Global Economics Paper: 224 - TAUyashiv/gs_emu.pdf · Global Economics Paper: 224 Economics Research What makes a monetary union work? As European policymakers attempt to construct

April 29, 2014

Global Economics Paper: 224

Economics Research

What makes a monetary union work?

As European policymakers attempt to construct the Euro area’s post-crisis steady state, we seek to

provide investors with a framework to assess whether the institutional changes and structural reforms

being implemented will be sufficient to ensure EMU’s long-term survival.

We argue that establishing the right fiscal and financial institutional framework – to deal with problems

when they occur – is more important than trying to ensure that the economic conditions for a monetary

union are ideal.

While real wage flexibility and – to a lesser extent – labour mobility have important roles to play in the

adjustment to regional shocks, business cycle synchronisation and trade integration appear less important.

The negotiations taking place to develop the Euro area’s steady-state framework have developed along

two separate institutional dimensions: one seeks closer fiscal integration, while the other seeks closer

financial/banking integration. Because fiscal and financial integration can act as substitutes for each other,

neither approach is necessarily ‘correct’.

Progress along the fiscal dimension has largely stalled. While the European Stability Mechanism (ESM)

and the ‘enhanced surveillance’ procedure have altered the Euro area’s fiscal framework, there appears

little prospect of more radical options – such as common Eurobond issuance – being implemented.

Progress along the financial dimension remains ongoing, through efforts to establish a Euro area banking

union. But the more far-reaching options along this dimension – such as the introduction of common

deposit insurance – also appear unlikely to be implemented.

Whether the changes that are being implemented will make the Euro area’s institutional structure

sufficiently robust to deal with a future crisis is questionable.

Investors should consider this report as only a single factor in making their investment decision. For Reg AC certification and other important disclosures, see the Disclosure Appendix, or go to www.gs.com/research/hedge.html.

Kevin Daly

+44(20)7774-5908 [email protected] Goldman Sachs International

The Goldman Sachs Group, Inc. Global Investment Research

Kevin Daly and Simon Wan would like to thank Huw Pill, Jan Hatzius, Dom Wilson and Dirk Schumacher for their advice and

detailed comments on previous drafts of this paper. Simon was an intern with the European Economics team.

April 29, 2014 Global Economics Paper

Goldman Sachs Global Investment Research 2

Contents

Overview: What makes a monetary union work? 3

Chapter 1: Introduction – A factor-by-factor analysis of what makes a monetary union work 7

Chapter 2: The role of ‘economic’ factors – synchronisation of business cycles, trade integration, labour mobility and

wage flexibility 9

The synchronisation of business cycles 9

A high degree of trade integration 13

A high degree of labour mobility 15

A high degree of wage flexibility 19

Chapter 3: The role of ‘institutional’ factors – fiscal transfers, financial integration and political union 21

Mechanisms for fiscal transfers 21

Financial integration and banking union 23

Political integration 26

Chapter 4: Conclusions: Institutional reform plans are not yet sufficiently robust 28

Bibliography 31

Disclosure Appendix 34



Overview: What makes a monetary union work?

Making ‘EMU 2.0’ workable

Market concerns over the survival of the Euro have subsided since ECB President Draghi

made his pledge to do “whatever it takes” to preserve monetary union in July 2012. Yet the

quest to make the Euro area a more ‘workable’ monetary union still faces significant

challenges. At the area-wide level, institutional reform is needed to improve Euro area

governance; and, at the national level, the painful processes of economic restructuring,

fiscal consolidation and private-sector deleveraging all have some way to go before

financial and macroeconomic imbalances are unwound and the conditions for sustainable

economic growth restored.

As European policymakers negotiate the structure of ‘EMU 2.0’, this paper seeks to offer

investors a framework to assess institutional changes and structural reforms and their

implications for the Euro area’s long-term survival. We do not assess the factors underlying

the Euro area’s broader economic performance – many economies that have low GDP per

capita levels and/or growth rates still function well as a monetary union. Rather, our focus

is on establishing the criteria required to ensure that internal adjustments do not prompt

periodic existential crises.

A natural starting point for such an analysis is the (pre-crisis) Optimal Currency Area (OCA)

literature. This proposes a list of at least seven criteria that determine the optimality of a

currency union:

1. Synchronisation of business cycles, so that one monetary policy can fit all.

2. A high degree of goods market (trade) integration between participating states,

to maximise the benefit of sharing a single currency.

3. A high degree of inter-regional labour mobility, to aid in the adjustment to

region-specific shocks.

4. A high degree of wage flexibility, to allow real exchange rate adjustments to play

out more easily in the absence of nominal exchange rate flexibility.

5. Mechanisms for fiscal transfers – such as fiscal federalism – to offset the

negative consequences of region-specific shocks.

6. Financial integration – either via a unified banking system or via greater capital

market integration – to enable greater risk-sharing across the monetary union.

7. A high degree of political and institutional integration, to promote the

acceptance of region-specific shocks (among the electorates of participating states)

and the irrevocability of monetary union (in financial markets).

It is a demanding list. And, were it the case that a high degree of each of these criteria was

required to ensure the Euro area’s long-term survival, then the Euro area would be unlikely

to survive in the long term. But few economies fully satisfy each of the criteria set out

above, yet many function effectively as monetary unions. So, rather than focus on what is

required to make a currency union optimal, we focus on what makes it workable – i.e., we

attempt to separate the necessary from the ‘nice to have’.



Institutions matter more than ‘economic’ factors

Our analysis draws on the experience of the Euro area and that of the US – a similarly-sized

economy, with diverse states, which (self-evidently) functions as a monetary union.

The seven criteria set out above can be broadly grouped into ‘economic’ factors

(synchronisation of business cycles, the degree of trade integration, labour mobility and

wage/price flexibility) and ‘institutional’ factors (mechanisms for fiscal transfers, financial

integration and political union). One key finding from our analysis is that establishing the

right institutions – to deal with problems when they occur and to help ensure that the

monetary union is credible – is more important than trying to ensure that each of the

‘economic’ conditions for a monetary union are met. While real wage flexibility and – to a

lesser extent – labour mobility have important roles to play in the adjustment to regional

shocks, we argue that business cycle synchronisation and trade integration are less

important than implied by the pre-crisis Optimal Currency Area literature.

Of course, the various characteristics identified by the OCA literature interact with one

another: on some dimensions, they may be complements; on other dimensions,

substitutes. Moreover, the distinction between economic and institutional aspects is – in

some respects – somewhat artificial: for example, wage flexibility and labour mobility

reflect the institutional structure of the labour market in the same way that the extent of

financial integration dictates the mobility of capital across intra-Euro area borders.

That said, in drawing some main messages from our analysis of the seven characteristics

of a currency area listed above, we find the following:

A high degree of business-cycle synchronisation does not appear to be a

necessary condition in making a monetary union work. First, Euro area countries

have exhibited more business-cycle synchronisation than US states on most

measures in the 15 years since EMU began and yet the US functions as a

monetary union while the Euro area currently does not. Second, looking at the

performance of US states over a longer timeframe, we find that severe and

persistent state-specific economic shocks are commonplace, yet this has not

prevented the US from continuing to function as a monetary union.

A high degree of trade integration does not appear to be a determining factor of

workability: the Euro area exhibits a high degree of trade integration but has not

functioned well as a monetary union.

A high degree of labour mobility does not appear to be a sufficient condition of

workability. While labour mobility is higher in the US in general, the response of

net migration to unemployment differences does not appear significantly different

in the Euro area from that in the US, so it is difficult to argue that labour mobility

represents the key distinction between the US’s functioning monetary union and

the Euro area’s malfunctioning union.

A high degree of real wage flexibility – in allowing easier real exchange rate

adjustment – appears to play an important role in offsetting the effects of lost

nominal exchange rate flexibility. Real wage flexibility is higher in the US than in

the Euro area and this greater degree of wage flexibility appears to play an

important role in US regional adjustment.

Fiscal transfers play an important role in offsetting region-specific shocks in the

US but not in the Euro area. We find that the US’s federal fiscal system directly

offsets around 25-30% of the initial effect on income from state-specific economic

shocks, but that only half of this is due to inter-regional insurance. The other half is

due to inter-temporal smoothing, which can be provided by national tax systems.



Integrated financial and banking markets provide an important means of risk-

sharing in the US and other monetary unions. To the extent that private financial

markets facilitate the sharing of region-specific shocks, this can offset the need for

fiscal risk-sharing (all else equal). That said, one lesson from the Euro area crisis is

that, without the appropriate regulatory structures, greater financial market

integration can also result in increasing overall risks, rather than greater risk-

sharing.

