Greek debt crisis and the single currency debate by Zohaib Waheed of The University of Manchester


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Greek debt crisis and the single currency debate by Zohaib Waheed of The University of Manchester

  1. 1. University of ManchesterBSc(Hons) Management (Accounting and Finance)Zohaib WaheedThe Greek debt crisis and thesingle currency debate 4th May 2012
  2. 2. Statement of OriginalityThis dissertation is my own original work and has not been submitted for any assessmentor award at University of Manchester or any other university. 2
  3. 3. AcknowledgmentsThis is dedicated to my family for their support and prayers that gave me the strength andability to complete this project and I hope to make them proud. 3
  4. 4. AbstractThe rising debate on whether or not Greece will default and/or leave the Eurozone hascaused much concern to policymakers and the Greek citizens. The violence seen inGreece because of the recent austerity measures imposed is the worst the country hasseen for many months. The Eurozone policymakers are still struggling to find possiblesolutions to save Greece. Nevertheless, most of the other troubled Eurozone countries areapprehensive that they may be the next victim of this crisis. The debate on whether theEurozone is an optimal currency area has been ragging for the last few years. This studyfocuses on the likely causes of the Greek debt crisis, in particular the factors that haveworsened the Eurozone crisis. Theoretical models and empirical evidence is used toanalyse the Eurozone as an optimal currency area. Findings suggest that the Eurozone isfar from being perfect and joining the Euro has exacerbated the Greek debt crisis. Theimplications of this are that prior to joining the Eurozone, Greece could increase itsmoney supply and pay back its debt as it had an independent monetary policy however,after adopting the Euro it is unable to do so. This is because a government can only payits bills by taxes, debt or increasing money supply. Greece is only left with two of thesechoices and since the Greeks have stopped paying taxes it has made it extremely difficultfor Greece to withstand the current financial crisis that Europe is facing. 4
  5. 5. ContentsIntroduction................................................................................................................................6Literature Review........................................................................................................................8 Introduction and aims of literature review ..............................................................................8 Public debt and default ...........................................................................................................8 When do countries default? ..................................................................................................10 Cost of default.......................................................................................................................10 Past instances of sovereign default........................................................................................11 The Eurozone crisis and significant increases in Greek debt ...................................................13 Banking crisis.........................................................................................................................16 The single currency debate?..................................................................................................17 What are the measures taken by Greece? .............................................................................18 Support from Eurozone members .........................................................................................19 Conclusions from the review .................................................................................................19Theoretical Analysis ..................................................................................................................21 Introduction ..........................................................................................................................21 What are the requirements of an optimal currency area?......................................................22 Cost-benefit analysis of fixed exchange rate ..........................................................................26 Consequences of single and national currency areas? ...........................................................28 Mundell Models and the comparison of single and national currencies .............................28 The Mundell-Fleming model and possible scenarios? ........................................................31 Example of UK’s quantitative easing ......................................................................................45 Is Eurozone an optimal currency area? ..................................................................................50 Has the single currency exacerbated the Greek debt crisis?...................................................52 Critical analysis and conclusion..............................................................................................54Data Analysis.............................................................................................................................56 Greece’s economic performance ...........................................................................................56 Comparison of Greece with other Eurozone nations and the UK............................................61Policy recommendations and conclusion...................................................................................68References ................................................................................................................................70 5
