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Is the Euro Sustainable?

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  • Mike Wickens

Abstract

It is widely recognised that the "one-size-fits-all" monetary policy of the euro-zone is a potential problem. How much of a problem has not been much investigated. It is argued in this paper that it may result in the euro not being sustainable in the longer term without drastic changes to other aspects of the EU and, in particular, to fiscal policy. The problem is not the fault of the ECB, but is due to having a single nominal interest rate. As a result, the evidence reveals that national price levels are diverging over time which is leading to a permanent and unsustainable loss of competitiveness. A formal theory of in.ation in the euro-zone based on an open-economy version of the New Keynesian model is used to analyse the problem. Although the euro system has automatic stabilising mechanisms arising from the changes in competitiveness and from absorbtion effects, these are shown to be not strong enough. The model is then modified to allow for fiscal transfers between countries and the size of the transfers required to produce a euro that may be sustainable are derived. It is shown that, in effect, this is an inflation tax, requiring high inflation countries to make transfers to low inflation countries as often happens within a single country in the form of unemployed benefits to low activity regions. Ultimately, the choice may lie between closer political union and a break-up of the euro-zone.

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File URL: http://www.york.ac.uk/media/economics/documents/discussionpapers/2007/0718.pdf
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Bibliographic Info

Paper provided by Department of Economics, University of York in its series Discussion Papers with number 07/18.

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Date of creation: Jun 2007
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Handle: RePEc:yor:yorken:07/18

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Keywords: euro; ECB; monetary policy; inflation;

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  1. Robert J. Barro & David B. Gordon, 1981. "A Positive Theory of Monetary Policy in a Natural-Rate Model," NBER Working Papers 0807, National Bureau of Economic Research, Inc.
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Cited by:
  1. Christopher Allsopp & David Vines, 2008. "Fiscal Policy, intercountry adjustment and the real exchange rate within Europe," European Economy - Economic Papers 344, Directorate General Economic and Monetary Affairs (DG ECFIN), European Commission.
  2. Oliver Landmann, 2012. "Rotating Slumps in a Monetary Union," Open Economies Review, Springer, vol. 23(2), pages 303-317, April.
  3. Oliver Landmann, 2009. "EMU@10: Coping with Rotating Slumps," Discussion Paper Series 9, Department of International Economic Policy, University of Freiburg, revised Jul 2009.
  4. Alho, Kari E.O., 2011. "How to Restore Sustainability of the Euro?," Discussion Papers 1259, The Research Institute of the Finnish Economy.

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