more likely lead to
increased political conflicts within the EMU, with a number of adverse
consequences, as is the euro area’s experience today.

2.2 Demand disturbances and trade
Optimistic voices emphasized that the establishment of the euro, besides
other benefits, also would favor a further increase in the volume of trade
among EMU member states and in trade dependence, thereby increasing
welfare (Emerson et al., 1992; Rose, 2000; Rose and Stanley, 2005). Some
authors’ results could support such optimistic predictions as having
the volume of trade tripled by monetary union participation (Rose,

2000, Rose and Engel, 2000). The elimination of currency fluctuations
within the EMU was expected to mark the end of a period of uncertainty, which is considered to diminish trade itself and trade-promoting
benefits (McKinnon, 1994). In addition, since the EMU member states
enjoy a large volume of trade among them, it was seen to be to their
benefit to abolish national currencies, as the exchange rate policy tool
becomes inefficient in tackling unexpected real asymmetric shocks.
On the other hand, free trade combined with fixed exchange rates
to a large extent prevent governments from devising their domestic
financial policy for the purpose of preserving domestic stability. With
an exchange rate irrevocably fixed and the level of prices of domestically
produced goods “sticky” to an unsupportable level, the loss of competitiveness can possibly lead to a fall in exports and, as a consequence, of
trade volume. This way, overall trade both within the EMU and, as a
consequence, between the EMU and other trade partners may decrease
in the worst-case scenario. For the weakest Mediterranean EMU countries, it was argued that there may be an increase of trade balance problems in particular. In fact, external deficits for Portugal and Greece at the
time that they joined the euro area were as high (16% and 14% of GDP
respectively), the same as they were in 1990; higher than they were right
after the implementation of convergence policies (around 12–13% in
1992–1993 for both countries3). The deterioration of the external position of the aforementioned countries might be, at least partly, attributed
to a loss of competitiveness provoked in turn by the “hard currency”


The Costs and Benefits for Joining a Common Currency 11

convergence strategy followed during the 1990s on the road to EMU4
and, of course during the following “euro area period”(2000–2010).
The inefficiency of EMU mechanisms in facing the incidence and
magnitude of demand disturbances under a single currency regime,
might impair production systems and so diminish trade, particularly
in lagging regions, which otherwise may be able to survive. Trade and,
as a consequence, welfare may then also diminish, as an individual

member state could not leave its currency free to fall in line with a
fall of a foreign currency, such as the dollar, to maintain exports. If
economic growth in such weak EMU countries (or regions) kept up with
that external balance pressure, an overvalued euro would not be such a
problem. But if it did not, as the most possible scenario might suggest,
an “expensive” euro might cause a further loss of competitiveness,
deepening the initial asymmetric shock.
Moreover, a country, which trades to a large extent with countries
outside the EMU, is likely to be affected by large fluctuations in the
euro–dollar exchange rates. Such countries are Greece (around 50%
trade with non-EMU countries), Ireland, and Finland, while other countries such as Austria, Benelux, and Portugal are unlikely to be affected
so much. The observed sharp differences, which exist within the EMU
area, are large enough for the one-size-fits-all monetary policy to be
effective. Thus, the larger the differences, the greater the strains in
managing the dollar–euro exchange rate, and the greater the political
disputes over the appropriate policy.

2.3 Responses to labor market rigidities
The view of many analysts was that postponing the idea of a federal,
truly unified euro area deprives the EMU from the absolutely necessary,
according to OCA theory, option of a strong redistribution of income
among European regions and/or member states through a high(er), as
percentage of GDP, European budget. Idiosyncratic shocks, low mobility
of factors of production, stickiness of wages and prices, and quite low
economic performance in the so-called peripheral EMU southern countries, seriously obstruct the accommodation of shocks by changing relative prices and costs. Cohen et al. (1997) put the blame mainly on the
high cost of firing workers, while Abowd et al. (1997) emphasized the ill
effects on jobs of a high minimum wage, which negatively affects the
growth rates and, as a consequence, the creation of net new jobs. Similarly,
Blanchard and Wolfers (1999) and Blanchard (2000), pointed-out that
labor market rigidities magnify the effects of shocks, although tight

12 Who’s to Blame for Greece?

macroeconomic policies still remain the number one culprit for the
high rate of unemployment in the EMU.5
As far as the European periphery in particular is concerned, the available data confirmed the aforementioned stories. As Figure 2.1 below
shows, the regulatory framework and employment protection legislation was fairly strict by international comparison at least at the time of
euro inauguration, in the EMU and in its periphery in particular, with
the exception of Ireland. As a consequence, the economies could hardly
absorb asymmetric shocks as labor market rigidities get in the way of
any adjustment effort. Figure 2.1 also shows that labor flexibility was
limited and differed from country to country in the EMU at the time
of the euro inauguration. Thus, given that labor flexibility is a prerequisite as a channel for adjustment in a monetary union, and since
the exchange rate instrument can no longer serve as an adjustment
mechanism, as Alesina et al. (1997) correctly emphasize, aggravation of
social tensions and increased political conflict both within and across
countries might be a possibility.

EMU lacks the adjustment mechanisms necessary to compensate for the loss of
exchange rate flexibility
... but alternative mechanisms have not been activated
Flexibility of real
wages and industry
adaptability1
EMU has
removed floating
Capital and
exchange rates
as an adjustment labor mobility

mechanism...

Increase in unit labor costs, 2000–10
Percent
Germany 2
Greece

35

Interstate immigration, 2008
Percent
EU
0.18
US

2.80

Fiscal transfers, 2009
Percent of GDP
Fiscal transfers

EMU
US

0.1
2.3

1 Countries in EMU relying on globally less competitive industries have not been able to reorient activities
towards more attractive sectors

Figure 2.1 McKinsey presentation of lack of adjustment mechanism in euro area
Source: McKinsey & Company (Germany) (2012), The Future of the Euro: An Economic
Perspective on the Euro Area Crisis, McKinsey.


The Costs and Benefits for Joining a Common Currency 13

EU

Canada

Australia

US
0

0.5

1

1.5

2

2.5

3

3.5

%
Figure 2.2 Labor migration in key economic areas
Source: US Census Bureau, Current Population Survey, Eurostat LFS. McKinsey & Company
(Germany) (2012) analysis of this data.

As far as the antidote to labor migration (Figure 2.2), the shorthand
for labor market flexibility, is concerned, labor flows of euro area
nationals remained significantly low. Indeed, net EMU-national and
non-EM national migration to EMU has been sharply curtailed since the
internal market was inaugurated.
The existing social, cultural, and language barriers that significantly
contribute to the low propensity of workers to migrate away from
countries and regions where unemployment exceeds the local natural
rate (Obstfeld and Peri, 1998), operate similarly within each country.6
Krueger (2000) presents evidence confirming that region-to-region
migration is more than twice as high in the US as in many euro area
countries and so euro area unemployment cannot be headed-off by
emigration. The US absorbs asymmetric shocks by migration while the
euro area does it by a reduction in the labor force participation rate.7 It
is evident that, in the EMU case, labor does not migrate if one member
state or region flounders. With rigid labor markets, cyclical unemployment turns into structural.
A generous increase of the EMU budget could partly offset labor market rigidities. The EMU budget represents only 1% of the EMU combined
GDP, a much lower share than what the Commission itself has proposed
in the past (5–7% of GDP) to moderate idiosyncratic business cycles.8
In the US, the federal budget is four times higher than even those past
EMU proposals. Through transferring tax revenues to disadvantaged