The importance of greater institutional integration is reinforced by the self-

fulfilling aspect of the perception of irrevocability (among investors and

electorates). An important reason why the ‘US Dollar zone’ functions as a

monetary union – despite the existence of frequent and substantial state-specific

shocks – is because few question its existence. When a US state is hit by a

negative shock, it does not face the additional burden of a rise in funding costs

resulting from the perceived risk that it may leave the Dollar zone. By contrast, the

defining characteristic of the Euro crisis has been the emergence of what Mr.

Draghi has labelled “convertibility risk”. As concerns about a possible exit from

the Euro area emerged in some countries, the (natural) financial market response

(of widening spreads and increasing risk premia) exacerbated those concerns

rather than dampened them and the Euro area was placed on a destructive path.

Institutional reform plans are not yet sufficiently robust

The conclusion that ‘institutional’ factors (fiscal transfers, financial integration and political

union) and wage flexibility are more important than other ‘economic’ factors (cyclical

symmetry, the degree of trade integration and labour mobility) is – tentatively – positive for

the Euro area. This is because European policymakers have it within their power to adjust

institutional factors and to implement reforms that would increase wage flexibility,

whereas there is little they can do to adjust deeper economic relationships (such as

business cycle synchronisation and trade integration). This is not to suggest that adjusting

Euro area institutions or implementing labour market reforms to make EMU work is easy –

as it clearly isn’t – but it is at least possible.

In determining which criteria are necessary and which factors a monetary union can work

without, we also need to recognise that there is more than one way to make a monetary

union workable. As Huw Pill has argued in previous research, progress towards deeper

integration in one dimension can be a substitute for making progress along another.1 For

instance, the size of cross-country fiscal transfers in the Euro area may never match inter-

state transfers in the US, but a greater degree of risk-sharing through a more integrated

financial system could be sufficient to make EMU work.

The negotiations taking place to develop the Euro area’s steady-state framework have

developed along the two institutional dimensions discussed here: fiscal/political and

financial/banking. As the Euro area’s principal creditor country, Germany has fought to

ensure that fiscal and financial risks will not be shared across either dimension without

countries first displaying a willingness to consolidate and reform. It has also been one of

the strongest advocates for greater fiscal/political integration, while displaying markedly

less enthusiasm for financial/banking integration. France, by contrast, displays greater

enthusiasm for financial/banking integration, while being reluctant to relinquish

fiscal/political sovereignty.

1 “Creating a workable monetary union”, Huw Pill, European Economics Daily, October 23, 2012.



Because fiscal and financial integration can act as substitutes for each other, neither

approach is necessarily ‘correct’. Moreover, there is an element of complementarity

between them: banking integration may require a common area-wide fiscal backstop for

the financial system, which raises fundamentally fiscal issues. There is also a question of

sequencing: Germany may justifiably claim that sharing fiscal risks requires that its

partners have demonstrated a willingness and ability to make necessary but painful

adjustments, whereas France and countries in the periphery can equally justifiably argue

that, without explicit financial support from Germany, adjustment is infeasible in economic

and/or political terms. Finally, the choice of how to proceed across these dimensions of

reform and adjustment has important distributional consequences along national lines,

which can naturally complicate the ongoing negotiation process.

Partly as a result of these complications, there has been a marked reduction in the impetus

to implement changes across either dimension since market pressures in the Euro area

have abated following Mr. Draghi’s “whatever it takes” intervention:

In terms of fiscal/political integration, there appears to be a reluctance to move

beyond the ‘enhanced surveillance’ procedures set out in the revamped Stability

and Growth Pact. We are sceptical that the changes implemented to date imply a

sufficient degree of fiscal/political integration to ensure the Euro area’s long-term

survival (at least in the absence of much deeper financial/banking integration).

In terms of financial/banking integration, the introduction of a common

supervisory framework is a necessary – but not sufficient – step towards deeper

financial integration. However, there has been back-tracking on an earlier

commitment to introduce direct recapitalisation of peripheral banks from the ESM

bailout fund – precisely one of the banking issues that potentially has deep fiscal

implications.

Progress has been made but, in our view, Euro area institutions are not yet sufficiently

robust to ensure that the monetary union remains workable in the long run. While

institutional reforms that would represent a sufficient steady-state framework have been

discussed, they do not appear likely to be implemented to a sufficient degree. This is not to

suggest that an eventual break-up of the Euro area is likely, but the Euro area may ‘need’ a

renewed bout of market tension to provide policymakers with the impetus required to

complete the construction of a workable monetary union in order to overcome some of the

impediments noted above.



Chapter 1: Introduction – A factor-by-factor analysis of what makes

a monetary union work

As policymakers continue to grapple with the challenge of ensuring EMU’s long-run

survival and investors remain sceptical as to whether it will survive in the long run, in this

paper we ask: What makes a monetary union work?

The original Optimal Currency Area (OCA) literature, as first developed by Nobel prize-

winning economist Robert Mundell (1961) and advanced by the economist Ronald

McKinnon (1963), suggests that the benefit of maintaining a currency union depends

negatively on the degree of economic asymmetry (the preponderance of nation-specific

shocks) and positively on the share of output devoted to trade between the member states.

Over time, other studies have added to the list of criteria considered important in

determining whether a monetary union would be ‘optimal’ or not, with a greater focus on

the importance of mechanisms that enable participants in a monetary union to adjust to

region-specific shocks once they occur:

A high degree of inter-regional labour mobility (Feldstein (1998), Bonin et al (2008),

Zimmermann (2009)).

A high degree of wage flexibility (Berthold (1998), Krugman (2012)).

A high degree of fiscal/political integration (Kenen (1969), Sachs and Sala-i-Martin

(1992), Hishow (2007)).

A high degree of financial integration (Asdrubali, Sorensen and Yosha (1997)).

These criteria are likely to be substitutable to some extent – if a monetary union does not

have enough of one, it may be possible to substitute it with more of another. But, while a

number of previous studies have emphasised the importance of one factor over another,

no previous study that we know of has considered each of the factors collectively. Here, we

attempt to fill that gap: we consider the list of criteria proposed in the OCA literature and

identify the criteria that are necessary to make a monetary union work and those that are

simply ‘nice to have’.

Although our primary goal is to draw lessons for the Euro area, our empirical analysis

focuses as much on the US as it does on the Euro area. This is because we know that the

US ‘works’ as a monetary union. Moreover, while 15 years is arguably too short a time

period to judge the importance of each of the criteria in the context of the Euro area, the

US provides an example of a long-running monetary union that is of similar size to the

Euro area and combines a number of diverse states/regions. Trying to understand why the

US functions as a monetary union can help offer an insight into what could make the Euro

area work better.

What we mean by a ‘workable’ monetary union

One of the attractions of setting out a list of criteria that determine whether a monetary

union is ‘optimal’ or not is that it is relatively easy to define optimality. However, while an

optimal (or perfect) monetary union may be easy to define, in practice there is no such

thing as a perfect monetary union. A large number of monetary unions ‘work’ just fine,

even if they fall some way short of optimality. But trying to define precisely what we mean

by ‘work’ in this context is difficult.

We do not mean to assess the factors underlying an economy’s overall economic

performance – many economies that have low GDP per capita levels and/or growth rates

nevertheless function well as a monetary union.



Nor does our test of workability require that internal shocks within the monetary union

adjust quickly or painlessly – as we discuss in our results, many functioning monetary

unions do not satisfy this criterion. In the US, region-specific shocks often have permanent

effects on employment and income. And many European economies still suffer from the

legacy of regional shocks that pre-date the formation of EMU: parts of the UK are yet to

recover fully from the decline of heavy industry, the former German Democratic Republic

remains heavily dependent on large-scale fiscal transfers from western Germany, and

unemployment is persistently higher in southern Italy than in the north.

Rather, our focus is on establishing a set of criteria that is required to ensure that internal

adjustments – which we view as largely unavoidable – do not prompt periodic existential

crises. In other words, how institutional design ensures that shocks to the monetary union

do not trigger explosive dynamics in financial markets or the real economy that both create

and compound ‘convertibility risk’ leading to existential crises. Instead, we seek to identify

the institutional framework that would induce behaviour that supports the integrity and

viability of the monetary union.



Chapter 2: The role of ‘economic’ factors – synchronisation of

business cycles, trade integration, labour mobility and wage

flexibility

The synchronisation of business cycles

Why it is considered important

A key potential cost of forming a monetary union is that members lose two important

mechanisms for macroeconomic stabilisation. First, member exchange rates are no longer

freely floating against those of other members. Second, individual states can no longer set

monetary policy independently – they must adopt the policy stance set by the union-wide

monetary authority. A key tenet of the Optimal Currency Area (OCA) literature is that the

cost of losing monetary independence is limited if the countries/regions forming a

monetary union exhibit synchronised business cycles.

