Is the Eurozone an optimal currency area?

The European Commission introduced the European Monetary System in 1979 that entailed several countries that were part of the European Economic Community and pegged their exchange rates based on a European Currency Unit. It is following this event that discussions ensued over the likelihood of the Eurozone becoming an Optimal Currency Area (Krugman,2013). The Euro got introduced in 1999 by the European Union which became common currency. At first, the Euro served as an electronic currency that was used by banks. However, as of January 2002, the Euro was used as bank notes and was a legal tender used by 12 countries in their transactions such as Germany, Greece, Luxembourg, Belgium and Austria among other nations.

Mundell postulated the optimum currency area theory in 1961 and mainly focused on geographic areas that could benefit from using a single monetary policy with a common currency or fixed exchange rates. The theory was a counter to arguments developed by Friedman that it is the flexible exchange rates that facilitated correcting changes responsible for ushering in external equilibrium. In establishing the premise that a geographical region was an optimal currency area, Mundell conducted a series of studies on the mobility of factors with regards to labor as the primary prerequisite.

A currency that is characterized by the high mobility of labor and other factors translated to a high likelihood that degree for altering the real factor price was probably to be lower (Scharpf,2015). High degree of labor mobility meant that employees could have the flexibility and freedom of moving to different nations which could be attributed to having desirable demand conditions in reducing the level of unemployment in their respective domestic countries. On the other hand, wage flexibility meant that adjustment in the exchange rate in case asymmetric shock occurred as possible, and such an adjustment originated from wage adjustments as wages are the most vital elements of costs thus affect prices.

In the 1990s, the future of one European currency was an interesting debate, and according to some scholars they revealed that asymmetrical shocks were more conspicuous in European countries compared to others such as the US (Moravcsik,2012). However, some findings revealed a correlation between the advantages to be accrued from a common currency such as its microeconomic nature translates to minimize transaction costs and fewer risks. On the other hand, the costs of a common currency are also microeconomic and are linked to the loss of freedom of monetary policy and exchange rate adjustment if asymmetric shocks take root.

Considering the EMU and for instance, Italy becomes a victim of asymmetric shock which could lead to increased unemployment in Italy but not in any other country in the European Union. In such a case, the adjustment has to originate from the relative prices in member nations aiming to make Italy competitive thus reducing its level of unemployment. Since the exchange rate is pegged, the adjustment has to be effected in the prices of goods and services (Costantini et al.,2014). Wages have been found to be the vital component with regards to costs, and thus an adjustment in the exchange rate can stem from changes in wages. Thus, flexibility in wages becomes desirable in the context of a common currency.

The flexibility of price and wage

The primary cost associated with a common currency is that member nations are more likely to bear suffering from asymmetric shocks. For instance, a country that gets hit by one of the shocks responsible for unemployment in that nation but does not affect other countries in the same currency union means that such a state cannot devalue its exchange rate so that it becomes competitive as the exchange rate is pegged. Also, the country does not have the option to relax its monetary policy to rejuvenate and revive its economy as the monetary system is autonomous. Thus, dealing with macroeconomic shocks is are limited to a great extent for individual nations. The only adjustments accepted have to come via other channels that define the optimal currency area.

From the above discussions, it is clear enough as to whether the Euro Zone is an optimal currency area. It is important to acknowledge that welfare advantages of member states of European union increased following the consolidation of the monetary union under the Euro which now became common currency (Keklik, nd). Factors such as flexibility of price and wage, mobility with regards to factors of production such as labor and fiscal integration became the relevant parameters to evaluate the extent of optimality of the currency area. This meant mobility for labor was to be low, and wages were to be rigid while on the area of fiscal integration nothing was to be done.

The fiscal policy continued being a national policy as opposed to being a common one. Political integration remains a controversial matter as the European Union got stuck with regards to its approval process. Generally speaking, it would be prudent to state that Eurozone is not an optimal currency area. The Economic and monetary union should prioritize becoming effective in many regions to ensure that the Eurozone meets the stipulated conditions set out by the Optimal Currency Area theory for it to be recognized as the Optimal Currency Area.

