The structure of the EMU was that the country had to take fiscal discipline by the governments own reliance, as the Eurozone does not intervene the fiscal sovereignty of governments. This lead to a group of countries with diverging growth potentials as the fiscal discipline was non-existent whereas the monetary discipline was. This is where the “… changes in a relative competitiveness are reflected in the dynamics of current account deficits” (Lacina and Rusek, 2012). Thus the imbalance between sovereign nations would need to be leveled out by an adjustment mechanism and would succeed the original method of currency devaluation in deficit economies against the currency in surplus economies. Due to the relinquished monetary powers of Eurozone members, exchange rates are fixed and competition is automatically fixed as a result. On that account, the following set criteria need to be met to adjust imbalances and become more economically integrated (Mundell, 1961). Putting this into context to the EU, according to the ‘Optimum Currency Areas’ theory as developed by Mundell, in order for the euro to become optimal, the Eurozone must be highly economically integrated in that there must be free and substantial movement in goods, and services, capital and labour.
The currency union needs to have labour mobility across the continent, as labour from the countries in deficit cannot be prevented to enter countries with more successful industries. This itself prevents the problem of skill shortages in surplus economies and unemployment in deficit economies. Labour mobility was relatively low in the EU and the influx of Eastern European rather than Southern European workers accounted for most of the labour mobility.
The formation of fiscal transfers to prevent asymmetric shocks includes the international transfers to foster economic and social cohesion (Lacina and Rusek, 2012). The peripheral economies may need to be given money by the rest of the Eurozone so they can regain their competitiveness. The ECB has intervened far less in fiscal transfers whereas the counterparts of Americas Federal Reserve and United Kingdoms Bank of England has contributed much more GDP to fiscal reserves comparison to the ECB (Schmiedling, 2012).
Another important factor is the flexibility of product and capital across the continent where both wages and prices have to be able to react to competitive market forces. In 2003, Germany embarked upon a program of an important labour market reform and wages had been restrained for the benefit of German business. The strong employment protection rules and a degree of mutual trust on behalf of employees lead to close relations with unions to aim for a repression in wage inflation. Germany’s huge boost in exports was linked to the repression and not due to intensive productivity rates as the workforce work fewer hours than others are not particularly productive (BBC News, 2012). This lead to stable real interest rates and unlike those in other EU countries where higher inflation meant real rates decreased making borrowing cheaper. The mercantilist approach of Germany helped them remain highly competitive in labour costs in comparison to other member states, the peripheral countries in particular and therefore created an imbalance in the EMU.
Mundell emphasised that all member states must have similar business cycles to prevent asymmetric shocks and imbalances. When a country experiences a boom or a recession, other participating members are likely to follow suit and this relates to the inflation policies that the European Central Bank (ECB) put forward which are largely leveraged by the old German Bundesbank. Many member states experienced high unemployment rates from the adoption of policies to adopt the proposed inflation rates (Bache et al, 2011).
Summarising the criteria of Mundell’s notion of an Optimal Currency Union, the EMU has failed to meet any of the points. The Eurozone has low labour mobility rates, insufficient fiscal transfers, no true wage flexibility due to the wage moderation of Germany, inflation policies that benefit surplus countries, it is hard to see the why the irrational decision to include the adoption of the single currency in the Maastricht Treaty. As the German growth is from a rise in exports and domestic consumption, it has resulted in other Eurozone countries to run a deficit and remain uncompetitive. The peripheral countries have one common problem in their respective economies and that is the lack of competitiveness in exports and high import rates from other countries, which increases and worsens the trade deficits. Since the policy tool to devalue exchange rates as the respective Eurozone member can no longer implement what was the normal adjustment mechanism, and as the optimum currency area criteria has not been acknowledged and put into effect, the EMU carries notable systemic flaws that lead to the Eurozone crisis.
Germany plays a significant role in the crisis and as a country that contributes the most to the ESM and Eurozone GDP they have a major influence politically on reforms and have intensified the severity of the crisis. The German politicians and press have failed to identify the systemic failures of the EMU and has therefore criticised the peripheral countries for their incapability to manage their own deficits. Due to the difference in cultures, it is rationally impossible for other European states to adopt the same policy preferences of Germany such as the mercantilist approach would not work in the peripherals and therefore the system would not work. The whole concept of the Eurozone did not take sufficiently recognise the fragility between its members but focused on the ruling project of Germany and France. (Shambaugh, 2012) The sense for nationalism still exists and influences decisions on the high levels. The position of Germany as the forefront of the Eurozone and the lack of reforms for adjustments to the mechanisms has created disparity within the Eurozone that ultimately led to the current crisis.
Local instabilities existed in the member states in the manner they managed their economies prior to the crisis. The implication of budget deficits and debt accumulation is a popular misconception but it is the portrayal or certain conditions that ultimately exposed the vulnerability of their economies. The systematic mispricing of sovereign risk of the peripherals during the introduction of the euro currency led to unsustainable booms in housing and construction in both Ireland and Spain. Financial markets could not see that sovereign risk existed and as interest rates were favourable, there were no incentives to reduce the debt levels. (De Grauwe and Ji, 2012). The spark of the crisis led the burst of real estate bubbles and consequently house prices crashed and jobs in construction fell. Prior to the crisis, the fiscal positions of both Ireland and Spain were sustainable but during the crisis and the events of bailouts and liquidation of the largest companies, government revenue decreased and expenditure increased resulting in higher trade deficits and subsequently the public debt was beyond controllable. Portugal had spent a lot of their debt in large construction projects, which also in relation to Ireland and Spain, led to rising public debt. Both Greece and Italy are had high public debt levels prior to joining the Eurozone and are politically unstable countries. Many corrupt politicians existed where they manipulated policies for their self-preservation in power rather than for the well being of their economies. They used loans from financial markets to fund their electoral campaigns and promised populist policies. These governments are prime examples of how the uses of loans were used ineffectively to finance growth but for the political reasons.
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BBC News (2012) BBC News - Eurozone's long reform wishlist. [online] Available at: [Accessed: 20/11/2012].
De Grauwe, P. and Ji, Y. (2012) Mispricing of Sovereign Risk and Macroeconomic Stability in the Eurozone. Journal of Common Market Studies, 50 (6), p.866-880.
Lacina, L. and Rusek, A. (2012) Financial Crisis and its Asymmetric Macroeconomic Impact on Eurozone Member Countries. International Advances in Economic Research, 18 (1), p.63-73.
Morrison, J. (2011) The Global Business Environment: Meeting the Challenges. 3rd ed. Basingstoke: Palgrave Macmillan, p.105-110.
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Schmiedling, H. (2012) Tough Love: The True Nature of the Eurozone Crisis. National Association for Business Economics, 47 (3), p.178-189.
Shambuagh, J. (2012) The Euro's Three Crisis. Brookings Papers on Economic Activity Spring 2012, p.1-55.
World Bank (2012) Gross Domestic Product 2011. [online] Available at: [Accessed: 20/11/2012].
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