  6. 6. IntroductionThis paper is concerned with the likely causes of the Greek debt crisis and the conditionsthat have exacerbated the Eurozone crisis. It seeks to gain an insight on Eurozone as anoptimal currency area by analysing theoretical models and empirical evidence. Theargument that I would like to develop is that the advent of the Euro has exacerbated theEurozone crisis.The Economy of Greece is 32nd Largest in the world in terms of nominal gross domesticproduct (GDP) and 33rd as compared to purchasing power parity (PPP) according to thedata by the World Bank in the year 2010. Greece is considered as a developed countryand ranked as the 31st most globalised country in the world. It is classified as high incomeand the standard of living is also very high but since the past few years it has been goingthrough one of the worst debt crisis it has ever faced. Its government failed to reform theeconomy and reduce public spending, including doing the huge military budget when itjoined the euro zone. Greece entered the recession ill equipped to cope. In response topressure from the European Union and the financial markets, Greece announced anaggressive plan to cut its deficit to 8.7% of GDP in 2011 and to bring its debt ratio intobalance with the EU policy of 3% of GDP by 2012. Several credit rating agencies havedowngraded Greeces credit rating, including Standard & Poors. These actions havefostered fear among potential investors in Greek bonds, making it very difficult for thecountry to borrow money to repay its debt. (World Development Indicators database,2011).The Euro zone sovereign debt crisis became prominent in early 2010 but, it has its rootsback to the 2007-2009 recession. Greece, financial markets and the Eurozone authoritieshave played a role in this crisis. Greece authorities have lost their credibility due tomismanagement and deception and the financial markets have become destabilised.Furthermore, the Eurozone government failed to give clear signals on their willingness tosupport Greece and the European Central Bank. This created ambiguities about the 6
  7. 7. capability of the Greek government debt to act as collateral in liquidity provision. (Paul,2010). Policymakers are struggling to find a solution to put an end to this crisis.Greece joined the Eurozone in 2001 and replaced its drachma to Euros. The likely causesof the Eurozone crisis are evident from the current financial conditions faced by theEurozone however, the single currency may have intensified the Greek debt crisis.Cabannes (2012) has argued that the single currency has worsened the Greek debt crisisbut, his conclusion suffers criticism by Kaletsky (2012) who believes that the Germanpoliticians and central bankers are responsible for the Eurozone crisis. Some studies havealso been conducted optimal currency areas. Prominent ones are of Mundell (1961; 1973)and McKinnon (2000). This study will build on this work and explain how the singlemonetary policy affects Greece using theoretical models and empirical analysis.A set of recommendations for the policymakers are developed from the analysis in thispaper. Finally, a concluding argument is made on whether or not the single currency hasexacerbated the Greek debt crisis? 7
  8. 8. Literature ReviewIntroduction and aims of literature reviewThe main aim of the literature review is to give us a historical and fundamentalperspective of sovereign debt and the Eurozone crisis. To study the causes andconsequences of the Greek debt crisis, it is essential to have an understanding ofgovernment debt and default. Sovereign debt is in essence different from corporate debt.It is a norm to have high amounts of debt in some nations. The government debt of theEurozone countries is increasing and questions about default of Greece are being asked.This review will evaluate the costs of default and possible explanations for mitigatingthese costs. Furthermore, this review will establish the current position of the Eurozonecrisis and the likely causes and consequences of the Greek debt crisis. Also, the impact ofthe tight financial conditions in Eurozone on European banks will be discussed to gain anunderstanding of the severity of the Greek debt crisis. Finally, a brief review of thesingle currency area and the gaps in the literature review regarding optimal currencyareas will be discussed.Public debt and defaultIn simple words, public debt is the accumulate sum of past public deficits. Countriesborrow money by issuing securities, government bonds and bills. Countries run a deficitwhen the government spending exceeds its financial savings and a surplus when thefinancial savings exceeds the spending. (Campos, Jaimovich & Panizza, 2012)Panizza, Sturzenegger and Zettelmeyer (2009) conclude that sovereign debt is issued tosmooth consumption and in this process income is transferred from rich to poor states ofthe world making sovereign borrowing countercyclical.Unlike the corporate world where debt contracts are enforced by the courts, theenforcement mechanism in sovereign debt is limited. Panizza, Sturzenegger and 8
  9. 9. Zettelmeyer (2009) explain the reasons behind this. Firstly, in the case of sovereigndefault, a sovereign cannot credibly commit to hand over its assets. Secondly, sovereignassets are protected by legal principles when they are located in foreign jurisdictions.However, the strength of this protection is not as strong as it used to be.If countries cannot easily claim back their debts then we may assume that the only actionthey can take in retaliation is to refuse future credit to the borrowing nations. However,this has been criticized by Eaton and Gersovitz (1981) who propose that with thisassumption the creditors and debtors would both be at a loss. This is because after adefault both parties reach a fruitful outcome as they reach a new improved agreement.However, if this is the outcome then the expected punishment is underestimated.(Kletzer, 1994). Further criticism of this assumption was put in the picture by JeremyBulow and Kenneth S. Rogoff (1989). They proposed that lending was the only methodby which countries could improve economic conditions. With this assumption we ignorethe fact that a country may fix shocks in output by increasing saving or purchasinginsurance. An insurance scheme could enable a country to receive payments in pooreconomic conditions. This as we see is an alternative to increasing debt.We can discuss the concept of sovereign immunity to explain how sovereign debtors areprotected. This immunity shields sovereigns from being sued in foreign courts withouttheir consent. However, after the Second World War, the interpretation of sovereignimmunity began to change in the United States. A possible explanation for this is that theUS was uncertain with granting immunity to the Soviet Union owned companies in theUS. (Panizza, Ugo & Sturzenegger, 2009)Therefore, sovereigns can be held responsible and sued in foreign courts as it done in thecorporate world. The central bank however, is viewed as a separate legal entity and is notresponsible for the acts of its sovereign. The sovereign may locate such that it becomesunreachable of foreign courts. If holding sovereign debt is risk-free, then why don’t allnations continue borrowing money without having to care to repay their debt? This willbe discussed in the sections that follow. As for now, I would like to discuss the conditionsunder which countries default. 9
