The Eurozone consists of a variety of blocks, with different socio-political, cultural and economic backgrounds. As a result, sharing a common currency, monetary policy and exchange rate policy is not optimal for all member economies of the Eurozone. With Southern European economies resurging after years of recession and fierce austerity, they might find themselves in a better position to bargain over the Eurozone’s monetary policy, hence enlarge the rifts on the Eurozone’s financial future.

Our observations

  • Economist Robert Mundell identified four conditions for an ‘Optimum Currency Area’ (a geographical region where sharing a common currency would maximize economic benefits): i) high factor mobility (labor and capital can move easily between regions); ii) wage and price flexibility (markets can ‘clear’ demand and supply between regions); iii) a well-functioning risk-sharing mechanism (fiscal transfers to redistribute wealth between regions); and iv) the currency area’s regions must have similar and converging business cycles (external shocks should increasingly have more or less the same effects in regions).
  • France, Spain, Portugal – and even Greece and Italy – all posted strong and accelerating GDP growth at the end of 2017 and beginning of 2018, and their growth forecasts are higher than the Eurozone’s average (except for Italy).
  • France, Spain, Portugal, Greece and Italy have run large government budget deficits for decades and have high debt-to-GDP ratios, failing to meet two of the key Maastricht criteria (the criteria that must ensure the stability and convergence of member states within the Eurozone).
  • Greeks work the most hours every year followed by Italians, Spaniards, and the French in the Eurozone. However, labor productivity in Southern European economies is much lower compared to Northwestern economies (which explains the strength of, for example, the German labor force).
  • Southern European countries play an important role in Europe: Spain, Italy and France are the only European economies with a GDP above €1 trillion besides Germany, while seven out of the ten largest cities in the European Union are in Greece, Portugal, Spain, France and Italy.

Connecting the dots

Economic regions share a common currency to reduce transaction costs, by eliminating exchange rate risks, for example, or the need for costly monetary exchange when trading. But there is an upper limit to including new regions in a currency area; it might be suboptimal for a geographical area to share a currency, hence have a common central bank, monetary and exchange rate policy. In theory, the Eurozone satisfies the first of Mundell’s conditions, as the ‘Four Freedoms’ of the European Single Market guarantee the free movement of labor, capital, goods and people (note, however, that this holds for the European Union, which is the political instead of the monetary union). But the financial crisis and especially the Eurozone debt crisis has shown that the Eurozone’s ‘regions’ (member economies) of the Eurozone do not have similar business cycles and respond differently to external shocks. Furthermore, because of these crises, the Northwestern and Southern economies saw diverging growth, wage and price levels and significant yield differentials. As the Eurozone lacks a proper risk-sharing mechanism, it fails to meet most of Mundell’s conditions, hence cannot be characterized as an optimum currency area. But with growth rebounding and momentum increasing in the Eurozone’s weakest member states, these problems seem to fade.

However, this trajectory will not be that easy. One of the biggest ‘problems’ is that Northwest European economies are too efficient and run large current account surpluses compared to Southern economies.

Therefore, they require different monetary and exchange rate policies. For example, Germany’s exchange rate is 15% undervalued, while most Southern European economies prefer a cheaper Euro to boost their exports. Another inflection point is that the current monetary policy is much too expansive for most Northwestern economies, hurting their frugal consumers and failing to impose stringent budget discipline on Eurozone member states, leading to critiques of Dutch and German central bankers. However, the low interest rate regime is critical to keeping debt levels in Southern economies sustainable.

Therefore, paradoxically, a stronger Southern Europe might mean that the internal cohesion in the Eurozone might deteriorate. As these countries will start growing faster than Northwestern European peers for the first time in a decade, price, wage and income differentials will decrease. However, before this convergence pattern leads to an equalization within the whole Eurozone, significant differences will remain. A resurgent Southern Europe, with economies and cities large enough to significantly influence Europe-wide matters, might be in a stronger position to bargain for a Eurozone monetary policy that might be beneficial to them (i.e. a lower Euro exchange and/or extending the ECB’s QE program). As a result, differences between Northwestern and Southern member states on the Eurozone’s financial future might increase in the medium-term.

Implications

  • As we have written before, money always has a political side. Although functionally independent on paper, it seems that the upcoming ECB reshuffle will become a political struggle. Five out of seven top prime posts at the ECB will change hands by 2019, including the post of ECB President, following Mario Draghi’s retirement. Rumor has it that Jens Weidmann, Merkel’s former chief economic advisor and current Bundesbank President, will be pushed as Draghi’s successor by Merkel to leverage Germany’s power into more influence in the Eurozone’s monetary policy.
  • With €2.3 trillion in debt, or 135% of its GDP or 20% of the Eurozone’s debt, Italy is ‘too big to fail’ for the Eurozone. Italy’s upcoming elections next month will be crucial to the Eurozone’s survival, and things do not look well for the Euro. Currently, the Eurosceptic Five-Star Movement is the largest single party, followed by a coalition of right-wing and mildly Eurosceptic parties led by Silvio Berlusconi.