Benefits and costs of entering the eurozone.

• Author: Tavlas, George S.

Europe's single-currency undertaking is perhaps the boldest attempt ever in which a large and diverse group of sovereign states has attempted to reap the efficiency gains of using a common currency. On January 1, 1999, 11 European Union countries initiated the European Monetary Union by adopting a common currency, the euro, and assigning the formulation of monetary policy to the Governing Council of the European Central Bank, based in Frankfurt. Two years later, Greece became the 12th member of the EMU. In May 2004, 10 additional countries joined the EU and eventually will become members of the EMU. (1) The EMU is the culmination of a process that began in the aftermath of World War II with a range of narrow economic-cooperation agreements, leading to the creation of a common internal market, and, now, to a common central bank and a single currency.

The decision whether to join the EMU is part of a broad economic and political calculus about the advantages and disadvantages of participation in a monetary union. What are the benefits and costs of entering the eurozone? This article addresses that question.

Exchange Rate Regimes and Globalization

In recent years, a large part of the economics profession appears to have become converted to "the hypothesis of the vanishing middle." The underlying premise of this hypothesis is that increasing globalization has undermined the viability of intermediate exchange rate regimes, such as adjustable pegs, crawling bands, and target zones (Eichengreen 2000: 316). (2) What has caused the retreat from the middle ground?

First, an explosive increase in capital flows has had important implications for the ability to conduct an independent monetary policy. While the rise in capital flows has increased the potential for intertemporal trade, portfolio diversification, and risk sharing, it has made the operation of soft pegs problematic. This circumstance gave rise to Cohen's (1993) thesis of the Unholy Trinity: under a system of pegged exchange rates and free capital mobility, it is not possible to pursue an independent monetary policy on a sustained basis. (3) Eventually, current account disequilibria and changes in reserves will provoke an attack on the exchange rate. Consequently, economies that wish to maintain pegged exchange rates will have to relinquish their monetary policy autonomy or resort to capital controls.

Second, the enormous increase in capital flows has been accompanied by abrupt reversals of flows. Whereas the logic of the thesis of the Unholy Trinity suggests that exchange rate attacks typically originate in response to current account disequilibria and build up gradually, in fact, recent speculative attacks have often originated in the capital account, have been difficult to predict, and have included the currencies of economies without substantial current account imbalances. Capital-flow reversals have involved a progression of speculative attacks, mostly against pegged exchange rate arrangements, beginning with the currencies participating in the exchange rate mechanism (ERM) of the European Monetary System in 1992-93, and continuing with the Mexican peso in 1994-95, the East Asian currencies in 1997-98, the Russian ruble in 1998, the Brazilian real in 1999, and the Turkish lira in 2001. These reversals of capital flows and resulting exchange rate devaluations or depreciations have often been accompanied by sharp contractions in economic activity and have, at times, entailed "twin crises"--crises in both the foreign exchange market and the banking system (Kaminsky and Reinhart 1999, Tavlas 2000).

Third, there has been a tendency for instability in foreign exchange markets to be transmitted from one pegged exchange rate regime to others in a process that has come to be known as "contagion" (Masson 1998, Edwards 2000). The victims of contagion have seemingly included innocent bystanders--economies with sound fundamentals the currencies of which might not have been attacked had they adopted one of the corner solutions.

Fourth, the expansion in international trade in goods and services has heightened the relationship between exchange rate volatility and trade performance. The use of a common currency eliminates exchange rate risk and facilitates trade in goods and services and financial exchanges. The expansion of world trade has made this factor increasingly important (Alesina and Barro 2001). In the case of the EU, the rising concentration of trade among the members has meant that there are greater savings in transactions costs associated with the use of a single currency.

The implications of the hypothesis of the vanishing middle for smaller and medium-sized EU economies are clear-cut. In a world of highly mobile capital, two exchange rate regime options are viable: either floating exchange rates or a hard peg. Within the hard-peg option, there are several alternatives: a monetary union, a currency board, or official dollarization (or euroization). In what follows, the rational for the monetary union option is discussed and compared with the alternatives of a currency board, dollarization, and floating exchange rates.

The Calculus of Monetary Unification

Traditional optimal currency area (OCA) theory deals with the conditions under which economies can join together to peg the exchange rates of their currencies against each other irrevocably or adopt a single currency, follow a common monetary policy, and provide for the complete freedom of both current and capital transactions with each other; and the benefits and costs of participating in such an arrangement. (4)

With regard to the conditions necessary for monetary union, the earlier literature identified several characteristics as relevant for choosing the likely participants in an OCA. Friedman (1953) observed that an economy afflicted with price rigidities should adopt flexible exchange rates to maintain internal and external balance. Friedman's argument left the impression, however, that any economy should adopt flexible exchange rates irrespective of its other characteristics (i.e., apart from price flexibility) (Ishiyama 1975). Subsequent work, therefore, sought to refine the optimum currency domain. Thus, Mundell (1961) singled out factor mobility as the key attribute since where such mobility exists there is less need for nominal exchange rate variations as a means of correcting external imbalances in the event of an asymmetric shock between two economies. McKinnon (1963) introduced the idea of openness as a key characteristic. The more open the economy, the greater the desirability of fixed exchange rate arrangements since exchange rate changes in open economies are unlikely to be accompanied by significant effects on real competitiveness. Kenen (1969) argued that the higher the level of fiscal integration between two areas, the greater their ability to smooth asymmetric shocks through fiscal transfers from a low-unemployment region to a high-unemployment region.

While the foregoing approach has proven useful in some circumstances, it has lacked predictive power. For example, it is widely accepted that, in terms of the above criteria, the 12 participants in the EMU do not constitute an OCA to the extent that regions of the United States do (e.g., Beine et al. 2003 and De Grauwe 2003). Yet, the EMU is a reality. One major problem associated with the earlier approach is that the attributes by which optimality is judged need not point in the same direction. For example, an economy might be open (suggesting the preferability of a single currency), but the same economy might also possess a low degree of factor mobility with adjoining areas (implying the desirability of flexible exchange rates). This problem of inconclusiveness is compounded by the fact that the criteria are difficult to measure unambiguously and, therefore, cannot be formally weighed against each other (Robson 1987: 139).

The alternative approach, based on the benefits and costs of monetary union, is more pragmatic, has proven more relevant, and sheds considerable light on the drive toward the EMU.

Exchange Rate Uncertainty and Trade

The basic case in favor of monetary union rests on the desirability of eliminating exchange rate uncertainty, which is alleged to hamper trade and investment. The adoption of a single currency, however, eliminates exchange rate risk. This risk is equivalent to a cost to a risk-averse trader, and the trader will sometimes bear an explicit cost to avoid it. Although this cost may be small, particularly for short-term transactions (because transactions costs are low for foreign exchange), the bid-ask spread widens with volatility; also, forward markets exist for only about a year or so into the future. Since it is like a transportation cost, in that exchange rate risk affects trade in both directions, exchange rate risk will tend to reduce a country's exports and imports (Tower and Willett 1976). (5) With regard to the EU, the single market has led to a substantial rise in trade among the members. The elimination of exchange rate uncertainty has been an important factor underlying the creation of a common currency.

Information and Transactions Costs

A single currency enhances the role of money as a unit of account and medium of exchange. With a single unit of account, price comparisons are facilitated, resulting in less market segmentation (Mongelli 2002). Since buyers can engage more effectively in comparison shopping, a single currency may promote competition. The benefits of a common unit of account are likely to be especially pronounced for open economies...