  10. 10. When do countries default?It is likely that Greece may default, breaking up the Euro. So when do countries default?Countries tend to borrow money during poor economic conditions and repay the loanswhen conditions have improved. One may think that countries would prefer to defaultthan to repay. However, creditors will not lend beyond a certain limit after which thecountry is likely to default. LevyYeyati and Panizza (2006) have researched usingquarterly data to study the changes in GDP growth with 23 default episodes between1982 and 2003. Their findings tell us that defaults are followed by output contractions.This has been criticized by Michael Tomz and Wright (2007). Their research suggestsevidence to support the negative correlation between output and defaults. Tomz andWright (2007) support their conclusion by pointing out a number of reasons for thisnegative correlation. Firstly, defaults may provide insurance as besides output shocks,societies may be subject to some other narrower component of economic activity. Fordefaults may be favourable in condition when there is a decline in exports. Secondly,defaults may be optimal when domestic shocks cannot be alleviated by additionalborrowing.Cost of defaultDefaults do have costs attached to them that the country must bear. The time it takes acountry to become stable varies but, we have seen that in the last three decades countriesdefaulting have recovered quickly by having access to international capital markets insurance or bank borrowing in international markets. (Sandleris, Gaston Gelos, andRatna Sahay, 2004) Furthermore, research by Peter H. Lindert and Peter J. Morton(1989), Bhagwan Chowdhry (1991), and Sule Özler (1993) show that defaults do notaffect borrowing costs in the long run and only have small effects on borrowing costs inthe short run. News about a country’s default may lead to capital flight and/or decline inconsumption and investment.Creditors may place sanctions on the defaulting country. The three types of sanctions thatthey may pace are political/military pressure, legal sanctions and reduction in trade. The 10
  11. 11. mechanism through which defaults are resolved has evolved over time since the 1980s asa result of debt securitization and changes in the identity and representation of creditorswith the IMF playing an important role in the debt restructuring. (Panizza, Ugo &Sturzenegger, 2009)In past countries have been able to ease the costs of default. Examples of mechanisms toreduce the costs of debt crisis can be seen following the 1995 Mexican and 1998 Russiancrisis, ‘to reform the institutions and/or contracts governing debt flows and debtrenegotiation in order to reduce the cost of crises. For the most part, these proposals—which climaxed in the proposal by management and staff of the IMF, in 2001, to create abankruptcy-type “sovereign debt restructuring mechanism” (SDRM) for countries—focused on making the debt renegotiation process smoother and faster, in particular, bymitigating creditor coordination failures’. (p. 689. Panizza, Ugo & Sturzenegger, 2009)However these have been criticised for being inappropriate as creditor coordinationfailures did not turn out to be a major hindrance to the debt renegotiations of that period.Lowering the costs of renegotiations across the board, or taxing short term-term debt, forexample is not a reasonable solution. When designed carefully, public intervention canreduce the costs of debt crises ex post and improve efficiency ex ante. This can be doneby creating institutions that improve information; helping in the development of morecomplete contracts between creditors and debtors. Alternatively, it can be done bycreating institutions to substitute for more complete contracts. (Panizza, Ugo &Sturzenegger, 2009)Past instances of sovereign defaultRecent cases of sovereign default can be seen in Russia in 1998 and Argentina in 2000.There are several other examples of sovereign debt such as Latin American countries inthe 1980s and Southeast Asian nations in the late 1990s where a country’s problems alsohad an impact on its neighbours. In 2010, Greece we saw a similar situation in Greeceand several of its southern European neighbours. (Altman & Rijken, 2010) 11
  12. 12. The 1999-2002 Argentina economic crisis is worth taking note of as Argentinaexperienced a similar economic crisis as Greece.Argentina had fixed its pegged its peso to the dollar in the 1990s. The fixed exchange ratedid not succeed as the increase in wages demanded was not compensated by increasedproductivity and strong trade unions of Argentina prevented a reduction in productioncosts. Hence Argentina became less competitive. Furthermore, the government wasapprehensive of increasing interest rates high enough because of the damage it would doto the economy and wages did not fall much in response to the poor economic conditions.Therefore the current account deficit remained and investors lost confidence in theexchange rates long- term viability. However, the fixed exchange rate made it impossibleto devalue the currency to increase competiveness. This was worsened by the resistanceof unions to lower wages. As a result, Argentina was unable to control its spending andso the external debt increased. The increase in debt made new debt more expensive asArgentina had to pay higher interest rate to foreign creditors. This further increased theforeign debt and default became unavoidable. Argentina eventually defaulted on $155billion of central and provincial government debt in December 2001. This was the largestsovereign debt default in history and Greece along with other Eurozone nations can learnlessons from this event. First, a fixed exchange-rate system may lead to an overvaluedexchange rate and default. In contrast, a floating exchange rate system can avoid this.Furthermore, large foreign borrowing is a very risky strategy. (Nataraj & Sahoo, 2003)Figure 1 shows the number of sovereign defaults from 1824-2004. It shows that overall;Latin America had more recent bond and loan defaults than any other region of the world. 12
  13. 13. Figure 1 Altman & Rijken, 2010The Eurozone crisis and likely causes of the Greek debtcrisisHaving discussed the concept of debt and default, the Eurozone debt crisis will bereviewed to get an insight on how the debt crisis in the Eurozone has evolved.Following the 2007-2009 recession which was a consequence of the speculativemortgage lending by US financial institutions, a financial crisis in Greece developed atthe end of 2009. The situation had become more challenging as the state expenditure wasnot controlled and this intensified the sovereign debt crisis. Germany has produced thelowest increases in nominal labour costs thus its competitiveness in the Eurozoneincreased. This has given Germany a surplus and this surplus has been translated intocapital exports i.e. bank lending and foreign investment in the Eurozone including theperiphery. However, the peripheral economies (Greece, Portugal, Spain and Ireland) areunable to compete in productivity with Germany because of mediocre technology. Hencethe peripheral countries tried to compete by using alternative growth strategies such asincreasing consumption by borrowing money. This included a fall in interest rates and a 13
  14. 14. rise in household debt but, in 2009-2010 the countries soon realised that this method ofexpanding growth was not feasible in the long run. When the effect of recession hit theeconomy, weaknesses of monetary union emerged and this resulted in public debt crisisin Greece and other peripheral countries. Speculative attack on the Greek economy andloss of credibility due to systematic fiddling of national statistics to reduce the size ofbudget were major factors that lead to the financial crisis in Greece. (Lapavitsas,Kaltenbrunner, Lindo, Michell, Painceira, Pires, Powell, Stenfors and Teles, 2010)Figure 2 shows that the household debt has increased across the peripheral countries inthe sample. The rise in price of real estate and increase in consumption have lead to thisincrease in debt. An exception is Germany where households have been reducing therelative burden of their debt. Figure 2 Household consumption (percentage of GDP). Source: Eurostat 14
  15. 15. Figure 3 Government expenditure (percentage of GDP). Source: EurostatFigure 3 shows that the public expenditure declined steadily in the 1990s except inGreece where it stayed fairly constant. In 2000s, the expenditure was constant across thesample except Germany where it continued to fall and Portugal where it increased gently.Germany and France, the richest countries of the European Union are concerned abouttheir financial markets since their banks have financial claims not only from Greece butalso from Spain, Ireland and Portugal. Therefore in case there were impacts of Greece’sdebt crisis on other EU countries, the French and German banking sector would bedeeply affected. The debt amount of Greece reached €300 billion in 2010. But it isexpected that Greece should first seek financing from the bond markets. The pressure willinevitably increase on other weaker members of the monetary union, notably Portugal,Ireland and perhaps Spain and Italy. What’s more, even if Greece is rescued, the appetitefor another bailout would surely be limited. First, the recent economic recovery from theglobal financial crisis has been driven by a massive policy stimulus that cannot berepeated. Interest rates have already been cut to near-zero and, while they are likely toremain low for much longer than generally anticipated, the scope for further cuts isobviously limited. It is a slump in financial markets or the growing recognition of the 15
  16. 16. scale of public spending cuts and tax increases that will be needed. This spare capacity isalso maintaining the downward pressure on wages and prices, so another financial shockcould tip the world into widespread deflation. Any upward pressure on benchmarkgovernment bond yields would raise borrowing costs throughout the economy, includingcorporate bonds and mortgage interest rates. The balance sheets of the banks would alsotake another hit, reducing their capacity to lend. (Gença, 2010)The likely causes of the Greek debt crisis are significant overspending after joining theEurozone, inappropriate reforms and investments, lack of adherence to austeritymeasures, lack of clarity shown by Eurozone states to support Greece and false reportingof fiscal data by Greek government. All these factors lead to the lost of investorconfidence and made new debt more expensive.Banking crisisThe banking system in Europe has also been severely affected by the Banking crisis.The percentage of liability that European banks hold is much larger than that what theEurozone nations hold. For example, in 2007 German Bank debt was over 300% ofGermany’s GDP. The corresponding figures for Belgium and Ireland were 400% and700% respectively. (Baldwin, Gros and Laeven, 2010)Banking crisis can affect the whole nation and may cause spill-overs to other economies.A typical Eurozone government may have to seek fresh loans of, say, 10% of itsoutstanding debt per year whereas a typical Eurozone bank has to seek fresh loans worth10% or more of its total debt on a daily basis. The risk of default can spread throughoutthe country and around other countries as well. For example, Lehman’s default affectedthe entire US credit market within hours and was spread to the rest of the world withindays. At the beginning of the world financial crisis in 2008 many Eurozone banks weremassively overleveraged and at the same time the wholesale market, that many banksrelied for funding was wiped out. The ECB stepped in to replace this short termadditional funding but the EU government failed stress testing banks hence many 16
  17. 17. Eurozone banks entered the Greek crisis in a fragile state. The rescue plan for bankingmade the situation more challenging as private debt was turned into public debt. Also, therecession reduced the borrowers’ ability to repay loans which further deepened thefinancial crisis. (Baldwin, Gros and Laeven, 2010)Numerous explanations for the causes banking crisis have been discovered. However, thepolicies implemented by the core Eurozone countries of permanent deflation may havelead to the financial crisis. These policies started in the late 1970s and were implementedto protect the Eurozone governments against any American-type temptation to favourexpansionary policies in support of full employment. (Alain Parguez, 2011).Since the financial conditions of other markets can have significant effects on othercountries, the causes of Eurozone financial crisis should not be limited to the activities inthe Eurozone.China has recently taken the initiative to aid Europe bail-out as it is China’s long termand intrinsic interest to help Europe because it is China’s biggest trading partner (Voigt,2011).The single currency debate?Firstly, I would like to discuss a historical perspective on countries and currencies.The number of independent currencies has been increasing in the past few decades untilthe advent of the Euro. For example, in 1947, there were 65 currencies in circulation,whereas in 2001 there 169. The increase in the number of currencies and economicintegration generates a tendency for single currency areas. The question is shouldcountries merge together and be a part of a single currency area? Alesina, Barro &Tenreyro (2002) discuss the costs and benefits of a single currency area with respect to acountry that is considering adopting another country’s money as a nominal anchor.Firstly, there are trade benefits. Two countries that have the same curencies trade muchmore with each other than they would do if they had national currencies. McCallum 17
  18. 18. (1995) researched U.S.-Canadian trade in 1988 and found that trade between Canadianprovinces was estimated to be a 2200% larger than between otherwise comparableprovinces and states. Also, Alesina and Barro (2002) find that a common currencyreduces trading costs between two countries. Moreover, adopting the currency of acredible anchor could help eliminate the inflation-bias problem which was pointed out byBarro and Gordon (1983). This could help a country maintain stable inflation rates.However, the main cost to a country of abandoning its currency is that it can no longerpursue an independent monetary policy to overcome domestic economic shocks. Thesecosts are lower if the shocks that the countries face are correlated. In the EuropeanMonetary Union the monetary policy of the union is not targeted to a specific country(say Germany or Greece), but rather to a weighted average of each countrys shocks. Thismay be a cause of concern as countries in the Eurozone may have different businesscycles. (Alesina, Barro & Tenreyro 2002)The question remains unanswered that are national currency areas more efficient thatsingle currency areas? I would elaborate more on this area in the chapter that follows.What are the measures taken by Greece?With the presentation of its draft for the 2010 budget, the new government aimed toreduce its budget deficit to 9.1% of the GDP in order to improve the financial situation ofthe country. In parallel, it is foreseen that the public debt that was 113.4% of GDP in2009 will increase to 121% in 2010. In this programme, the Greek government expressedits aim of reducing this year the public deficit by 4 percentage points down to 8.7% ofGDP. It also aims to reduce the public deficit thereafter to 5.8% in 2011, to 2.8% in 2012and 2% in 2013. For this purpose, the expenditures will be limited and tax revenues willbe increased. For example, a rise of duties on fuel products, the raise of the retirementage, the reduction of public expenditures, no increase in the wages of civil servantsincluding the Prime Minister and Deputies for the year 2010, no recruitment and set aceiling to salaries. It has been observed that social security expenditures constitute aconsiderably high share of the country’s budget compared to other EU countries.Moreover with its ageing population, it becomes more than ever indispensable for Greeceto restructure its social security system in order to spread its public debts in the long term. 18
  19. 19. Along with Greece, other countries of the Eurozone had to increase their publicexpenditures in order to deal with the economic recession following the global financialcrisis. As a result, their budgetary deficits and public debts have significantly increased.According to the latest data published by Eurostat, in 2009 public deficit was 12.7% ofGDP last year in Spain, 12.5% in Ireland, 8.3% in France and 8% in Portugal. The publicdebt-to-GDP ratio was also high in these countries in 2009 (77.4% in Portugal, 65.8% inIreland, 76.1% in France, 114.6% in Italy). (Gençay, 2010)Support from Eurozone membersOne of the advantages of being part of the Eurozone is that a member is supported by itsneighbours.In July 2011, European leaders announced a second financial assistance package forGreece totalling €109 billion ($157 billion). This second financial assistance programmewill provide loans to Greece on more favourable terms than the first package (lowerinterest rate and longer maturities), as well as extend the maturities on existing Eurozoneloans to Greece. At the time of the announcement, it was unclear whether the IMF wouldbe contributing to the second financial assistance package. The official Europeancommuniqué called on the IMF to “continue to contribute to the financing of the newGreek program” but subsequent news reports indicated that the IMF would refrain fromcontributing to the second package. To help contain the crisis, European leaders alsoannounced that they would make the EFSF (European Financial Stability Facility) moreflexible. Instead of just providing loans, they announced that the EFSF will be able toprovide precautionary lines of credit to countries under market pressures and finance therecapitalization of Eurozobe banks. (Nelson, Belkin, and Mix, 2011)Conclusions from the reviewThe Eurozone crisis has been a cause of concern for the Eurozone leaders. Greece inparticular has been hit hard by this crisis owing to its generous spending and high 19
  20. 20. borrowings. There are certainly costs attached if Greece is to default and the Greekgovernment is finding ways to cut down on spending to pay back its debt. Nevertheless,the Eurozone member states have shown their willingness to support Greece and are alsoaffected by the tight financial conditions. The impact on European banks has made usrealise that the effects of the Greek debt crisis have far-reaching effects on other countriesas well.Having said that, being part of the Eurozone has some costs attached to it as a countrysuch as Greece is dependent on the central bank to overcome domestic shocks. This isevident from the different economic conditions across the Eurozone. For exampleGermany has a much stronger and efficient economy than Greece.There are austerity measures are taken by Greece. These measures require large cuts incash benefits paid to public workers, increase in retirement age, increased taxes tocompanies and individuals. The aim of the austerity programme is to lower the deficitrelative to GDP and improve Greek’s ability to repay its foreign debt.However, the of the benefits that Greece has from being part of the Euro is that otherEurozone members are there to support Greece. But is Greece better off by joining theEuro or has the Greek economy become less efficient after Greece joined the Euro? If thisis the case then how do we define efficiency? In the theoretical analysis I wouldelaborate more on the requirements and consequences of a single currency area withrespect to the Greek debt crisis. Also, I would discuss the impact of a single monetarypolicy on Greece. Finally in the empirical analysis I would analyse different indicatorsto discuss the efficiency of the Greek economy before and after it joined the Euro andcompare it with other Eurozone member states and the UK (has an independentmonetary policy but is part of the EU) 20
  21. 21. Theoretical AnalysisIntroductionThe focus of this paper is on the difficulties that the Eurozone is facing, especiallyGreece. In this chapter I would like to develop the argument that the advent of the Eurohas exacerbated the Greek debt crisis using appropriate theoretical models.Greece joined the Eurozone ill equipped in 2001. It abandoned its drachmas and startedusing Euros so the Greek citizens could use Euros to buy goods and services. I wouldbegin my analysis by describing the requirements of an optimal currency area. Movingon, I would then discuss the consequences of single and national currency areas using theMundell models To support my argument I would derive and analyse the Mundell-Fleming model using IS-LM equations and explain the possible scenarios of fixed andfloating exchange rates in Greece. Also, relevant empirical evidence will be used toanalyse whether or not the Eurozone is an optimal currency area. Finally I would supportmy analysis with answering the question: whether or not the single currency hasexacerbated the Eurozone crisis and critically analyse my conclusions. 21
  22. 22. What are the requirements of an optimal currency area?Many scholars, especially Mundell (1961), McKinnon (1963) and Kenen (1969) havediscussed optimal currency areas. A currency area can be defined as an optimalgeographic domain of a single currency, or of numerous currencies, whose exchangerates are irrevocably fixed and might be unified (Mongelli 2002). So the question is whatis optimal currency area? We can explain this with the properties of a currency area thatimprove welfare of the population that lives within the area above the level enjoyed wheneach country has a separate monetary entity.Firstly, Mundell (1961) defines the optimal currency area as one in which there is fullmobility of factors of production. Factor mobility is important as it allows the mostefficient allocation. Also, since labour mobility is higher in the medium to long run, theadjustment to the permanent shocks is easier Petreski (2007). Labour mobility across thesingle currency area should ideally by large. This allows workers to travel across theregion without barriers to entry, for example visa requirement. Moreover, similar cultureand less language barriers facilitate the movement of labour across a region.Secondly, price and wage flexibility in the short run allows the adjustment process not toend up with sustained unemployment in one country and inflation in the other (Petreski,2007). With price and wage flexibility, there is lesser need of exchange rate flexibility.This feature allows a region to overcome domestic shocks without the need of anindependent monetary policy. As we shall discuss in the sections that follow, nations in asingle currency area cannot use monetary policy to overcome asymmetric shocks such asunemployment. Price and wage flexibility is therefore an alternative to having anindependent monetary policy in order to stabilize an economy. For example Germany,has been able to maintain its competitiveness due to high wage flexibility.Thirdly, financial market integration is vital as there is lesser need for exchange rateadjustments. Again this is an alternative to having an independent monetary policy asexchange rate adjustments are impractical. Empirical analysis by Imbs (2004) suggeststhat more financially integrated countries illustrate more correlated business cycles. This 22
  23. 23. will be further discussed in the chapter that follows. With financial integration a regioncan also benefit from risk-sharing. Cross-border ownership of assets and means ofproduction due to financial integration allows nations in a common currency area tobenefit from the insurance against production risk Schiavo (2005). Frankel and Rose(1997) discuss another criterion of optimal currency areas; the extent of trade. Highintegration with respect to international trade in goods and services represents optimalcurrency areas. Openness leads to greater savings in the transactions costs and risksassociated with different currencies.Furthermore, similarity in inflation rates is another important feature of optimal currencyareas. Fleming (1971) argues that similarity in inflation rates allows terms of trade toconverge. This diminishes the need for exchange rate adjustment.Finally, political integration is very important as a successful currency area needscompatibility by policy makers in their preferences towards growth, inflation andunemployment (Tower & Willet, 1976). Countries in a single currency area are likely tofunction efficiently when their political leaders follow similar fiscal and economicpolicies. This seems to be a very important factor when we consider the case of Germanyand Greece. German politicians seem to be less generous when it comes to increases inthe wages of the public sector workers. Germany had reforms a decade ago and this hassaved the German economy from the dire consequences that some of the Eurozonecountries face in the Eurozone debt crisis. Hence a single monetary policy would not besuitable for all members unless there is strong political integration.We can therefore conclude that the requirements of the optimal currency area all givealternative strategies to having an independent monetary policy in order to maintain orincrease competitiveness. One of the implications of factor mobility is that workers cantravel to other nations when their country suffers from domestic shocks such asunemployment. Likewise, financial integration allows risk sharing. Furthermore, wageflexibility can overcome domestic shocks without the need of an independent monetarypolicy. An example of this can be seen in the case of Germany. Since money supply 23
  24. 24. cannot be altered by a country which is part of a single currency area, the interest rates ofall the members must be similar. This allows better implementation of the singlemonetary policy and allows the one-size-fits-all policy to run efficiently across allmember states. Above all, political integration is essential as similar economic and fiscalpolicies by individual member states could help all the member states reach a fruitfuloutcome by changes made in the single monetary policy.The question is: what does a single currency area do to function as an optimal currencyarea? Since the focus of this paper is on the Eurozone, I would like to discuss therequirements that the nations must satisfy in order to join the Euro.The European Monetary System was launched in 1979. At this time the majority of thecurrencies fixed their exchange rate around the European Currency Unit (ECU). Thisinitiated the debate on whether the Eurozone is an optimal currency area. The debatebecame more popular when the Euro was introduced in 1999. (Petreski, 2007)The decision to use the Euro as single currency by the major European countries wasmade in the 1990s. This was a two step plan i.e. first it was used for business transactionsin 1999 and then for all citizens in 2002. Since then the Eurozone has a single currency.(Cabannes, 2011)To set the Eurozone as an optimal currency area, there are certain conditions that themembers must fulfil in order to join the Eurozone. This is known as the Maastrichtconvergence criteria. It states that countries should achieve low inflation and long-terminterest rates and prove monetary stability of national currency by participating in theExchange Rate Mechanism II (ERM II) for a minimum period of two years. OnlyDenmark and U.K. are exempted from this as they have not accepted to use the Euro. Buthave the countries met these requirements? 24
  25. 25. Figure 1 Source: CS Monitor 2011Figure 1 shows the debt as percentage of GDP in the selected Eurozone countries. Themaximum debt allowed was 60%. However, most countries have failed to comply (theUS is depicted for comparison).Also, the maximum deficit spending allowed by the European Union is 3 percent of GDP.Deficit spending occurs when a country spends more than it generates in revenue. Figure2 shows that apart from Germany, most countries have high deficit spending as apercentage of GDP. As we have seen the Maastricht convergence criteria is not adheredto at all times.Figure 2 Source: CS Monitor 2011 25
  26. 26. However, the criteria should be met for the efficient functioning of adjustmentmechanisms to restore the equilibrium in particular countries and in the entire union as acurrency area. The countries that differ in economic growth and mechanism of economicfunctioning need to undergo real convergence. (Bukowski, 2007).Cost-benefit analysis of fixed exchange rateThese requirements must be met in order to realise the benefits of a single currency area.The main advantage of a floating exchange rate system is the ability to pursue anindependent monetary policy. Two or three decades ago, floating exchange rates were notpopular because of the uncertainty it would create with high exchange rate variability.This risk discouraged international trade and investment. Following these ideas, countrieswould fix the exchange rate or even adopt the neighbour’s currency as their own. Thiswas thought to not only encourage trade and investment but reduce transaction costs aswell. These ideas became less popular with the passage of time as exchange rate can behedged through the use of forward exchange market. In an area of common monetarypolicy, the labour force perceive that inflation will be low in the future as the currencypeg prevents the central bank from expanding even if it wanted to. With low expectedinflation, the workers and managers set their wages and prices accordingly. This resultsin low level of inflation in the countries for any given level of output. Evidence tosupport this argument comes from Italy, Spain, and Portugal, which had high inflationrates in the 1970s and they were eager to tie their currencies to those of Germany and therest of the EMS (European Monetary System) countries. (Frankel 1999)The benefits of having a single currency are that you achieve greater stability so you getlow inflation and interest rates. However, there are major differences in economicperformance so it is hard to put in practice similar fiscal policies amongst all members.Also, the international credibility of the currency is improved so there is an increase ininvestment and employment. (Obringer, 2012) 26
  27. 27. Furthermore, one the main advantages of fixing the exchange rate is to reducetransactions costs and exchange rate risk which can discourage trade and investment(Frankel, 1999). As far as transaction costs are concerned, costs occur for at least one ofthe transaction partners in comparing prices, exchanging foreign currency and managingexchange rate risk. Transaction costs savings brought about by the euro are estimated tobe around 0.3% to 0.4% of GDP (Commission of the EC 1990, p. 68) and 0.8% of GDP(IFO Institute 1998, p. 46).After analysing the requirements of an optimal currency area and the costs and benefits offixed and floating exchange rates, we may conclude that the requirements of an optimalcurrency area are there to mitigate the costs of a single monetary policy. The questionthen becomes: is having a fixed exchange rate a better option? No system of exchangerate comes without drawbacks and we must analyse the costs and benefits of each systemwith respect to the countries under consideration. A single currency area would only beinitiated if the benefits of sharing a common currency outweigh the costs attached withindependent monetary policies for individual nations across the region. 27
  28. 28. Consequences of single and national currency areasThe theory of the optimal currency area was initiated Robert Mundell. His theory onoptimal currency area evolved over time. He explains the consequences of both singleand national currency areas and this will be discussed in the following section.Mundell Models and the comparison of single and national currenciesA single currency means that there is a single central bank. This central bank has theability to issue notes and therefore it has a potentially elastic supply of interregionalmeans of payments. On the other hand, in the case of national currencies the supply ofinternational means of payment is conditional upon cooperation of many central banks.(Mundell , 1961)Hence we may conclude that there is a major difference in adjustment in areas whichhave a single currency and areas which use national currencies. Robert Mundellresearched on the optimum currency area and provided us with two models. I will discussthese two models in turn to compare the single currencies with national currencies.In Mundell’s 1961 paper A Theory of Optimum Currency Areas. He illustrated a rathersimplistic example, in a currency area such as the EU where there is more than onecurrency, unemployment and inflation are controlled through the willingness of surpluscountries to inflate. A shift of demand from the goods of Country B to Country A willcause unemployment in Country B and inflationary pressure on Country A in the shortrun. Since prices are sticky in the short run, the only option available is unemployment inCountry B.‘The existence of more than one (optimum) currency area in the world implies variableexchange rates. If demand shifts from the products of country B to the products ofCountry A, depreciation by Country B or an appreciation by Country A would correct theexternal imbalance and also relieve unemployment in Country B and restrain inflation in 28
