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. …