Who considers it important

The view that the frequency and severity of asymmetric shocks is an important

consideration in evaluating the costs and benefits of forming a currency union is discussed

in much of the OCA literature:

In Robert Mundell’s seminal “A Theory of Optimum Currency Areas” (1961), he

suggests that “if the case for flexible exchange rates is a strong one, it is, in logic,

a case for flexible exchange rates based on regional currencies, not on national

currencies”. And, for Mundell, the “region” that defines an optimal currency area

is one in which similar industries operate so that responses to economic shocks

are uniform throughout the area.

Eichengreen (1991): “An optimum currency area (OCA) is an economic unit

composed of regions affected symmetrically by disturbances.”

Bayoumi and Eichengreen (1992): “EMU involves a sacrifice of monetary

autonomy...If disturbances are distributed symmetrically across countries,

symmetrical policy responses will suffice...Only if disturbances are distributed

asymmetrically across countries will there be occasion for an asymmetric policy

response and may the constraints of monetary union bind.”

Furceri and Karras (2008): “The higher the correlation of business cycles, the lower

the stabilization cost of giving up an independent monetary policy...[I]f a member

economy’s business cycle is very highly correlated with the union-wide cyclical

output, then monetary policy conducted by the common central bank will be a

very close substitute for the country’s own independent monetary policy.”

Since the crisis, other authors have questioned whether similarity in economic structures

and business cycles is either a necessary or sufficient condition for a functioning monetary

union:

Carney (2014) shows that the industrial structures of the Euro area core and

periphery are more similar than the regional economies of the US and Canada:

“Theory notwithstanding, being similar doesn’t necessarily help and being

different doesn’t necessarily hinder. This suggests we should look elsewhere for

the ingredients of a successful union.”



Exhibit 1: Correlations of growth between Euro members

and the Euro area as a whole over the 1999-2012 period

are higher than…

Exhibit 2: …the correlations of growth between US

states and the US as a whole over the same period

Source: Eurostat, National Statistics Offices, Goldman Sachs Global Investment Research

Source: US BEA, Goldman Sachs Global Investment Research

What we find

To explore the importance of business cycle synchronisation further, we compare a

number of different measures of cross-country symmetry for the Euro area and of cross-

state symmetry for the US.

In a result that we believe may be contrary to many people’s priors, we find that

business cycles within the Euro area have been more synchronised than those within

the US across many of the measures that we consider. This is true of the pre-crisis

period – which suggests that the asynchronous nature of Euro area cycles was not a

primary cause of the crisis. But, on most measures, it even remains true when the pre- and

post-crisis periods are included together in the comparison.

The most commonly used measure of business cycle synchronisation in the pre-crisis

literature was simply to compare the correlations of annual GDP growth of participating

economies within the monetary union. Admittedly, this is a reduced-from exercise: it does

not distinguish the underlying fundamental shocks that drive divergent behaviour across

regions from the policy and behavioural responses to those shocks (that may dampen or

amplify their impact over time). Nevertheless, this exercise can give us an initial view of

cross-country variation.

Exhibits 1 and 2 plot the correlations of annual GDP growth rates of individual Euro area

countries with growth in the Euro area as a whole and similarly for the individual states of

the US, for the period 1999-2012. Over this timeframe, growth rates have been more

correlated within EMU than within the US (with an average correlation coefficient of 0.84 vs.

0.65 in the US). US states also exhibit greater variation in growth correlations, with four

states (Alaska -0.55, North Dakota -0.20, Louisiana -0.08 and Wyoming -0.08) exhibiting a

negative correlation with the US as a whole over the period 1999-2012.

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Exhibit 3: Growth correlations of US states over the

1978-2012 period were relatively low on average and very

low in some cases

Exhibit 4: Euro area dispersion has been relatively low

Negative divergence

Source: US BEA, Goldman Sachs Global Investment Research

Source: US BEA, National Statistics Offices, Goldman Sachs Global Investment Research

One can argue that 14 years of data is too short a period to judge the frequency and

severity of asymmetric shocks in the Euro area. Imbalances in the Euro area periphery

developed over a period that extended beyond the typical business cycle. In this respect,

the experience of US states may be more instructive since they have a longer history of

being members of a monetary union. Exhibit 3 plots the correlations of annual GDP growth

rates of individual states with the US as a whole (the same as Exhibits 1 and 2) over a

longer period, from 1978 to 2012. The average growth correlation over this period is very

similar to the 1999-2012 period (0.66 vs. 0.65) and the range of correlations is wide,

indicating that growth rates are reasonably dispersed. A number of states exhibited a low

correlation with the US over the period as a whole, and frequent periods of negative

correlation. Yet, despite this low degree of business cycle synchronisation, the US clearly

functioned as a currency union over this period.

The message presented by the static analysis above is reinforced by various dynamic

measures of business cycle synchronisation. Exhibit 4 displays a measure of growth

dispersion, calculated as the cross-country/state standard deviation of GDP growth rates in

the monetary union. The dispersion of growth rates rose with the onset of the sovereign

crisis but, even at its peak (in 2011), the level of growth dispersion did not appear

particularly acute relative to US norms.2

2 Previous studies have used a number of other dynamic measures of business cycle synchronisation that we do not reproduce here, largely because they provide similar results. These include measures of the absolute value of the difference in GDP growth between individual members and the monetary union as a whole (Giannone, Lenza and Reichlin (2009) and Kalemli-Ozcan and Papaioannou (2009)) and measures that capture underlying similarities in growth by comparing the residuals from regressions that strip out area-wide and time effects (Morgan, Rime and Strahan (2004)).

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Cross-country standard deviation of growth rates

More dispersion

Less dispersion



Exhibit 5: The dispersion of country unemployment

rates in the Euro area has increased significantly since

the crisis

Exhibit 6: Goods trade with Euro area countries as a

share of total trade* is high * = Goods exports to and imports from other Euro area countries

as a share of total trade (1999-2012)

Source: Goldman Sachs Global Investment Research.

Source: IMF, Goldman Sachs Global Investment Research.

Measures of cumulative divergence suggest the Euro area’s post-crisis divergence

has been more extreme than in the US. One criticism of the static and dynamic

measures of business cycle synchronisation we have presented so far is that they do not

capture the cumulative divergence generated by prolonged economic booms and slumps.

One means of doing this is to compare the dispersion of output gap or labour gap-type

measures. Exhibit 5 plots the cross-country standard deviation of unemployment rates for

the Euro area and the US (i.e., it doesn’t strip out differences in structural unemployment,

which tend to be larger across Euro area countries than US states3). There has been a sharp

increase in the dispersion of Euro area unemployment rates since the onset of the

sovereign crisis. However, this appears to have been a consequence of the Euro area’s

difficulties in adjusting to the crisis, rather than a cause of the crisis.

Indeed, one of the paradoxes of the Euro area crisis was that its catalyst was a shock that

affected the monetary union as a whole (the 2007/08 financial crisis), whereas, prior to the

crisis, it was envisaged that a major challenge for the Euro area would be its ability to deal

with shocks that directly affected some parts of the monetary union but not others. In the

years leading up to the crisis, the dispersion of unemployment rates across the Euro area

had been decreasing but that dispersion rose sharply in response to a shock that initially

affected the Euro area as a whole.

We will argue that one of the most important lessons from the crisis has been that

weaknesses in the Euro area’s institutional structure meant that a common shock could

affect different parts of the Euro area in very different ways, and that the correlation of

shocks itself is a relatively unimportant factor in determining the workability of a monetary

union.

If the Euro area countries have exhibited a high degree of symmetry (but the currency

union does not currently function well), while US states often exhibit a high degree of

asymmetry (yet the US does function well as a currency union), this suggests that

symmetry among member states is not a key determinant of whether a currency area is

workable or not.

3 See, for example, Layard, Nickell and Jackman (1991).

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Cross-country standard deviation of unemployment rates

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AverageGoods trade with other Euro countries as share of total trade



A high degree of trade integration


A key potential benefit of forming a monetary union is that the adoption of a common

currency eliminates costs related to foreign exchange transactions between participating

states. The elimination of transaction costs provides a lump-sum benefit and is likely to

encourage greater micro-efficiency as economic resources are allocated within the region

more efficiently. The OCA literature thus proposes that regions that are suitable for forming

monetary unions exhibit a high degree of inter-regional trade, since the greater the degree

of trade that takes place between regions within the currency area, the greater the potential

benefit from eliminating foreign exchange costs related to these inter-regional transactions.

While the initial gain from reducing transaction costs in trade should be roughly

proportionate to the amount of existing trade that already takes place between regions

forming a monetary union, more recent OCA studies have also emphasised the dynamic

effect that reducing transactions costs can have on trade. States that share a common

currency are likely to trade more with each other because they share a common currency

relative to those that do not, creating a self-fulfilling element to the trade integration aspect

of OCA theory.

