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«Paper prepared for the Foutth Pan-European Conference on EU Politics 25-27 September 2008, Riga, Latvia. Homogeneity of national economic policies ...»

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How to analyse heterogeneity in EMU : the case of

French/German economic policies

Paper prepared for the Foutth Pan-European Conference on EU Politics

25-27 September 2008, Riga, Latvia.

Homogeneity of national economic policies within a monetary union is necessary in order to

build a robust economic growth for all members.

However, the French-German example of the past decade underlines the fact that, in spite of

strong and long-time economic links, non-cooperative economic policies can still appear in EMU, leading to potentially gloomy economic performances for the whole monetary union.

This article uses a political economy analysis’ framework based on four criteria (stemming from the OCA’s theory) to reveal the depth of heterogeneity between the French and German economic policies.

This situation finally emphasizes the need to reform the present EMU economic and institutional framework, in order to take this heterogeneity into account, and to avoid non cooperative economic policies.

Author :

Damien TRESALLET Research fellow Fondation pour l’innovation politique, 75007 PARIS damientresallet@aol.com Acknowledgement This paper was made possible by the OFCE’s (Observatoire Français de Conjoncture) authorization to use GTAP data.

I – Introduction: What history tells us for a sustainable EMU The last years have seen a debate engaged in several Eurozone countries to know if it was desirable or not to leave EMU. It especially took place in France and Italy, where consumers have been subjected to high inflation rates and poor economic growth. For them, the Euro was the only one to blame for it, because it does not allow national economies anymore to use competitiveness devaluation in order to artificially regain price-competitiveness.

Apart from being absurd, this debate1 on leaving EMU or not shows how difficult it is to shape a monetary union that would be convenient to every country. Consequently, it is strongly needed to reflect on possibilities to improve the functioning of EMU. Whatever good would be the economic performances of the Eurozone at the European macroeconomic level, it is important to keep in mind that past monetary union experiences on the continent did not last that long, and therefore to explore the reasons for their failure.

The Latin Monetary Union (LMU) began in 1865 and included Belgium, France, Greece, Italy and Switzerland. The first difficulty appeared when nobody could agree on whether to choose bimetallism (gold and silver) or monometallism (only gold). The second one was the non-cooperative economic policy of Italy, whose Central Bank emitted new bills to replace old silver coins, without preparing their neighbours to it. As a consequence, the four other LMU countries were flooded with Italian coins.

The diplomatic tensions arising from these events, along with WorldWar I, finished strengthening divisions that led to the end of the monetary union in 1925.

An other famous experience of monetary union is the Scandinavian Monetary Union (SMU), which began in 1873 and comprised Denmark, Sweden and then Norway in 1877. Problems arose with World War I, showing wide diplomatic differences between the three neighbours.

During the War, Denmark traded much more with Germany than Sweden did, preferring to remain neutral. Contrary to Denmark, Norway helped the British with their navy fleet.

Afterwards, the two latter speculated intensively on the Swedish money, which was much Leaving EMU implies political as much as economic consequences, for a country as much as for the whole monetary union. Therefore, the accession to eurozone can be considered as irreversible. See for example Eichengreen (2007).

stronger after the conflict than Danish and Norge ones. This finally led to a progressive monetary divergence and to the end of the monetary union in 1931.

Non-cooperation is at the origin of the rupture of the LMU and SMU (Olszak, 1996). As a consequence, facing the critics over EMU, it is necessary to pay a careful attention at possible non-cooperative economic policies, and a reflection on EMU economic framework. This paper is aimed at trying to create a useful framework in order to analyse heterogeneity. In the next part, we will present the main theories dealing with adjustment and sustainability in a monetary union. Then, we will study an example of economic divergence in EMU, taken from the German and French economic policies of the last ten years, and the responsibility of the economic and institutional framework of EMU in these policies. Finally, considering this worrying example, we will conclude with a presentation of some solutions for the economic and political sustainability of EMU.

II – Sustainability, and how to adjust to country specific shocks in a currency union:

theories

1. Review of the literature about adjustment in a Currency Union, theoretical and empirical Joining a currency union (CU) implies its own benefits, as Robert Mundell ever set in 1961 in his primary article. These are the decrease of transaction costs, the improvement of prices transparency, the stimulation of competitiveness, the elimination of exchange rates uncertainties and the soar of Foreign Direct Investment (FDI).

But the American economist also found a great difficulty for a country in joining an OCA:





adjusting to country-specific (asymetric) shocks. Leaving the monetary policy independent, national economies can only use taxation to prevent and adjust to economic disruptions. That is why Mundell asserted the necessity for economies to increase wage flexibility and labour mobility.

After this famous article, many economists studied currency unions, developing OCA’s theories, i.e. the number of criteria a country has to match before entering a currency union, in order to minimize potential asymmetric shocks to occur.

In 1963, Robert McKinnon proved that the opportunity to create a CU depends on the degree of economic openness between two economies. The more they trade with each other, the weaker asymmetric shocks will be. Six years later, Peter Kenen (1969) emphasized the importance of product diversification. Obviously, each country has to develop a diversified production, not a specialized one. If a sector experienced a disruption, the centralised monetary policy could succeed much better than if this type of production was settled in only one country. Finally, Cooper in 1977 and Kindleberger in 1986 published articles that dealt with homogeneous preferences. They explained that a high level of international trade between two countries reveals common economic preferences and that in case of a monetary union, the closer the economic preferences are, the easier both countries face economic shocks. In Kindleberger’s article, economic preferences are defined as economic policies based on similar concepts/theories (the way two countries face unemployment/inflation dilemma). Homogeneity of preferences is linked with cultural and geographical integration.

In fact, for the economists of OCA’s theories, joining a currency union is possible only for the countries respecting some specific criteria, in order to cover the risks of future potential country-specific shocks. Obviously, the longer the list of criteria is, the harder it is for a country to join a currency union. After several decades of completing the OCA theory, economists turned the currency union’s theory upside down, thanks to Jeffrey Frankel and Andrew Rose.

Their 1998 original article explains that countries first had to enter a currency union before complying to a list of criteria, which anyway would never be complete. Actually, the surplus of trade and economic interdependence given by accession to CU makes the optimality endogenous. Consequently, the economic cycles of countries inside the CU become synchronised and, in a theoretical vision of economics, asymetric shocks disappear.

Frankel and Rose’s research, based on the gravity model, paved the way to numerous other articles like Smith (2002) or Frankel and Rose (2002) that tried to calculate the impact of monetary integration on international trade. The results are balanced. On the one hand, they succeeded in proving that a “trade effect” exists indeed and they even could quantify it. But on the other hand, the results are so different across the studies that it is impossible to consider a single or an average figure for this “trade effect”. Results go from 1,46 for Smith (2002) to 3,9 for Frankel and Rose (2002) ! The figures are even smaller in studies relying only on EMU2.

Moreover, regarding business cycles, this is not clear whether empirics are getting the same way as theories. Several studies demonstrated that European national cycles were synchronising (Bordo and Helbling, 2003; Hanaut and Mouhoud, 2003; Darvas and Szapary, 2005; De Lucia, 2008). However, the beginning of the convergence is very different along with the study. Some economists emphasize the synchronisation during the 1970’s, whereas some others prefer to concentrate on the period after the Maastricht treaty signature.

On the contrary, many other articles stress the fact that it’s hard to detect any homogeneous European cycle (Artis, Krolzig and Toro, 1999; Artis, 2007). Furthermore, it may be worrying to read articles concentrating on German economic cycle. Fichtner (2003), for instance, shows that the German asymmetric shocks may be closer to the American than to the European member states ones. Flaig, Sturm and Woitek (2003) exhibit a weak correlation between the German cycle and the one in other Eurozone member states. De Bandt (2006) emphasizes the importance of German reunification as a major cause for the remoteness of the German cycle from the other European ones.

Conclusively, adjustment to country specific shocks is still a matter of concern in EMU, and needs to be studied.

2. Our theoretical framework: sustainability, country specific shock and heterogeneity For OCA economists, a country specific shock occurring within a CU stems from a lack of economic integration. This lack of integration comes from heterogeneity, and that is why the latter must be reduced before the entry of a country inside a currency union.

The problem of OCA theories is that they never analysed how economic optimality can evolve (i.e. the ability for countries in a CU to face asymmetric shocks) after the creation of a CU – if we suppose that all OCA criteria are come up by all the applicant countries, so that optimality can exist. They do not answer the question of sustainability. Frankel and Rose

See for example Micco, Stein and Ordonez (2003), or Mancini-Griffoli and Pauwels (2006).

answered this question by showing that integration endogenously created optimality, but their estimation was not verified by empirical studies of business cycles.

Therefore, we can not consider trade integration to induce optimality. On the contrary, we consider that a currency union, even if it’s a far advanced stage of trade integration, can still lead to non-cooperative policies, when common mechanisms are not strong enough to correct national policies. Even after several years of economic integration, heterogeneity could still lay under common regional mechanisms, and we need a framework to understand and make them visible.

As some economists ever managed (Torres, 2007), we base our analysis on the same basis as OCA theories: heterogeneity (asymmetric shocks appear because of a lack of integration).

Consequently, we apply the four original criteria of OCA theories to study economic

heterogeneity:

• Wages flexibility (basis : Mundell, 1961)

• Economic openness (Mc Kinnon, 1963)

• Sectoral diversification (Kenen, 1963)

• Economic preferences (Kindleberger, 1986)

We focus on an empirical case of economic divergence during the 1997-2007 period of time:

German specific shock and its consequences for France, its first economic partner.

III – Frankel and Rose discussed: the evidence lying under the France/Germany economic policies (1997-2007) In the lack of empirical studies verifying Frankel and Rose’s intuition for the EMU experience, it is important to consider how Germany’s (the largest economy of the Euro area) economic policies evolved and what consequences it had on France.



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