About nine days ago, I left the following comment on the excellent analysis by Matthew Klein on the non-inevitability of the Euro. Some reader said that I was wrong and that Germany was flag-marched into the Euro. I need to do some more work on it.
A very good summary. Great summary of the IMF research and the contrarian examples will be stimulating to students of optimal currency areas. – why currency union is neither necessary nor sufficient for economic integration.
The fact that these examples would have been known when the currency union in Europe was being contemplated lends further credence to the hypotheses as to why it was pursued. It was, as correctly noted, about Germanisation of Europe so that Germany would not have to contend with currency debasement of its neighbours as a competitive threat. For others, it was about binding Germany more closely with their economic fates so that history of political conflicts was not repeated. The threat might not be eliminated with economic integration but many fondly believe that it reduces the risk of political conflicts.
So, the project was always as much about economic interests of specific countries blended with political goals.
Towards the end of this detailed post, Matthew Klein had pasted a paragraph from the IMF report on how the Select Peripheral countries “attracted a greater share of portfolio and cross-border banking flows,”
In contrast, despite volatile exchange rates, the CE4 countries received FDI. The answer lies in interest rates.
These countries had volatile exchange rates vs. Euro. That would have led to their interest rates being much higher than SP countries. Now, the interest rates are not much different between SP and CE4 countries.
But, in the first flush of the single currency launch, the SP countries saw their borrowing costs plunge. They had begun to come down from 1995 onwards. When interest rates drop too low and too rapidly, they usually lead to speculative end-use rather than productive capital investment end-use. That has been the empirical reality.
Yet, academics cling to their belief – theory is right and data are wrong! – that lower rates lead to higher investment. They forget that ‘everything else is not equal’. Larry Summers should take note.