In the context of the analysis in this paper, one key issue is whether the gains in terms of

deepening trade integration via sharing a common currency can bolster the economic and

political workability of the monetary union as a whole. In turn, this raises questions about

the visibility and distribution of the economic gains from the resulting increases in trade,

thereby creating further complementarities and substitutabilities with other aspects of the

analysis, e.g., the flexibility of economies and the scope for offsetting fiscal redistribution

measures (both within and across countries).


Multiple studies examining whether regions (EMU, the CFA Franc zone, or the states of the

Gulf Cooperation Council) should form a monetary union have stressed an increase in

inter-regional trade as one of the key potential benefits from forming a union:

Frankel and Rose (1997): “The benefits of being a member include a reduction in

the transaction costs associated with trading goods and services between

countries with different moneys. Countries with close trade links to EMU members

will benefit more from monetary union.”

Frankel (1999): “[one of the] big advantages of a fixed exchange rate, for any

country, is that it reduces transaction costs and exchange-rate risk, which can

discourage trade and investment.”

In a study of trade flows between Canadian provinces and US states, McCallum

(1995) provides evidence that trade between countries tends to be significantly

more limited than trade within countries.



Exhibit 7: Goods trade with Euro area countries as a

share of GDP is also high* * = 0.5 x Goods exports to and imports from other Euro area

countries as a share of GDP (1999-2012)

Exhibit 8: Intra-Euro area trade increased after 1999, but

at a slower rate than the growth of trade globally



What we find

The Euro area economies exhibit a high degree of trade integration. Exhibit 6 displays the

average of intra-Euro area merchandise exports and imports as a share of total exports and

imports over the period 1999-2012 for individual Euro area members. On average, half of all

goods trade conducted by Euro area economies has been conducted with other Euro area

economies. Over the same period, intra-EMU goods trade has represented around 45% of

GDP for Euro area countries, on average (Exhibit 7). Over time, trade within the Euro area

has also increased, including since the introduction of the Euro in 1999 (Exhibit 8).

It is difficult to say whether a high degree of trade integration is a necessary condition for a

monetary union to work, since there is no monetary union – that we know of – that does

not exhibit a high degree of trade integration.4 What we can say is that a high degree of

trade integration does not appear to be a sufficient condition for a monetary union, on the

basis that the Euro area exhibits a high degree of trade integration but has not functioned

well as a monetary union.

The evidence as to whether monetary union has boosted trade integration – viewed as a

key potential benefit of EMU prior to commencement – is inconclusive. Using gravity-type

models to examine whether EMU membership has had a significant impact on European

trade flows, studies find that EMU had a significant impact on trade in the early-to-mid

2000s but this effect appears to have died out by the late 2000s.5 While trade between Euro

area economies has risen as a share of GDP since the introduction of the Euro, it has risen

no faster than trade elsewhere in the world.

4 One would ideally be able to consider the performance of a selection of monetary unions with varying degrees of trade integration and functionality. We don’t have this luxury: while there is detailed data for trade between Euro area member states, there is no equivalent data on inter-state trade flows between US states. There is, however, data on trade between Canadian provinces, which suggests that their goods markets are highly integrated.

5 Broadbent and Bahaj (2008). One explanation for why the estimated effect of EMU on intra-Euro area trade may have declined during the mid-2000s is that the Euro real trade-weighted exchange rate appreciated significantly between 2002 and 2008, reducing the competitiveness of Euro area producers versus non-Euro area producers.

0.00

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91 93 95 97 99 01 03 05 07 09 11 13

World exports as% of world GDP(lhs)

Intra-EMU tradeas % of EMUGDP (rhs)



A high degree of labour mobility


In the absence of a floating exchange rate and independent monetary policy to carry out

macroeconomic stabilisation, the OCA literature suggests that factor mobility becomes an

important instrument for internal adjustment. In place of nominal adjustment through

independent monetary policy and flexible exchange rates, members of a monetary union

must rely on real adjustment to avoid overheating or stagnation. One means of adjusting in

this way is for idle factors of production from one part of the union to be redeployed to

other parts of the union, where they are needed more. If the monetary union is affected by

asymmetric shocks, high labour mobility may help correct internal imbalances by

redirecting unemployed workers from stagnating regions to growing ones within the union.


A number of OCA studies have cited labour mobility as an important factor in determining

whether a currency union is optimal or not. Moreover, several studies (including Feldstein

(1998) and Bonin et al (2008)) have suggested that levels of labour mobility in the Euro area

may be too low for EMU to function as a currency area.

Mundell (1961): “The argument [for an optimum currency area] works best if each

nation (and currency) has internal factor mobility and external factor immobility.

But if labour and capital are insufficiently mobile within a country then...one could

expect varying rates of unemployment or inflation in the different regions.”

Blanchard and Katz (1992) found that inter-state migration played an important

role in correcting internal imbalances between US states: “A (US) state typically

returns to normal after an adverse shock not because employment picks up, but

because workers leave the state.”

Feldstein (1998): “a decline in demand need not raise unemployment if workers

are geographically mobile and move to places where jobs are available. But

although the legal barriers to labour mobility within the European Union have

been eliminated, language and custom impede both temporary and long-term

movement within Europe...the American heritage of immigration and national

settlement makes Americans much more willing to move internally than their

European counterparts.”

Bonin et al (2008): “Geographic mobility serves as an equilibrating factor between

regional labour markets. To the extent that mobility of capital and goods does not

achieve convergence of employment and real wages in open or integrated

economies, mobility of labour may help balancing labour market outcomes.”

Set against this view, other authors dispute the extent to which labour mobility is a

substitute for exchange rate flexibility:

Bean (1992) expresses scepticism that factors of production can migrate between

regions over a shorter timescale than wages and prices adjust: “The Mundellian

argument (that factor mobility is a key condition for optimality) rests on the

premise that factors move faster than prices, something which I find

implausible...Certainly, some regions will prosper and others will decline, but this

will happen independently of whether there is a single currency or not.”



Exhibit 9: After the oil shocks, payroll levels diverged

significantly, suggesting a highly asymmetric response

Exhibit 10: The difference between unemployment in

Michigan and Texas was high and persistent after the oil

shocks

Source: US BLS

Source: US BLS

What we find

There are marked contrasts in the performance of employment and unemployment across

US states over time. In Exhibits 9 and 10, we compare the performance of employment and

unemployment in Michigan (a major car-producing state) and Texas (a major oil-producing

state) in the aftermath the oil shocks of the 1970s and the period following the Plaza Accord

in 1985 (when oil prices and the Dollar both fell sharply, for reasons that were not driven by

initial cross-state differences in the US).6

Employment fell sharply in Michigan and rose sharply in Texas following the 1970s oil shocks,

and never returned to its pre-crisis levels (Exhibit 9). The respective trends in employment in

these states that began in the 1970s were only broken by the Plaza Accord in the mid-1980s.

In other words, it took a major shock in the opposite direction to stabilise the labour market

divergence. Meanwhile, unemployment in Michigan and Texas also diverged significantly

over this period but ultimately re-converged in the aftermath of the Plaza Accord (Exhibit 10).

To consider the persistence of employment and unemployment shocks in the US and Euro

area more formally, we employ a similar methodology to Blanchard and Katz (1992). Our

results are based on annual data for all 50 US states and the original Euro area economies

and Greece (12 countries in total), using panel data estimations allowing for fixed state

effects.7

6 The US was hit by two oil shocks in the 1970s. In October 1973, members of the Organization of Arab Petroleum Exporting Countries (OAPEC) enforced an embargo, resulting in a fourfold increase in the price of oil by early 1974. The second oil crisis started from November 1978, when political tensions in Iran reduced supply and raised oil prices again. The rise in oil prices as a result of these crises was beneficial to oil-producing areas of the US, such as Texas, but naturally hurt areas associated with automotive and other manufacturing production, such as Michigan. The Plaza Accord (September 1985) was an agreement between the US and other advanced economies to deliberately devalue the US Dollar. From 1985 to 1987, the US Dollar depreciated 51% against the Yen. At the same time, oil prices also fell sharply from late 1985 onwards. This shock had the opposite effect to that of the oil shocks of the 1970s: oil-producing Texas suffered relative to manufacturing states in the Midwest, which benefited more directly from the devaluation of the US Dollar.

7 We use annual data from 1976-2012 for the US and 1993-2012 for the Euro area. However, Euro area migration data are only available for the period 1999-2010.

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73 74 75 76 77 78 79 80 81 82 83 84 85 86 87

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MichiganNew YorkOhioPennsylvaniaTexas

Plaza accord

2nd oil shock

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Difference betweenMichigan & Texasunemployment

2nd oil shock

Plaza accord



Exhibit 11: State-specific employment shocks in the US

are generally not reversed Impulse response of 1pp state-specific employment shock

Exhibit 12: State-specific unemployment shocks in the

US are persistent but are ultimately reversed Impulse response of 1pp state-specific unemployment shock

Source: BEA, Blanchard & Katz (1992), Goldman Sachs Global Investment Research

Source: BEA, Blanchard & Katz (1992), Goldman Sachs Global Investment Research]

The variables we consider are: (i) the difference between state (country) and US (Euro area)

employment growth; (ii) the difference between state (country) and US (Euro area)

unemployment; (iii) the difference between state (country) and US (Euro area) wage

growth; (iv) the level of state (country) wages versus US (Euro area) wages; and (v) the

difference between state (country) net inward migration and US (Euro area) net inward

migration (as a share of the population).

In common with Blanchard and Katz, we find that state-specific employment shocks in the

US tend not to be reversed over time. Indeed, if employment rises/falls in one state relative

to the rest of the US, it continues to rise/fall over the following 5-6 years, significantly

extending the initial ‘shock’ (Exhibit 11). By contrast, state-specific unemployment shocks

do tend to be reversed over time but they are nevertheless quite persistent, with a ‘half-life’

of around five years (Exhibit 12). The principal reason why employment shocks in the US

are persistent but unemployment shocks are not is that, over time, workers leave the state

that has been negatively affected by the shock.8 While the US clearly functions better than

the Euro area as a monetary union, the process of regional adjustment in the US is lengthy

and involves the de-population of stagnant regions over time.

One of the complications of applying the same analysis to Euro area countries is that the

Euro area has been in existence for a relatively short period of time and the estimated

response of country-specific unemployment is sensitive to the time period chosen (Exhibit

13).9 Nevertheless, the adjustment of country-specific unemployment in the Euro area is

clearly slower than the adjustment of state-specific unemployment in the US.

Comparing Euro area countries with US states over the period 1993-2008, we find that full

adjustment takes around 9-10 years in total (vs. 6-7 years for the US) and that the ‘half-life’ of

country-specific unemployment shocks is around 6-7 years (vs. 5 years for the US; Exhibit 14).

If we include the post-crisis labour market performance in our analysis, country-specific

unemployment shocks in the Euro area appear to have even more persistent effects.

8 In principle, the difference between the performance of employment and unemployment could also be due to variations in state labour force participation but, in practice, this has not been quantitatively important.

9 To focus on the adjustment process with a monetary union, one would ideally want to restrict the analysis to the period since EMU began. However, the sample would then be relatively short and the results highly sensitive to whether the post-crisis period is included or not. Our justification for including the period from 1993 to 1999 in our main analysis – even though EMU didn’t begin until 1999 – is that the Euro area countries operated a fixed exchange rate regime during this period with no major realignments.

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Exhibit 13: Response of country-specific unemployment

in Euro area sensitive to period chosen Impulse response to 1pp country-specific unemployment

shock

Exhibit 14: Country-specific unemployment shocks more

persistent in Euro area than US Impulse response to 1pp state/country-specific

unemployment shock (1993-08)

Source: Eurostat, OECD, Goldman Sachs Global Investment Research

Source: BEA, Eurostat, OECD, Goldman Sachs Global Investment Research

Do differences in labour migration flows play an important role in accounting for the US’s

faster adjustment to unemployment shocks? It is certainly the case that inter-state

migration represents an important part of the US’s regional adjustment mechanism in the

long run. In the past 40 years, there has been a steady flow of people migrating from the

‘rust belt’ states of the north to the ‘sun belt’ states of the south, resulting in cumulatively

large differences in the relative size of state population and employment. Michigan’s share

of the total US population has declined from 4.4% to 3.1% since 1970, while the population

of Detroit – the largest city in the state of Michigan – has declined from a peak of 1.8 million

people in the 1950s to just 0.7 million people today.

However, while net migration flows in the US are cumulatively important over time, we

find that the response of net migration to differences in unemployment is quantitatively

small in the short run (Exhibit 15). Moreover, while labour mobility in the US is higher in

general, we do not find migration in response to unemployment differences to be

significantly higher in the US than in the Euro area (Exhibit 16). This finding needs to be

treated with some caution, not least because the Euro area results are based on a more

limited data set than for the US.10 But we nevertheless find it difficult to attribute a major

role in the higher persistence of country-specific unemployment in the Euro area to lower

migration. In addition, intra-Euro area mobility – and also extra-Euro area mobility –

appears to be rising over time (although whether this is a structural change or a response

to current incentives remains unclear).

In summary, while inter-state labour mobility appears to be an important adjustment

mechanism of internal imbalances between US states, these adjustments take time and are

far from costless. Moreover, the response of net migration to unemployment differences

does not appear significantly different in the Euro area from that in the US, so it is difficult

to argue that differences in labour mobility represent the key distinction between the US’s

functioning monetary union and the Euro area’s malfunctioning union.

10 One reason why this result is surprising it that it suggests that the various language and other differences that exist between Euro area countries has not impeded net migration relative to US states. While we are comfortable that our estimates are accurate given the data available, migration data for Euro area countries are only available for the period 1999-2010 and not for every country. It is also difficult to rule out the possibility that US state data fail to capture inter-state migration to the same degree that European country data capture international migration.

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Unem vs. EA (93-08)

Unem vs. EA (99-08)

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Exhibit 15: Migration response is quantitatively small but

cumulatively important over time Impulse response to 1pp state-specific unemployment shock

(2001-12)

Exhibit 16: Greater persistence of Euro area

unemployment shocks not due to migration Impulse response to 1pp country-specific unemployment

shock

Source: BEA, US Census Bureau, Goldman Sachs Global Investment Research

Source: Eurostat, OECD, Goldman Sachs Global Investment Research

A high degree of wage flexibility


A high degree of nominal wage flexibility can offset the need for nominal exchange rate

flexibility – if a region experiences a negative demand shock that leads to higher

unemployment, then a timely and extensive downward adjustment of real wages would

reduce the cost to employers of hiring and retaining staff, and thus would place downward

pressure on unemployment. Indeed, in the limit, if wages and prices can adjust

instantaneously to shocks, wage and price flexibility are perfect substitutes for exchange

rate flexibility, and there are no costs associated with the loss of monetary independence.


The original OCA literature of the 1960s, in keeping with the dominant Keynesian

orthodoxy of the time, assumed that prices and nominal wages were largely sticky and

persistent even following shocks, and so did not focus on wage flexibility as a relevant

criterion for optimal currency areas. More recently, however, the academic literature has

focused more on the role of real wage flexibility in determining the performance of

employment subsequent to slumps.

Berthold (1998): “Real wage flexibility has been an issue in Europe at least since

the late 1980s when persistent unemployment became the number one topic of

economic policy in Europe.”

Krugman (2012): if “workers [from a stagnating state] can’t or won’t leave the state,

the only way to restore full employment is to regain the lost jobs, which will

probably require a large fall in relative wages to make the state more competitive,

a fall in wages that is much more easily accomplished if you have your own

currency to devalue”...“the Euro experience strongly suggests that downward

nominal wage rigidity is a big issue. This means that ‘internal devaluation’ via

deflation is extremely difficult, and likely to fail politically if not economically”.

Schmitt-Grohe and Uribe (2012): “The observed failure of nominal wages to adjust

downward after 2008 despite sizable increases in unemployment motivates a

model in which the combination of downward nominal wage rigidity and a fixed

exchange rate lie at the heart of the current unemployment crisis.”

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Equiv. US response



What we find

Using the same panel data approach applied in the previous section on labour mobility, we

find significant differences between the degrees of real wage flexibility in US states and

Euro area countries. State-specific wage levels respond more rapidly to state-specific

unemployment shocks in the US than is the case for Euro area economies (Exhibit 17).11

However, while wages respond more flexibly in US states in the short run, wage shocks are

also much less persistent in the US than country-specific wage shocks are in the Euro area.

This is not surprising. If there is little labour market flexibility – in quantities or prices – it is

not the case that the relative adjustment that is required will simply be avoided. Rather, the

adjustment is likely to take longer and be more painful (in the sense that unemployment

will have to rise by more to achieve the same decline in real wages) than would have been

the case under the flexible labour market scenario.

Painful as the price of adjustment may be in the Euro area, it is a price that peripheral

countries have so far been prepared to pay. Unemployment has risen sharply in the

periphery, but clear progress is being made in regaining competitiveness. Exhibit 18

displays whole economy ULCs relative to the Euro area for Germany and the peripheral

states from the start of the crisis (2008) onwards. With the exception of Italy, all of the

peripheral states have made significant progress in regaining competitiveness.

