Academic journal article International Advances in Economic Research

From Hero to Zero? the Role of the Euro in the Current Crisis: Theory and Some Empirical Evidence

Academic journal article International Advances in Economic Research

From Hero to Zero? the Role of the Euro in the Current Crisis: Theory and Some Empirical Evidence

Article excerpt

Abstract A simple theoretical model of monetary unification and data from 11 euro members are used to investigate the common currency's role in the macroeconomic performance of these countries. Euro membership has been typically accompanied by lower (or steady) inflation, but also by higher business-cycle volatility In addition, synchronization of cyclical output was substantially affected by the common currency only in Greece (where it declined considerably) and Finland and Ireland (where it increased). Consistent with the theoretical predictions, the empirical evidence shows a strong negative relationship between cyclical synchronizations and volatilities, which however is not much stronger under the euro than it was during the Maastricht period.

Keywords Euro * Monetary integration

JEL E42 * F36 * F42

Introduction

In the early stages of the global financial crisis of 2007 through 2009, the consensus was that membership in the euro area was a highly effective way of shielding a European economy, especially a small open one, from the most damaging consequences of the crisis. Conversely, an independent currency was thought to expose an economy to dangers that were, at least partly, avoidable. The classic example then was Iceland--being a small economy out of the euro which was thought to provide a sure way of amplifying the shocks that were destabilizing the economy (Buiter 2008; Economist 2008).

Later on, however, the consensus changed, eventually making a turn of 180 degrees in less than two years. It is now thought that, for a European economy during a crisis, membership in the euro was not only unhelpful--it was actually detrimental (Tully 2010; Economist 2010b). The classic example became Greece and the argument was that euro membership was the surest way to lead to a destabilizing trap of reduced competitiveness and high debt. The argument progressed so far that the entire euro architecture was thought to be unstable or undesirable (Brittan 2010; Economist 2010a).

As the 2008 and 2010 vintages of the consensus are diametrically opposed, it is obvious that at least one of them must be wrong. In fact, it is tempting to say that probably both are. As the economic theory we will use in the next section makes clear, adopting a common currency comes with both benefits and costs, and it is only natural to expect that these will be time varying, so that the net benefit may at times be positive and at other times negative. It is not surprising then that looking at isolated instances, membership in a currency union can be made to appear sometimes as an asset and at other times as a liability.

This paper investigates the role of the euro in the recent macroeconomic performance of 11 euro member countries, including Greece. First, a simple theoretical model is used to derive the predicted macroeconomic consequences of adopting a common currency.(1) Then, we use the data to quantify the magnitudes of these effects and the relationships among them. Finally, we ask whether the empirical observations are consistent with the theoretical predictions.

The paper's results suggest that euro membership has been typically accompanied by lower (or steady) inflation, but also by higher business-cycle volatility. Additionally, the synchronization of most countries' cyclical output was not substantially affected by the common currency--except in Greece (where it declined considerably) and Finland and Ireland (where it increased). Consistent with the theoretical predictions, the empirical evidence shows a strong negative relationship between cyclical synchronizations and volatilities, which, however, is not much stronger under the euro than it was during the Maastricht period.

The rest of the paper is organized as follows. Simple Theory outlines the paper's basic theoretical framework. The Data introduces the data sources and definitions and presents some basic time series. …

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