The Costs of EMU and Economic Convergence

Giving up national monetary policy for output stabilization purposes, with correspondingly greater dependence on fiscal policy, is commonly accepted as a primary cost of joining a monetary union. A major objective of EU policy, however, is to foster stronger economic integration in Europe. This process may create a more synchronous European business cycle, placing less importance on national stabilization (including fiscal) policies. We argue that only limited information on these costs of EMU may be inferred from historical economic relationships. Our empirical results, based on structural VAR model estimates from 13 European countries, suggest that the extent of common shocks and dependence on the German economy has increased markedly over the past twenty years. A core group may be identified on the basis of strong trade and financial linkages with Germany, which in turns leads to rapid and powerful transmission of German shocks. Shocks transmitted in this way are frequently misinterpreted in the literature as common disturbances. These linkages are likely to be enhanced if the periphery group were to join EMU.