Lastly, it is worth emphasising that, of the various ‘economic’ factors highlighted by

Optimal Currency Area theory, only real wage flexibility can credibly claim to play an

important role in the US’s greater workability as a monetary union. Limited wage flexibility

appears to be the ‘Achilles Heel’ of the Euro area adjustment process.

Exhibit 17: Wage response in Euro area countries takes

longer to come through Impulse response to 1pp country/state-specific

unemployment shock

Exhibit 18: Most peripheral economies have gained

competitiveness since 2008 Real unit labour costs relative to the Euro area (2008=100)

Source: BEA, OECD, Goldman Sachs Global Investment Research

Source: EU Commission

11 Other authors have also found that real wages in Europe respond less to unemployment than in the US. See Grubb, Jackman and Layard (1983), and Bruno and Sachs (1985).

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Country wage response

Equiv. US response

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Greece

Ireland

Italy

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Spain



Chapter 3: The role of ‘institutional’ factors – fiscal transfers,

financial integration and political union

Mechanisms for fiscal transfers


As we discussed in the previous chapter, OCA theory posits that the business cycles of the

economies within a monetary union should be reasonably correlated, so that one monetary

policy can fit all, and so that high levels of factor mobility and price flexibility can reduce

the adjustment cost to asymmetric shocks once they occur. A third means of improving the

functionality of a monetary union is for participants to insure against the risk of an

asymmetric shock, either through increased fiscal integration or through increased

integration of capital markets and banking systems.

The important role that a more unified fiscal system can play in reducing the costs

associated with the loss of monetary independence, by levying taxes on cyclically-strong

nations/regions and transferring those resources to cyclically-weak nations/regions, is one

that has been emphasised by a number of OCA studies, both before and since the crisis. It

is also commonly noted that the US – through its federal fiscal system – and other well-

functioning monetary unions all possess such a mechanism, but the Euro area does not.

One can argue further that the example of German unification – which brought together

two very different economies – illustrates that there is always a level of transfers that can

make every monetary union work.


A number of studies focus on fiscal federalism as a relevant criterion for optimal currency

areas, starting with Kenen (1969). Some notable examples include:

Sachs and Sala-i-Martin (1992), in a study of the US, estimate that federal fiscal

taxes and transfers offset between 30% and 40% of a fall in state income: “One of

the reasons why the US exchange rate system has held up reasonably well is the

existence of a ‘Federal Fiscal Authority’ which insures states against regional

shocks.”

Mongelli (2002): “Countries sharing a supra-national fiscal transfer system that

would allow them to redistribute funds to a member country affected by an

adverse asymmetric shock would also be facilitated in the adjustment to such

shocks and might require less nominal exchange rate adjustments.”

Hirshow (2007): “...Europe will not turn into an OCA soon but it could finally

achieve similar quality. What must come to enable the economic and monetary

union to better absorb asymmetric shocks?...A highly efficient fiscal response.”

Set against this view, other authors downplay the role that fiscal federalism plays in

ensuring that the US functions well as a monetary union:



Exhibit 19: The US federal budget is much larger than its

EU equivalent Federal budget revenues as % of GDP

Exhibit 20: US federal fiscal policy offsets 25% of income

shocks, but only half is due to inter-regional insurance Estimated response of federal fiscal policy to GDP shock

Source: US Office of Management and Budget, Eurostat

Source: Goldman Sachs Global Investment Research

Fatas (1998) argues that Sachs and Sala-i-Martin (1992) overestimate the amount

of interstate insurance provided by the US federal system by a factor of three

because they fail to exclude the effects of inter-temporal income smoothing (that is

provided by the US federal system but which could just as easily be provided by

national tax systems). In other words, there is a need to distinguish between (i)

cross-country risk-sharing within the monetary union; and (ii) inter-temporal risk-

sharing with individual countries (fiscal jurisdictions) within the monetary union. In

the face of temporary asymmetric shocks, either mechanism could, at least in

principle, be used to smooth the profile of economic activity. He concludes that

“the benefits of a European fiscal federation would be modest”.

What we find

One basic means of gauging the relative scope for area-wide fiscal stabilisation in the US

versus the Euro area is to compare the respective size of their area-wide budgets. US

federal budget expenditure has averaged around 20% of US GDP in the past 20 years

(1993-2013), but the budget of the European Union budget has represented only 1% of EU

GDP (there is no budget that is specifically designated for the Euro area) (Exhibit 19).

In addition to being much larger than the EU budget, the means by which US federal taxes

are gathered and expenditure is allocated provides a significant degree of automatic

stabilisation of state-specific shocks (because tax revenues fall and budgetary expenditure

rises automatically in response to negative region-specific shocks). This is less true of the

EU budget, where country contributions are voted on over multi-year periods and where

much of the expenditure is in areas – such as the Common Agricultural Policy – that are not

designed to be counter-cyclical.

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GDP shock Federal fiscal offset Net federal fiscal vs.US



More formally, to estimate the role that federal fiscal transfers and taxes play in offsetting

state-specific shocks in the US, we use the same panel-data approach that we applied in

the previous sections. To construct a measure of net federal transfers into and taxes from a

state, we use: (a) data on federal taxes, broken down by state of collection, published by

the Internal Revenue Service; (b) data on grants from the federal government to state

governments, from the US Census Bureau; and (c) data on federal transfers to individuals

(e.g., various benefit payments such as Social Security), broken down by state, from the

Survey of Current Business (published by the US Bureau of Economic Analysis). Our

measure of net federal transfers/taxes is calculated as the difference between the transfers

into a state and taxes out of the state (i.e., (b) + (c) – (a)). Our estimates are based on annual

data spanning the period 1990-2010.

We first consider the importance of federal fiscal policy in offsetting the impact of gross

state product (GDP) shocks to US states. We find that US federal fiscal policy offsets

around 25-30% of the initial effect on income from state-specific economic shocks, with

around two-thirds of this effect occurring in the same year as the shock and the remainder

of the effect occurring in the subsequent year. This estimated response is a little smaller

than the results obtained by Sachs and Sala-i-Martin (1992) – who estimated that federal

fiscal taxes and transfers offset between 30% and 40% of a fall in state income – but not

dramatically so.

However, as Fatas (1992) has argued, part of the offset provided by US federal fiscal policy

in response to economic shocks affecting states reflects the inter-temporal smoothing

provided by fiscal policy in response to common shocks affecting the US as a whole.

Distinguishing between the smoothing provided by inter-temporal transfers and inter-

regional insurance is important because inter-temporal transfers can be provided by

countercyclical budgets at a national level (i.e., they don’t require a common federal

budget).

To estimate the genuine inter-regional insurance provided by the US’s federal system, we

consider the difference between the federal fiscal response to state-specific shocks at a

state level and at a national level. On this basis, we find that the amount of inter-state

insurance provided by the US federal fiscal system drops by a factor of two, to around 14%.

This is a slightly higher estimate than that obtained by Fatas (1992). There is little or no

equivalent smoothing provided by EU fiscal policy.

It is difficult to gauge how critical the degree of inter-state insurance provided by the

federal fiscal system is in ensuring the US exchange rate system’s long-term survival. Our

own assessment is that the size of the transfers is material without being critical and could

be substituted by effective counter-cyclical policy at a national level and/or the increased

integration of capital markets and banking systems.12

Financial integration and banking union


Integrated financial and banking markets can provide an alternative means of risk-sharing

to fiscal federalism in a monetary union, operating via two principal channels: via the

capital markets channel (through increased portfolio diversification) and via the credit

channel (through increased cross-country borrowing and lending).

12 Dirk Schumacher has argued that there is sufficient flexibility within national fiscal policy to adjust to ‘normal’ shocks, which he defines as 2% drop in national GDP (European Economics Analyst, 2013/11).



To the extent that private financial markets facilitate the sharing of region-specific shocks,

this can – all else equal – offset the need for inter-country/state fiscal risk-sharing. That said,

one lesson from the Euro area crisis is that, without the appropriate regulatory structures,

greater financial market integration can also result in risks being pooled rather than shared

– bank failures and recapitalisation requirements have severely worsened government debt

dynamics in a number of peripheral Euro area economies (most notably, Ireland and Spain).

By comparison, the losses suffered at a regional level during the US Savings and Loan

crisis of the late 1980s were largely borne by the US federal government.


Asdrubali, Sorensen and Yosha (1997) emphasise the importance of integrated

capital markets as means of risk-sharing within the US. They estimate that 39% of

the impact of an asymmetric shock to gross state product on state consumption is

smoothed by capital markets (risky investments), 23% by credit markets

(borrowing and lending), 13% by the federal government and the remaining 25% is

not smoothed.

Daly (2001) argues that the introduction of the Euro, in reducing home bias in

portfolio allocation through the elimination of exchange rate risk, combined with

the secular increase of privately-held pensions, could increase the importance of

risk-sharing via portfolio diversification in Europe.

Furceri and Zdzienicka (2013), who apply Asdrubali et al’s (1997) framework to

European economies, find that there is negligible inter-country sharing of risk in

Europe via the capital markets and inter-country fiscal risk-sharing channels.

What we find

Asdrubali, Sorensen and Yosha (1997) identify three broad channels through which the

impact of an asymmetric shock to gross state product on state consumption can be

smoothed in the presence of a unified fiscal regime and integrated capital markets: first,

risk can be shared via the cross-ownership of assets (the capital markets channel); second,

the federal tax-transfer system can smooth income (the fiscal channel); and, third,

consumption can be smoothed through borrowing and lending from an integrated banking

system (the credit markets channel). There will also be a residual degree of idiosyncratic

volatility in state consumer spending that remains uninsured.

The authors argue that it is possible to estimate the relative importance of each of these

channels by comparing the performance of gross state product, state income, disposable

state income and state consumption: if state income is more highly correlated with national

output than gross state product, it implies that some of the idiosyncratic risk implied by

state output has been diversified away through the cross-ownership of assets (i.e., the

capital markets channel); if state disposable income is more highly correlated with national

output than state income, it implies that some of the idiosyncratic risk implied by state

income has been diversified away through the fiscal channel; and so forth. With full risk-

sharing, state consumption should be a fixed proportion of US output.



Although conceptually attractive, one problem with the approach taken by Asdrubali et al is

that it is unclear whether the state-level data are measured with sufficient accuracy to

isolate the three channels in the manner that the authors claim. While gross state product

and net fiscal transfers can both be measured with a significant degree of accuracy, the

split between company profits that are domestic to the state and those that come from

other states is not well measured, and there is no measure of consumption at a state level

(Asdrubali et al (1997) build a proxy of state consumption based on retail sales data). This

means that, while it is possible to identify the importance of the fiscal channel as a means

of risk-sharing among US states – as we did in the previous section13 – it is not possible to

separate out the effects of the capital markets and credit channels.14

This is not to suggest that the capital and credit channels are not important – our own view

is that the US’s integrated capital and credit markets play an important role in smoothing

the impact of region-specific shocks in that economy. Rather, we question whether it is

possible to quantify the relative importance of each of these channels for US states with

the degree of precision suggested by Asdrubali et al (1997).

The issue of measurement is less of a problem for European countries, as there is good

data at a national level for total consumption (household and government) and for factor

income flows from abroad. Using national income data, we apply the same approach as

Asdrubali et al (1997) to the original Euro area economies (plus Greece) in a panel data set-

up. Our results are displayed in Exhibits 21 and 22, and we compare our estimates with

those of Furceri and Zdzienicka (2013) for Europe and with those of Asdrubali et al (1997)

for the US in Exhibit 23.

Exhibit 21: There has been little/no cross-country fiscal or

capital market risk-sharing among Euro area countries...

Estimated channels of income smoothing

Exhibit 22: ...and the degree of risk-sharing has fallen

since EMU began

Estimated channels of income smoothing



13 It is notable in this respect that Asdrubali et al’s estimate of the degree of fiscal smoothing provided by the US federal system is very similar to our own.

14 Another problem with the approach adopted by Asdrubali et al is that it would have failed to capture the pooling of capital market and banking risks that took place in the Euro area prior to the crisis.

-0.20

0.00

0.20

0.40

0.60

0.80

1.00

1.20

Capitalmarkets

Net transfersPublic saving Privatesaving

Unsmoothed

1971-2012

-0.20

0.00

0.20

0.40

0.60

0.80

1.00

1.20

Capitalmarkets

Net transfersPublic saving Privatesaving

Unsmoothed

1999-2012



Exhibit 23: Country-specific shocks go mostly unsmoothed in the Euro area, in contrast to

state-specific shocks in the US Estimated channels of income smoothing across countries/states (panel regression results)

Source: Goldman Sachs Global Investment Research, Furceri and Zdzienicka (2013) and Asdrubali et al (1997).

Political integration


The importance of greater institutional integration is reinforced by the self-fulfilling aspect

of the perception of irrevocability, both among investors and electorates. The perception

that the ‘US Dollar zone’ is irrevocable is partly self-fulfilling: it functions as a monetary

union – despite the existence of frequent and substantial state-specific shocks – precisely

because few question its existence.

When a US state is hit by a negative shock, it does not face the additional burden of a

sharp rise in funding costs. By contrast, doubts over the long-run sustainability of the Euro

area have – at least until Mario Draghi’s “whatever it takes” commitment in July 2012 –

resulted in higher borrowing costs in peripheral Euro area countries, which, in turn, have

exacerbated the strains that pose an existential threat to the Euro area.

From the perspective of electorates (as opposed to investors), this distinction is also

important. When US states are affected by asymmetric shocks, the winners and losers do

not live and vote in separate political jurisdictions. This contributes to the acceptance of the

costs of high regional unemployment and the notion of irrevocability.


The role that the perception of irrevocability plays in making a monetary union work is not

one that was widely discussed in the (pre-crisis) OCA literature. However, it has been

viewed as increasingly important since the crisis:

De Grauwe (2011) argues that the weakness of the Euro area’s governing structure

gives rise to self-fulfilling crisis equilibria. He contrasts the performance of Spanish

and UK bond yields arguing that, despite a better deficit and debt performance,

Spain’s borrowing costs rose much more than the UK’s because of the perceived

fragility of the Euro area’s institutional structure and the existence of convertibility

risk.

De Grauwe and Ji (2012) provide evidence that a large part of the increase in

sovereign bond spreads in the Euro area periphery in 2011 and 2012 were

unrelated to conventional bond market fundamentals (such as government deficit

and debt levels).

1 2 3 4

US

1971-2012 1999-2012 F&Z (79-10) ASY (63-90)

Capital markets -0.06 -0.01 -0.01 0.39

0.01 0.01 0.04 0.13

Saving/credit markets 0.44 0.23 0.31 0.23

of which Public 0.08 -0.01 0.09

Private 0.37 0.23 0.22

Unsmoothed 0.61 0.78 0.66 0.25

Inter-country/ state fiscal transfers

Euro area



Carney (2014) argues that, more than other factors, “a durable, successful currency

union requires some ceding of national sovereignty.”

What we find

The role that the perception of irrevocability plays in making a monetary union work is

largely intangible and, for this reason, has to be indirectly inferred rather than directly

observed. However, one indication of its importance is the fact that the Euro area

descended into a sovereign debt crisis despite having government deficits and debts that,

in aggregate terms, were significantly less than in the US and most other advanced

economies. If the increase in Euro area periphery bond yields cannot be explained with

reference to commonly used bond market ‘fundamentals’, the most obvious explanation

for the rise is that they were singled out in this way because they were perceived as being

subject to ‘convertibility risk’ (i.e., the risk that one or more countries might leave the

monetary union). This is because, in contrast to the US, the Euro area remains a collection

of nation states whose commitment to the irrevocability of EMU remains in doubt.

One indication of the importance of convertibility risk in driving the high level of Euro area

periphery spreads in 2011H1/2012H2 is simply to observe the extent to which those

spreads narrowed once Mario Draghi made his “whatever it takes” commitment in July

2012 (because Mr. Draghi’s statement altered perceptions of convertibility risk but left bond

market fundamentals otherwise unchanged). Following DeGrauwe and Ji (2012), Exhibit 24

plots the change in Euro area spreads between June and December 2012 against the initial

level of those spreads. There is a strong link between the two, with an R-squared of 0.96

(falling to 0.93 if Greece is excluded).

By contrast, it is difficult to find a strong relation between the change in spreads and

conventional bond market fundamentals. Exhibit 25 plots the change in spreads against the

change in debt levels between 2011 and 2013. We have also compared the change in

spreads with the change in deficit levels, with similarly poor results.

That a commitment to the irrevocability of the Euro area from the ECB President could

have such a material effect on Euro area bond spreads – in the absence of any change in

bond market fundamentals or, indeed, in the absence of any actual policy action from the

ECB – underlines how important the perception of irrevocability is in ensuring a monetary

union’s long-term survival.

Exhibit 24: “Whatever it takes” triggered a large

compression in spreads…

Change in Euro area sovereign spreads vs. initial spreads

Exhibit 25: ...that was unrelated to fundamentals Change in Euro area sov. spreads vs. change in gross govt.

debt 2011-2013



R² = 0.9636

-16

-14

-12

-10

-8

-6

-4

-2

0

2

0 5 10 15 20 25

Change in spreads pp (6/12-12/12)

Initial level of spreads

R² = 0.0039

-16

-14

-12

-10

-8

-6

-4

-2

0

2

0 5 10 15 20 25

Change in gross dept pp

Change in spreads pp (6/12-12/12)



Chapter 4: Conclusions: Institutional reform plans are not yet

sufficiently robust

We have provided a factor-by-factor analysis of what makes a monetary union work,

discussing each of seven factors proposed by Optimal Currency Area (OCA) theory. The

most significant finding from our analysis, in our view, is that it is more important to

establish the right institutions and mechanisms to deal with problems when they occur and

to help ensure that the monetary union is credible than to try to ensure that each of the

‘economic’ conditions for a monetary union is met (and, in particular, we find that business

cycle synchronisation is less important than the original OCA literature proposed).