The Euro was once described as a building that is burning but lacks exits, and this has been proven through Italy’s experience over the past two decades as foretold by a conservative party leader, William Hague (Larry, 2018). It is during the end of the 1990s that becoming a member of a single currency was made easy for member countries. Italy as one of the signatories of the Rome treaty, it was desperately seeking to be among the monetary union first phase (Puetter,2012). There was little to no evidence of whether a nation such as Italy characterized by inflationary tendencies could handle the rigors associated with single currency membership. On the other hand, when it became known that Italy failed to satisfy the set criteria, it was apparent that the rules got bent to ensure that Italy got onboard (Larry, 2018). The outcome of this has led to Italy losing as a result of a dwindling economy for the last two decades where the standards of living have been reported to stagnate, and this has been attributed to be the sole reason why Italy gave up on mainstream politics.

Costs attached to a common currency

The coalition government which appears to be a product of two populist and skeptic parties that is the Five Star Movement and the League seems to be imminent. However, both wings of the coalition have not demonstrated any love for the euro, and they have identified the truth asserted by Hague (Larry, 2018). They drafted a policy agreement that entailed a proposal advocating that the EU should have a procedure for nations to leave the euro whenever they deemed fit to do so though this proposal was later dropped. It is apparent why the proposal was dropped as the financial markets would purport that the new populist state was serious about exiting the single currency, then the Italian government bonds would become riskier.

On the other hand, investors would demand a higher return for holding on such bonds, and that would eventually drive up interest rates in the market. The European Central Bank could help ease the situation by purchasing the Italian bonds but would have minimal to no incentive to assist a government in Rome disregard the monetary union (Larry, 2018). In this case, a financial crisis would engulf the new government. The nervous Italian Banking system would collapse, and Italy would fall into the worst recession ever witnessed in the country. The unemployment levels would rise, and the Five Star Movement and the League would be criticized and blamed for the unfolding of such events. The once popular populists would soon be forgotten. Thus, the new Italian government suffers the same fate as any other government the country has had for the past twenty years. Membership to one currency is indeed a curse but trying to exit the euro would have far dire repercussions. Just like Greece, Italy discovered when it was too late that it would have been much of relief if the euro was constructed with several fire exits (Massey and Coluccello,2015). It is much easier for Britain that has its central bank and currency to exit the EU than Italy.

However, despite Italy being unable to have monetary independence, the new government has plans with regards to tax and government spending considered to be a challenge in the manner the eurozone has been operated hitherto. These entail income of new citizens, pensions that are more generous and lower taxes. It is estimated that this will cost approximately €60 billion annually and this is roughly 3.5% of Italy’s gross GDP (Larry, 2018). This may lead the application of eurozone fiscal rules that impose limits on the size with which budget deficit could be allowed to operate. It would also raise the debt ratio of Italy from being over 130% of the GDP to 150 % of the gross GDP (Larry, 2018).

It is the possibility of having a marked flexible of policy that threatens the financial markets which may not be received lightly in other capitals of the European Union. However, it is the coalition of fiscal policies that seem to be noble. The primary challenge appears to be the eurozone’s deflationary fiscal regulations (Gros and Mayer,2010). The gross indebtedness in Italy is lower that is having both the private and public combined compared to countries such as Britain and Spain. However, the most pressing issue as far as EU’s fiscal rules are entailed public debt is the primary concern (Zoli and Sgheri,2009). The government of Italy was denied the opportunity of recapitalizing its banking sector, and this led to the Italian government stagnating for more than ten years.

Italy’s position in the Euro Area as far as its economy is concerned

It is following 2002 New Year day that Italians convened in Rome celebrating and ushering in the new era of euro notes and coins that had been confirmed as the legal tender (Larry, 2016). However, it soon became evident in the minds of many that the advent of the euro as the sole currency as a fresh start for the Italian economy was misplaced (Alesina and Giavazzi,2010). Poor performance as a whole had marked the eurozone though Italy remained adamant. Greece and Spain at least had a taste of booms before a series of tormenting busts came lurking in their doors. France and Germany have luckily managed to find their way back to the lost ground following the deep recession of 2008-09.

