Has the process of monetary unification in Europe led to economic convergence or economic divergence in the Eurozone since 1999? This is a key issue that was discussed at a conference on EMU Divergences in Berlin last week that was co-organized by RGE.

Indeed, the long-run performance and success of the EMU depends on whether economic convergence or divergence is occurring. The ideas and debates at the conference are nicely summarized by Sebastian Dullien and Daniela Schwarzer (who co-organized the conference) in a blog at Eurozone Watch. 

Before the formation of EMU there were long debates on whether or not the Eurozone was an optimal currency area. The economic criteria for a successful monetary union were widely debated in principle. Now several years after the formation of the monetary union (formally started in 2002 but already effectively in place since 1999) there is enough economic data to make a preliminary assessment of the success of the monetary union.  It is useful to go back to some of the conceptual criteria for a successful monetary union and then test whether the economic performance of EMU has been consistent with such criteria.  Here is a concise overview of the economic criteria that make a currency or monetary union desirable:  

a)      There are little asymmetries in shocks and in macroeconomic transmission so that business cycles (per capita output levels and growth rates) are not widely and persistently divergent across countries;

b)      Consumption risk is sufficiently diversified across borders. In other terms, international financial markets work efficiently, so that agents can easily smooth consumption via risk sharing and international borrowing and lending across time.

c)      Fiscal policy – at the national and union level - can help stabilize national economies given asymmetric shocks;

d)      Prices and wages are sufficiently flexible so that relative prices (including real exchange rates) can adjust sufficiently even in the absence of a domestic currency;

e)      Factors are sufficiently mobile across regions of the union also in the short run, at low private and social costs.  

In the RGE paper Economic Divergences in EMU? Facts and Implications  (co-authored by Christian Menegatti, Elisa Parisi-Capone and myself) that we presented at the EMU conference we conducted a systematic overview of the evidence on economic convergence or divergence within the EMU.  In summary we found that:

-         There is only little evidence of per capita GDP convergence (in PPP terms), with Ireland being the only true example of standard of living catching up. Portugal, Greece and Spain do not show evidence of per capita income catching up.  Italy shows a decline in the standard of living.

-         Based on some measures there has been some decrease in growth dispersion within the EMU countries. Whether the recent pick up in growth in the Eurozone will continue this trend is a still an open issue. 

-         Financial channels (credit and capital markets) provide only very modest degrees of smoothing of national shocks in the EMU, especially compared to their role within the United States. Only 7% of shocks were absorbed during the full sample. However, this risk-sharing channel via the financial channels and the fiscal channel has significantly improved over time in the Eurozone and during the EMU period. 36% of the idiosyncratic shocks are now smoothed via these channels across the Eurozone. This is consistent with the evidence that the degree of financial integration has increased over time in the Eurozone.

-         The role of the financial channel is larger than the one of the fiscal channel; even in the most recent EMU period only 9% of asymmetric shocks are absorbed by the fiscal channel (as opposed to 1% for the full sample period). In the most recent EMU period the financial and credit channel smooth 27% of shocks.

-        The real exchange channel provides a mixed picture: there is some evidence of mean reversion, especially in Germany; but there is also evidence of persistent loss of competitiveness in countries such as Italy, Spain and Portugal. 

-         Finally, real interest rates have moved in way that has been partly destabilizing: based on trends in housing markets and other variables differences in real interest rates may have exacerbated financial and asset price bubbles in some economies with the risk of a boom-bust cycle. This is what happened to Portugal and to the Netherlands and what could happen to Spain.  

 Based on these results what can we say about the success or limitations of EMU? I would summarize the evidence from our paper and from the discussions at the conference as follows: