UCL European Institute


The Problems of European Monetary Union

21 March 2012

Andrea Boltho, Emeritus Fellow, Magdalen College, Oxford and Wendy Carlin, Professor of Economics, UCL

The problems of European monetary union – asymmetric shocks or asymmetric behaviour?

Divergent behaviour from Eurozone countries that have very different economic, social, and political structures is threatening the existence of the single currency. This column argues that the Eurozone is a fragile bureaucratic creation that has hardly ever raised much popular enthusiasm anywhere. If behaviour across the area remains as asymmetric as it has been over the last decade or so, the project could run into even stronger headwinds in the long run.

Much of the literature that was sceptical of the prospective success of the euro feared the effects of Mundellian asymmetric shocks on an area which (unlike the US) had little inter-country labour mobility and no common fiscal policy. Early research, for instance, pointed out that Europe’s periphery, in particular, had suffered from large idiosyncratic shocks in comparison to Europe’s core, let alone to US regions (Bayoumi and Eichengreen 1992). This, many felt, could create difficulties for the operation of a monetary union. Yet when looking at the Eurozone’s experience over the last decade and at its problems today one is struck not so much by the effects of asymmetric shocks. The biggest shock, the so-called Great Recession, appears as symmetric as possible. Every country registered postwar record declines in GDP, but by the different behaviour that the member economies have followed since euro adoption.

Divergent behaviour could, of course, have been expected from countries that have very different economic, social, and political structures, but in a number of cases differences in the courses of action taken have led to the emergence of disequilibria that now, or in the future, may threaten the existence of the single currency. The most glaring set of differences has arisen between what could loosely be called the Northern and Southern parts of the Eurozone. To simplify, in what follows, the Northern Eurozone is defined as Germany, the Benelux, Austria and Finland, while the Southern one encompasses Italy, Spain, Greece and Portugal. France and Ireland are excluded, the former because it is, perhaps, not fully Northern, the latter because it is, obviously, not Southern. Many of the arguments developed below would, however, be equally valid if the two countries were to be included in the North and South respectively.

The most obvious example of differences in behaviour is in the realm of fiscal policy. The North of the Eurozone embraced fiscal austerity accompanied by a strategy of export-oriented growth and unit cost control (Carlin 2012). The same did not happen in the South. Greece, Italy, and Portugal, in particular, do not seem to have embraced the rigour that, on the whole, prevailed in Northern Europe. As an example, one can point to the steep decline in long-term interest rates from the early 1990s which offered the opportunity for a painless reduction in government debt. This was used to a much greater extent in Northern Europe than it was in the South. The contrast between Italy and Belgium is particularly striking. When the euro came into being in 1999, public-debt ratios were very similar in both countries (121% of GDP in Belgium and 128% in Italy). By 2008 they had been reduced to 91% in Belgium, but to only 113% in Italy, even though long rates had fallen much more sharply in the latter country (Figure 1). In Greece and Portugal debt actually rose over this period. Lower interest rates were taken as an opportunity to be less fiscally prudent. In Spain (and Ireland) low interest rates facilitated a monstrous housing bubble and rising private debt. The appearance of fiscal probity masked vulnerability as shown by the steep rise in public debt which materialized when banks collapsed and the recession came.

Even if concerted efforts both at the national and at the international level manage to solve (or at least alleviate) the present crisis, there is a second set of arguably more intractable divergences that have emerged over the last decade or so. These have to do with very different growth rates of wages and productivity between North and South. Unlike the experience of Bretton Woods, when inflation was relatively similar across countries, but poorer economies experienced rapid productivity growth, the last 12 years have seen almost opposite developments (Figure 2).1 Wage inflation in Italy and Spain was substantially higher than in Germany, while productivity growth was subdued in the South and relatively robust in the North. Commission estimates suggest that, as a result, the Southern intra-Eurozone real exchange rate may have appreciated by as much as 25% relative to the Northern one.

Bar an unlikely acceleration of wage inflation in Germany or an equally unlikely burst of productivity growth in the South, the only way to close this huge gap goes through a massive decline in real wages in Southern Europe. Can this be achieved in what looks like being a climate of low growth and continuing fiscal retrenchment? If not, the area is either condemned to even lower growth so as to eliminate its current-account deficit, or forced into nominal devaluation after all. A proper fiscal union, with transfers from North to South, could avoid both these outcomes, but at the cost of creating a Mezzogiorno-type problem at the pan-European level.

In any case, it is highly unlikely that Northern Europe would ever go as far as accepting a fully-fledged fiscal union (or ‘transfer union’ as it is pejoratively called in Germany). This is not just a matter of money. Northern Europe has only limited trust in Southern Europe, as amply illustrated by the increasingly stringent conditions that have recently been imposed on Greek politicians, but also by earlier Eurobarometer surveys showing how much (or how little) trust citizens of one country have in their EU neighbours (Guiso et al 2004). This makes it very unlikely that Germany, or Finland, or the Netherlands would wish to pool their sovereignty with nations whose governance standards are very, very different from their own.