It is surprising to find that the GDP per capita in Italy is 4% higher compared to the past 15 years. The economy has been reported to be much smaller than it was in 2008 (Larry, 2016). High unemployment rates have become the order of the day in Italy and currently stands at 11.6%, and participation of the labor market has been reported to be low (Larry, 2016). In 2014, the birthrate was said to be the lowest since Italy came into existence in 1861. Italy’s economy has been ranked as the third largest in Europe suffers from one major setback, the goods and services are exorbitant compared to those of rival countries (Hopkin,2012). It is due to such a lack of competitiveness that Italy’s economy has witnessed considerable surges in the export market share of developed economies.

The leader of the Five Star Movement has continued to criticize the European Commission for its continued arrogance following Britain’s decision to exit the bloc (Gaunt, 2017). The populist parties have been for a long time asserting how Italy has been impacted negatively by the European Union imposed austerity that has led to the decline of investment in the country (HOPKIN,2013). Italy has been shouldering on the burden of the European migrant crisis. It is at the discretion of many that the EU has had many talks about solidarity yet fails to provide enough finances for Italy to manage or distribute refugees equitably across the bloc (Jones,2015). The EU in this context was beholden to the markets, large enterprises and financial agents but not to the needs and interests of citizens particularly not in Italians, it is as though not enough austerity had been imposed from Brussels.

According to the polls that were conducted recently by Pew Research, the indication that the support by the Italians to leave the EU is declining. The polls indicate that more than 55% still advocate for Italy to remain in the bloc while 35% is for Italy to leave and this shows that the exit may not be successful such as Brexit (Paniello, 2018).

The main concern revolving Italy’s threat to forsake the Euro is that the Euro will soon begin to lose its value (Feldstein,2012). It is true that both Italy’s population and economy compose large portions of the Eurozone and the thought of losing labor and capital offered by Italy may have far-reaching dire consequences. However, it is evident that the primary issue in the matter of exchange values is the level of uncertainty that prevails in the status quo (Paniello, 2018). It is between November 2017 and April 2018 that saw the Euro lose a substantial amount of exchange value compared to other currency such as the dollar. It is since then that the Euro has witnessed a first rebound that was followed by a retraction. Using the exchange rate data of the past one decade, it is apparent that the international markets have been encountering greater extent of variability. Despite having several variables that contribute to such changes, the future uncertainty with regards to the role of Italy in the European Union has irrefutable significant impact.

Dropping the Euro and replacing it with a weaker currency presumably the Lira could play help a critical role in making Italy more competitive through cheaper exports (Paniello, 2018). However, this could be offset by the costs and complications involved in such a move as it will be more expensive for Italy to pay back the € 2.3 trillion debt raising the risks it is compelled to default (Paniello, 2018). Italy’s economy would also be under pressure as devaluation is attributed to sending levels of inflations high by increasing the costs associated with imports.

There is a need to address Europe’s low potential output growth rate (European Stability Mechanism, 2017). The poor demographics indicate that growth can only originate from gains in productivity. Structural reforms, in this case, need to advance in all countries and not just those that were recipients of the ESM assistance programme (Gocaj and Meunier,2013). There is also a need for Europe to raise the participatory rate of women involved in the labor market. Also, the compulsory and effective retirement age should be raised for everybody. The robust investment could also help increase the potential growth output.

The European Union should also consider prioritizing on financial risk-sharing. It is through risk sharing that shocks that are either positive or negative to a particular country’s economy get shared by other member countries (European Stability Mechanism, 2017). This has the effect of streamlining business cycles and make economies resilient spreading across to the euro area. Risk sharing here can entail fiscal means and also through private markets, and such channels need to be widened in the eurozone.

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