Lessons from the European Crisis Part II

Market movers and shakers are now seriously considering the possibility of a euro zone breakup or, at the very least the Greek exit and possibly one or two more other members of euro zone at most. Euro-skeptics economists such as Feldstein and Friedman had predicted it onset that the euro would not survive its first crisis on the premise that this was a purely political project that ignored a number of economic and institutional fundamentals necessary for the success of a monetary union. These skeptics had pointed out the flaws in the Euro project, mainly the fact that, some of the members countries did not meet even the minimum Optimum Currency Area criteria, and that, the failure of these was a matter of when, and not whether. They were right. The Euro crisis has exposed critical design flaws in the project, especially in its institutions, which was hitherto considered a good model of a successful Common Currency Area (CCA). But this has sent critical lesson to other economies contemplating monetary union. Nonetheless, all monetary unions world over have drawn from the theory of Optimum Currency Area (OCA) formulated by renowned economists (including Mundell, 1961, Mckinnon, 1963, and Kenen, 1969) which sets out optimum conditions for a successful monetary union. The most important criteria for suitability of a common currency are the intensity of intra-regional trade and level of convergence of macro economic conditions. Others are diversification of production and consumption, price flexibility, level of financial markets integration, levels of cross-country Foreign Direct Investments, level of economic openness and levels of labour Mobility. Over time, however, experiences in euro zone and elsewhere has made it clear that extensive institutional framework, political as well as technical issues must be addressed to ensure the success of a monetary union. Discussion of the above factors in these series will highlight (with empirical evidence) lack of readiness of the East African Community (EAC) as an Optimum Currency Area (OCA) and the need to address the underlying constraints if EAC is to avoid crisis that currently faces the euro zone. Benefits of a Monetary UnionMonetary Unions which are political projects as they have been world over are expected to deliver immense benefits to the economies and by extension the residents of these economies if they are successful. Critical benefits of the monetary unions include, among others, elimination of exchange rate fluctuations between member states thus minimising transaction costs to businesses and tourists which leads to price stability. This ultimately stabilises asymmetric shocks as a result increasing economic welfare. For member countries, single currency would lower costs of cross boarder business through elimination of foreign exchange risks. Greater flows of intra-regional trade would put pressure on prices, resulting in cheaper goods and services among member countries leading to the rise savings.Secondly, the monetary union is supposed to give rise to financial integration. This is even more appealing to the EAC where financial markets are highly fragmented, thin, illiquid, informational inefficient, limited in size and in capacity, inefficient regulatory regimes, excessive risk factors, dearth of risk sharing and hedging mechanism, as well as weak legal and contract enforcement environment. A monetary union would then reduce transaction costs and uncertainty in these financial markets, enhance mobilisation of financial resources and increase access to the large pool of capital that trades off returns and risk more efficiently.Due to gross undercapitalisation in most single country financial markets, increased access to diversified sources of intra, and external capital will reduce cost of capital through increased risk sharing in local financial markets by international investors as such union creates ‘discipline’ and exposure to best financial practices. Furthermore, an integrated monetary policy means less volatile interest rates which on average would be lower than in a single economy. This boosts regional investments and thus economic growth. The prospect of sustained low inflation rates would reduce long-run interest rates and stimulate sustained economic growth and overall competitiveness. Besides, a common currency removes significant barrier to free competition across national borders. A single currency promotes price-transparency and as such customers can readily assess the relative price of similar products from within the union. In addition, the union makes member countries more powerful players in the global economy, and each country benefits from full-scale participation for the common currency would strengthen EAC identity. Dangers of a Monetary UnionNonetheless, a common currency has serious negative consequences which if not mitigated, can have far reaching consequences to all member economies. In the first place there is no guarantee that a monetary union will be success. A number of currency unions have collapsed in the past.Indeed a common currency may be a recipe for economic stagnation and higher structural unemployment like is happening in many EU countries at present. This is particularly true if the supranational monetary authority created pursues a deflationary monetary policy for EAC at odds with the needs of domestic economies.It is also highly probable that a monetary union is not sustainable as some countries find themselves in critical economic situations that can only be sorted out outside the union in which case these will opt out and re-establish their independent currencies and an inflationary monetary policy.Perhaps the major limitation of a monetary union arises from the fact that member countries are at varying stages of development. Each of these stages of economic development requires high levels of flexibility in macro and micro economic fundamentals.Under these circumstances, major economies (more developed) gain at the expense of the weaker or the so called peripheral economies. Lack of country specific flexible exchange rates denies a country of a very effective mechanism with which it can use to adjust imbalances between countries that may arise from differential shocks (demand or supply) to their economies. Economic history demonstrates that, a well planned devaluation can help a country out of its fiscal difficulties. For instance, in recession (a common economic cycle) a country in a monetary union can no longer devalue its currency to increase its exports by making them price responsive and thus competitive in international markets.Moreover, domestic monetary policy (which is surrendered to a supranational monetary authority in a union) can no longer be used to enable the economy to respond flexibly to external economic shocks such as rise in international commodity inflation.Even if the EAC was to be deemed to be an optimal currency area (which is far from that as will be argued later in these series) economic shocks such as crisis of supply of primary products will lead to imbalances and there will be no mechanism to restore the imbalance at all in a union.

Insight

Lessons from the European Crisis Part II