In addition, we have also argued that: (i) the adjustment to region-specific shocks is painful

even in successful monetary unions, such as the US; (ii) Europe’s lack of wage flexibility

represents its key ‘economic’ – as opposed to ‘institutional’ – weakness; (iii) the inter-

regional insurance provided by US federal fiscal policy directly offsets around 14% of the

initial effect on income from state-specific economic shocks; (iv) among Euro area

economies, there has been negligible cross-country fiscal or capital market risk-sharing and

the degree of country or state-specific risk that remains unsmoothed is much higher than in

the US; and (v) the perception of irrevocability – among electorates and investors – plays a

crucial role in ensuring that monetary unions work.

One difficulty in trying to evaluate the precise importance of each of the factors discussed

in this paper is that, because they operate as complements and substitutes for each other,

there is no single combination of factors that ensures the workability of a monetary union.

A separate difficulty is that each of the factors discussed operates across different

dimensions and across different timeframes (with fiscal and capital market risk-sharing

helping to smooth the effects of region-specific shocks in the short run, while wage

flexibility and labour migration provide more permanent adjustments).

Nevertheless, the broad conclusion that ‘institutional’ factors (fiscal federalism, financial

integration and political union) and wage flexibility are more important than other

‘economic’ factors (cyclical symmetry, the degree of trade integration and labour mobility)

is – tentatively – positive for the Euro area. This is because European policymakers have it

within their power to adjust institutional factors and to implement reforms that would

increase wage flexibility, whereas there is little they can do to adjust deeper economic

relationships (such as business cycle synchronisation, trade integration and cross-country

labour mobility). This is not to suggest that adjusting Euro area institutions or

implementing labour market reform to make EMU work will be easy – as it clearly isn’t –

but at least it is possible.

Labour market reform

Of the various ‘economic’ factors highlighted by Optimal Currency Area theory, only real

wage flexibility can credibly claim to play an important role in the US’s greater workability

as a monetary union.

Regaining external competitiveness through wage adjustment is typically costly because

the Phillips curve – which sets out the relationship between the size of the output gap (or

the level of unemployment) and inflation – tends to flatten as unemployment rises. While

wage growth and inflation tend to fall when an economy is cyclically weak (i.e., there is a

negative output gap), inflation and wage growth typically struggle to fall below zero

regardless of how weak the economy becomes.



Exhibit 26: Cyclical adjustment of prices alone is difficult

because Phillips curve is flat Stylised Phillips curve linking inflation to output gap

Exhibit 27: A less flat Phillips curve means less 'pain' is

required to regain competitiveness Stylised Phillips curve linking inflation to output gap



Starting from Point A in Exhibit 26, the decline in inflation implied by the transition to Point

B starts the process of regaining competitiveness. But, as the output gap turns increasingly

negative (Point C), the additional benefit in terms of lower inflation (and, therefore,

improved competitiveness) is small.

This downward price rigidity at large negative output gaps in part reflects the importance

of the 0% nominal threshold in the setting of prices and the fact that nominal wages, in

particular, are rigid downwards (i.e., workers are less prepared to accept a 1% decline in

nominal wages when inflation is zero than a 1% rise in wages when inflation is 2%). In

economies where there is a high degree of flexibility in the setting of wages and other

prices, the importance of the 0% threshold typically appears less pronounced.

Two factors can help to reduce the cost of labour market adjustment in the periphery:

Structural reforms that adjust the slope of the Phillips curve: Exhibit 27 shows

how the situation would differ if the Phillips curve did not flatten out as the output

gap turns negative. If wage growth is responsive to labour market weakness, then

unemployment will need to rise by less to bring about the required

competitiveness adjustment. (In Exhibit 27, as the economy weakens, it transitions

to Points B’ and C’, where inflation is lower than at B and C and, thus, the ‘pain’

required to regain competitiveness is less.) Labour market reform can improve the

unemployment-inflation trade-off in this way, if it increases flexibility. Spain has

introduced reforms that have contributed to a steepening of its Phillips curve but

progress elsewhere has been mixed (and, given that labour market legislation is

implemented at a national level, this is likely to remain the case).

Raising the average rate of inflation at which the adjustment takes place: The

adjustment of real wages is particularly difficult when average inflation rates are

low (because workers are typically more willing to accept nominal pay freezes than

nominal pay cuts). Germany will have to accept a period of above-average

inflation if the periphery is to complete the task of regaining lost competitiveness.

Both factors played a role in Germany’s adjustment from Europe’s ‘sick man’ to

‘powerhouse’ during the 2000s. Its transition was partly due to the implementation of the

important Hartz labour market reforms, but it was also facilitated by the relatively high

inflation rates that existed in the rest of the Euro area.

-2.0

-1.0

0.0

1.0

2.0

3.0

4.0

5.0

6.0

-8 -6 -4 -2 0 2 4

Inflation

Output Gap

ABC

-2.0

-1.0

0.0

1.0

2.0

3.0

4.0

5.0

6.0

-8 -6 -4 -2 0 2 4

Inflation

Output Gap

AB

CB'

C'



Institutional reform

In determining which institutional structures are necessary and which a monetary union

can do without, we need to recognise that there is more than one way to make a monetary

union workable. Progress towards deeper integration in one dimension can be a substitute

for making progress along another. For instance, the size of cross-country fiscal transfers in

the Euro area may never match inter-state transfers in the US, but a greater degree of risk-

sharing through a more integrated financial system could be sufficient to make EMU work.

The negotiations taking place to develop the Euro area’s steady-state framework are

developing along the two institutional dimensions discussed here: fiscal/political and

financial/banking. As the Euro area’s principal creditor country, Germany has fought to

ensure that fiscal and financial risks will not be shared across either dimension without

countries first displaying a willingness to consolidate and reform. It has also been one of

the strongest advocates for greater fiscal/political integration, while displaying markedly

less enthusiasm for financial/banking integration. France, by contrast, displays greater

enthusiasm for financial/banking integration, but is reluctant to relinquish fiscal/political

sovereignty.

Because fiscal and financial integration can act as substitutes for each other, neither

approach is necessarily ‘correct’. But there is a clear risk that the lack of agreement on

which approach to prioritise could result in neither being implemented adequately.

Worryingly, there has been a marked reduction in the impetus to implement changes

across either dimension since market pressures have eased:

In terms of fiscal/political integration, there appears to be a reluctance to move

beyond the ‘enhanced surveillance’ procedures set out in the revamped Stability

and Growth Pact. Adherence to the Stability and Growth Pact rules may be a

necessary condition for preventing a future crisis but it is clearly not a sufficient

condition – after all, some of the countries that were hit hardest by the crisis had

been scrupulous adherents to the rules (Spain, Ireland), while those who had

flouted the rules went relatively unscathed (Germany, France). In the future, it will

remain difficult to uphold fiscal commitments made – even when enshrined in

treaties – as long as the political legitimacy remains at the national level. In other

words, there may need to be genuine political union before a fiscal union can work.

We are therefore sceptical that the changes agreed imply a sufficient degree of

fiscal/political integration to ensure the Euro area’s long-term survival (at least in

the absence of much deeper financial/banking integration).

In terms of financial/banking integration, the introduction of a common

supervisory framework is a necessary – but not sufficient – step towards deeper

financial integration. However, there has been back-tracking on an earlier

commitment to introduce direct recapitalisation of peripheral banks from the ESM

bailout fund and there appears to be little prospect of a single Euro area deposit

guarantee.15

Progress has been made but, in our view, Euro area institutions are not yet sufficiently

robust to ensure that the monetary union remains workable in the long run. While

institutional reforms that would represent a sufficient steady-state framework have been

discussed, they are yet to be implemented to a sufficient degree. It may be that the Euro

area ‘needs’ a renewed bout of market tension to provide policymakers with the impetus

required to complete the construction of a workable monetary union.

15 The European Commission originally proposed, in June 2012, that there would be four pillars to Europe’s banking union. These included: (i) a single EU deposit guarantee scheme covering all EU banks; (ii) a common resolution authority and a common resolution fund for the resolution of, at least, systemic and cross-border banks; (iii) a single EU supervisor with ultimate decision-making powers, in relation to systemic and cross-border banks; and (iv) a uniform single rule book for the prudential supervision of all banks.



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