Sunday, January 4, 2009

10 years of the Euro: Part I. Economic Dividend

Following one of the reader's suggestions, I decided to post some of my thoughts on the Euro and the direction of the EUR/USD and EUR/BPS exchange rates. This is the first blog post dealing with these issues.

A prior disclosure (see below)...

On December 29, 2008 Harvard’s Jeffrey Frankel – one of the world’s leading international macroeconomics experts wrote:
“By roughly the five-year mark after the launch of the euro in 1999, enough data had accumulated to allow an analysis of the early effects of the euro on European trade patterns. Studies include Micco, Ordoñez and Stein (2003), Bun and Klaassen (2002), Flam and Nordström (2006), Berger and Nitsch (2005), De Nardis and Vicarelli (2003, 2008), and Chintrakarn (2008)… Overall, the central tendency of these estimates seems to be a trade effect in the first few years on the order of 10-15%. None came anywhere near the tripling estimates of Rose (2000), or the doubling estimates (in a time series context) of Glick and Rose (2002).”

Reasons for relatively poor performance
In his 2008 paper, Frankel looks at the possible reasons for this poor (relative to the original expectations) performance of the common currency:
(1): It takes time for the effects on trade to reach full potential;
(2): Monetary unions have smaller effects on large countries than small countries, and
(3): The original estimates were spuriously high because bilateral currency links have historically been the result of bilateral trade links rather than the cause (the so-called endogeneity problem).

What Frankel found was that correcting for the first argument does not change the rate of underperformance of the Euro relative to the original expectations. In other words, “at the moment there is little evidence to support the lags explanation”. With respect to the second argument, Frankel established that “There is no tendency, overall, for currency unions to have larger effects on the trade of small countries than large.” Finally, testing the third explanation also shows that it fails “to explain the gap between the recent euro estimates and the historical estimates”.

What all of this suggests is that the original justification for the existence of the Euro – the idea that it will boos significantly economic competitiveness of the exports-driven Euro block of countries – is yet to be confirmed. Neither on its 5th birthday, nor on its 10th anniversary did the Euro show a significant (economically) prowess to drive economic development of the Eurozone.

Even more egregious is the fact that the estimated effectiveness of the Euro to generate exports growth did not appear to move up between January 1, 2004 and the end of 2008.

A handful of strengths
This is not to say that the Euro has been a failure. Frankel – long-time champion of the common currency – states in another article that: “Looking back, the euro has in many ways been more successful than predicted by the sceptics — many of them American economists.” The list of such successes that he provides relates only to the metrics which reflect the positive reception of the Euro and the ECB amongst the world economies.

More trouble ahead
However, as Frankel puts it:
“…some of the sceptics' warnings have come to pass: shocks have hit members asymmetrically; cushions such as US-type labour mobility have remained thin; and the Stability and Growth Pact has proven unenforceable. Furthermore, the popularity of the project with the elites does not extend to the public, many of whom are convinced that when the euro came to their country, higher prices came with it.”

The latter point is now being reinforced by the former across all European economies. In fact, popular decline of the Euro has been so steep in 2007-2008 that the Eurobarometer gauge of public opinion has shown declining willingness of the electorates in Germany, France, Italy and pretty much the rest of the Eurozone, to remain a part of the ECB-run common currency area in contrast to the upward support trend recorded in 2002-2006.

What is more problematic for the, still, relatively young currency is that the cost of the ‘one monetary policy – different economies’ strategy for the Euro might be a long-term suppression of growth across the entire Eurozone. If monetary policy were to become a tool for delivering European convergence, it might lead to the convergence benchmark being set at an anaemic growth trend of Germany, France and Italy. In other words, rather than pushing the slow growth larger Eurozone economies up, the Euro might be pushing faster growth ‘fringe’ economies (Ireland, Austria, Sweden and Finland, alongside the Accession 10 states that care to join common currency or peg to it) down.

Nobel Prize winning economist, Robert Fogel in a 2007 paper suggested that a rate of real GDP growth for the period 2000-2040 of 1.2 percent for the industrialized EU-15 will be only slightly higher than the 1.1 percent for Japan, but a “much lower than the 3.8 percent for the United states or 7.1 percent for India or 8.4 percent for China.”

A recent NBER paper by Michael Bordo and Harold James (NBER Working Paper 13815, February 2008) makes very similar point by stating that:
“In particular, there is the possibility for the EMU that low rates of growth will produce direct challenges to the management of the currency, and a demand for a more politically controlled and for a more expansive monetary policy. Such demands might arise in some parts or regions or countries of the euro area, but not in others and would lead to a politically highly difficult discussion of monetary governance.”

A litany of challenges
Bordo and James look into asymmetric regional shocks impact, labour mobility effects, wage and price flexibility conditions, and risk sharing mechanisms implicit under the Euro as discussed in the existent literature and find that in all of these issues, the Eurozone monetary policy institutions are inferior to the arrangements in the US.

“The most obvious threat to the single currency is usually held to arise out of the imperfect control and coordination of national fiscal policies,” say Bordo and James, going on to conclude, contrary to the pundits of greater federalism at the EU level that:
“A formalized system of fiscal federalism would however not necessarily deal with the problems of fiscal indiscipline on the part of member states. Indeed, the expectation of institutionalized transfers or bailouts following fiscal problems might well be expected to increase the incentives for bad behavior. Stricter observance of the existing system and its rules, on the other hand, might lead to pressure to reform. Fiscal reforms would in the longer run be expected to raise the rate of growth.”

Of course, to date, the EU has failed to enforce the code of fiscal discipline among its members. In fact, 2004-2005 saw a set of reforms aimed at diluting the Stability & Growth Pact criteria for fiscal performance.

Financial stability of the system is another area of challenge for the Euro, where the lack of coherent regulatory structure is the mirror image of the overly centralized monetary policy. Again, Bordo and Lames sum this up by saying that:
“The difficulty of an effective Europe-wide response to financial sector problems thus reflects a more general problem with respect to the making of monetary policy: there may be a different political economy of money in regions of the Euro-zone and EU member countries, leading to contradictory pressures on policy.”

All of this implies greater volatility around the trend for smaller and more open economies, so occasionally countries like Ireland will be going through more pronounced boom-and-bust cycles, but in the end, average (or potential) long-run growth will remain below that in the US, Canada, and the rest of the developed world.

Disclosure: I would like to explicitly state that I do not share in some analysts' view that Ireland would fare better outside the Eurozone, nor do I believe that the Euro has been a sort of a disaster. I see the Euro as a challenging and generally positive element of the European integration project. This view motivates my analysis of the weaknesses in the common monetary and currency policy to date. It is my desire to see a gradual strengthening of the European democracy and markets that inform my analysis. Sadly, I feel that this disclaimer is a necessity in the current climate of attacks on the freedom of thought and expression that characterise our (European) political and economic policy debates.
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