chapter  II
70 Pages

II.2 Living inside a monetary union

In the run-up to the launch of the euro area, there were two broad schools of thought on how individual member countries would be affected by entry into the monetary union.2

The discussion boiled down to two issues: first, the frequency and importance of idiosyncratic economic shocks to Member States leading to asymmetric developments; and, second, the effectiveness of adjustment to such shocks which depended on the relative strength of the stabilizing forces of competitive pressures and the destabilizing effects of the – generally pro-cyclical – real interest rates. On the one side were those who believed that the member countries were too diverse

leading to many important asymmetric economic developments. In their view, the common monetary policy would turn out to be pro-cyclical and destabilizing leading to protracted boom-bust cycles. Proponents of this view put the EMU project into question, considering that it implied economic instability resulting in inefficient resource allocation. On the other side were those who believed that the single currency in itself would gen-

erate forces for greater economic integration and economic stabilization. The importance of increased trade competition and financial integration would in their view reduce the frequency and importance of asymmetric shocks. And when they occurred, competitive pressures would induce rapid and effective adjustment. EMU would be inherently stable and benefits of the monetary union would outweigh the costs in terms of the loss of the exchange rate and monetary policy. Looking at the developments since the launch of the euro area, economic performances

have differed markedly between Member States. Differences in price and wage inflation have been substantial, perversely affecting real interest rates in the national economies. Moreover, inflation differentials have been particularly persistent, also compared to the experience in the US. This persistence implies large shifts in measures of competitiveness and in particular real effective exchange rates. At the same time, substantial and persistent current account imbalances have emerged. It is still difficult to arrive at precise estimates on the impact of the individual channels. We

approach this issue by asking the question how well a standard DSGE model – which makes strong predictions about the stability of a monetary union provided that the Central Bank targets the area-wide inflation rate – can account for the stylized facts on growth, inflation and current account divergences in EMU. We identify shocks and estimate their order of magnitude by means of shock accounting. The analysis applies to both adjustment in the euro area on entry and adjustment in the euro area in its steady state. This framework allows us to assess shocks that trigger adjustment dynamics and to pinpoint which factors determine the

speed of adjustment and the risk of overshooting. Models of this kind have been used by Fagan and Gaspar (2005) to study the current account developments and by Lopez Salido et al. (2005) to investigate inflation differentials in EMU. However, to our knowledge no attempt has been made so far to look at various developments and channels simultaneously. The countries that we consider in the simulations are: Germany, Spain, Ireland, Italy,

the Netherlands and Portugal. The Netherlands and Portugal, in particular, experienced high growth and overheating pressures towards the end of the 1990s and early 2000s. The subsequent slowdown was characterized by a drop in inflation, downward revisions of potential growth and a marked deterioration in the budgetary position. Other Member States have not seen a similar reversal in their economic fortunes. In Spain, economic growth and inflation continue to be above the euro-area average. These developments have been paralleled by high wage growth, booming asset prices and credit growth, and deteriorating current account balances. The experience of Germany in the euro area has been characterized by a protracted period of slow growth. This period of slow growth and lacklustre domestic demand has been accompanied by low inflation and wage growth and the regaining of competitiveness. Italy can be considered the ‘odd man out’ with a continuous loss in competitiveness coinciding with slow growth.