And this is the third dimension in which divergences have grown since the introduction of the euro. Contrary to what might have been expected (or, at least, hoped for), numerous gaps in governance that were, of course, well known already in the 1990s when the monetary union was being discussed, have not only not diminished, but have widened instead. A few examples will suffice (Figure 3). Perceptions of corruption, as measured by Transparency International, and efforts at controlling corruption, as measured by the World Bank, have worsened in Southern Europe over the last decade, both absolutely and relatively to what was happening in Northern Europe (all this is true whether the aggregates use GDP-weighted or -unweighted country observations). The importance of the underground economy (as estimated by Schneider 2011) has shrunk somewhat in the South, but the same has happened in the North so that a huge gap remains. The Fraser Institute’s  and Heritage Foundation’s Indices of Economic Freedom, rough measures of the extent of government interference in an economy, are not only lower in the Mediterranean area (denoting greater interference), but, after converging in the 1980s and 1990s, have declined there over the last ten years relative to Northern Europe (Figure 4). Most worrying of all, perhaps, the presence of the rule of law, as calculated by the World Bank, has risen in the North but declined in the South. Other indicators could be added.

Differences in governance exist within countries. Italy is probably the best known European example of an economy that suffers from sharp divisions in productivity levels and in competitiveness as well as from very different behavioural standards between its own North and South.2 Yet, and despite the rise of a separatist political party, these persistent gaps are not threatening the country’s union, which was, after all, the outcome of a long process of often enthusiastic nation-building, involving several wars. The Eurozone, by contrast, is a fragile bureaucratic creation that has hardly ever raised much popular enthusiasm anywhere. If behaviour across the area remains as asymmetric as it has been over the last decade or so, the project could run into even stronger headwinds over the longer run.


Bayoumi, T and BEichengreen (1992), “Shocking Aspects of European Monetary Unification”, NBER Working Paper No. 3949.

Boltho, A (2010), “Why do Some Regional Differentials Persist and Others do not? Italy and Spain Compared, 1950-2000”, Rivista di storia economica, Vol.26, April.

Boltho, A, W Carlin, and P Scaramozzino (1997), “Will East Germany become a New Mezzogiorno?”, Journal of Comparative Economics, Vol.24, June.

Carlin, W (2011), ‘Good Institutions are not enough: Ongoing Challenges of East German Development’, DICE  9(1), 28-34.

Carlin, W (2012), “Real exchange rate adjustment, wage-setting institutions, and fiscal stabilization policy: Lessons of the Eurozone’s first decade”, CEPR Discussion Paper No. 8918.

Carlin, W and A Glyn (2003), ‘British exports, cost competitiveness and exchange rate arrangements’ in HM Treasury, (2003), Submissions on EMU from Leading Academics. Stationery Office. Chapter 5.

Guiso, L, P Sapienza, and L Zingales (2004), “Cultural Biases in Economic Exchange”, NBER Working Paper No.11005.

Guiso, L and P Pinotti (2011), “Democratization and Civic Capital”, Banca d’Italia, Quaderni di storia economica, No.23.

Ichino, A and G Maggi (2000), “Work Environment and Individual Background: Explaining Regional Shirking Differentials in a Large Italian Firm”, Quarterly Journal of Economics, Vol.115, August.

Putnam, R, R Leonardi, and R Nanetti (1993), Making Democracy Work, Princeton, NJ: Princeton University Press.

Schneider, F (2011), “Size and Development of the Shadow Economy of 31 European and 5 Other OECD Countries from 2003 to 2012: Some New Facts”, mimeo.


1 The likelihood that the UK would not be able to match the unit cost growth of the Northern Eurozone was highlighted in Carlin and Glyn (2003) in their submission to the Treasury’s EMU study on possible UK adoption of the euro.

2 For standards of civic behaviour, for instance, see Putnam et a. (1993), Ichino and Maggi (2000), Guiso and Pinotti (2011); for crime see Boltho (2010). In spite of a huge productivity differential and very large transfers at unification, the rapid reestablishment of common behavioural norms in East Germany was almost certainly a major reason preventing the area from becoming a Mezzogiorno (Boltho et al 1997; Carlin 2011).

Andrea Boltho is now Emeritus Fellow of Magdalen College, Oxford. He was educated in Italy and at the Universities of London (LSE), Paris and Oxford. From 1966 to 1977 he was at the OECD’s Department of Economics and Statistics and for one year (1973-74), Japan Foundation Fellow at the Economic Planning Agency in Tokyo. From 1977 to 2007 he was Fellow and Tutor in Economics at Magdalen College, Oxford, where he specialized in international and applied macroeconomic issues. His publications include: Foreign Trade Criteria in Socialist Economies, Cambridge 1971; Japan  An Economic Survey, Oxford 1975; The European Economy: Growth and Crisis (ed), Oxford 1982, as well as numerous academic articles. At various stages consultant to the World Bank, the Bank of Italy and member of the Academic Council of the IFO Institute in Munich.

Wendy Carlin is Professor of Economics at UCL. She is co-managing editor of Economics of Transition. Her research focuses on macroeconomics, institutions and economic performance, and the economics of transition. She has published papers with a number of co-authors on subjects including economic restructuring in transition; ownership, finance and growth; competitiveness and export performance; competition and growth in transition; German economic performance; and New Keynesian macroeconomics. She published Macroeconomics: Imperfections, Institutions and Policies (OUP, 2006, co-author David Soskice). They are currently writing a new macroeconomics book: Macroeconomics: Finance, Stability and Crises (OUP, 2013). She is a member of the Expert Advisory Panel of the UK Office for Budget Responsibility and of the INET Advisory Board. DPhil Oxford, 1987.

First published on VoxEU.org.

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