  29. 29. Country A. This is the most favourable case for flexible exchange rates based on nationalcurrencies.’ (Mundell, 1961: p.659.)In contrast, a situation where there is a single currency a shift of demand from Country Bto country A leads to unemployment in country B and inflationary pressure in Country A.To overcome the unemployment in country B, the monetary authorities increase themoney supply and this aggravates inflationary pressure in Country A. (Mundell , 1961)Mundell (1969) explains that a flexible exchange rate is only valuable if shocks are feltacross all the countries that are part of the currency area. However, this is not usually thecase as shocks hit certain region only. It is obvious that Mundell’s earlier work was infavour of national currencies. Mundell supported his analysis by using the power ofindependent monetary policy.In a single currency area the cost of not having an independent monetary policy asinstruments of adjustment will be substantial when there are country specific shocks. Thisis because monetary policy in this case may be a powerful instrument for overcomingthese “asymmetric” shocks. (Eichengreen 1997)Econometric analysis by Eichengreen and Bayoumi (1993) show “a strong distinctionemerges between the supply shocks affecting the countries at the center of the EuropeanCommunity—Germany, France, the Netherlands, and Denmark—and the very differentsupply shocks affecting other EC members—the United Kingdom, Italy, Spain, Portugal,Ireland and Greece.” (p 104. Eichengreen, 1997) From this analysis it is evident that aone-size-fits-all monetary policy cannot be optimal for both continental Europe andBritain. One reason for this is the differences in business cycle conditions in Britaincompared to other European countries. (McKinnon, 2000)However, McKinnon (2000) criticised Mundell’s earlier model by pointing out a numberof limitations. He pointed out that Mundell used examples of countries that were notoptimum currency areas – ‘as when the main terms of trade shocks occurred acrossregions within a single country—rather than between countries’ (McKinnon, 2000: p.2).Therefore this model of Mundell is biased to his impressions of an independent national 29
  30. 30. monetary policy with exchange rate flexibility being the most efficient system to manageasymmetric shocks.Although the earlier model of Mundell (1961) suffered criticism by McKinnon (2000)who concluded that the main reason why a single monetary policy or fixed exchange ratecannot be successful all the time is because of differences in business cycles, it wassupported by econometric analysis by Eichengreen (1997) as mentioned above. Thequestion is about analysing the costs and benefits of each situation and then decidingwhich monetary system is more successful. It is evident from the current economicclimate and the Eurozone that not all countries in a single currency area face similareconomic shocks. For example Germany is going ahead with increased employmentwhilst Greece is in an economic depression and is reporting decreased employment. Forlarge differences in economic performance between Germany and Greece, it is verydifficult for the European Union to come up with a monetary policy that works well forboth countries.Moving on, in a 1970 Madrid conference on optimum currency areas, Mundell presentedtwo prescient papers on the advantages of common currencies. The first paper was onUncommon Arguments for Common Currencies (Mundell, 1972). This paper counters theideas about how asymmetric shocks can worsen conditions in a single currency area.Mundell argued that in a single currency area shocks can be mitigated by better reservepooling and portfolio diversification. This is because a country that suffers from such ashock can better share the loss with a trading partner because both countries hold claimson each other’s output in a single currency area. In contrast, in a flexible exchange ratewithout such portfolio diversification could find that its domestic currency assets areworth less in international markets when it suffers from adverse shock. Furthermore,events such as harvest failure, strikes and war in a single currency area would allow thecountry to run down its currency holdings and cushion the impact of the loss bybenefiting from the resources of other countries until the cost of the adjustment has beenequally spread over the future. On the other hand, in the case of national currencies, theentire loss has to be borne alone by the country suffering from such events. (Mundell,1973) 30
  31. 31. Mundell’s second paper A Plan for a European Currency (1973) again contradicted hisearlier conclusions. In this paper he acted as a proponent of single currency area and theEurozone. He explained that domestic shocks can be better handled with a singlecurrency area. For example when there threat of a strike to increase wages and is notjustified by an increase in productivity, the national currency become threatened. Incontrast, in a single currency area such as the Eurozone, domestic shocks in one countrycan be cushioned by capital movements. (Mundell, 1973)The Mundell-Fleming model and possible scenarios?Thus far, we have discussed Mundell models on single and national currency areas andthe empirical evidence on whether or not Eurozone is an optimal currency area. I wouldnow discuss the possible scenarios of single and national currency areas to analysewhether or not the single currency has exacerbated the Greek debt crisis. Previouslycountries such as Greece could increase their money supply by producing more money.However, after the advent of the euro this is not the case. With the Mundell-Flemingmodel we can compare the consequences of increased money supply on the total outputof the economy. This model uses IS and LM curves.The IS curve plots the relationship between the interest rate and the level of income.Before I explain the IS-LM model, I would like to discuss the Keynesian cross which is abuilding block of the IS-LM model. The Keynesian cross is the simplest interpretation ofthe British economist John Maynard Keynes. In 1936, Keynes proposed a new way toanalyse the economy in his book: The General Theory of Employment, Interest andMoney (1936). In his book, Keynes develops his argument that an economy’s totalincome in the short run is determined mostly by the spending plans of households,businesses and government. Keynes came to the conclusion that the problem duringeconomic depression is due to inadequate spending. The Keynesian cross helps explainthis. (Mankiw 2009)To derive the Keynesian cross we can discuss the determinants of planned expenditure. Ifwe assume that the economy is closed we can derive an equation for the plannedexpenditure as follows: 31
  32. 32. PE = C + I + GBy adding the consumption function to this equation we get:C = C(Y – T)If we take the planned investment and government purchases to be fixed and combine theabove mentioned equations, we obtain: PE = planned expenditurePE = C(Y – T) + I + G C = consumption(Mankiw 2009) Y = output T = taxes Y – T = disposable income I = planned investment G = government purchasesThe economy is in equilibrium when the actual expenditure equals the plannedexpenditure. The Keynesian model makes this assumption and we can write this as:Y = PEWhere Y is the actual expenditure in GDP.The diagram on the next page shows the Keynesian cross. The actual expenditure (E) isthe 45-degree line. The equilibrium is where the planned-expenditure line crosses theactual expenditure line. 32
  33. 33. Expenditure, E Actual Expenditure, Y Planned expenditure, PE A Income, Output, Y Equilibrium in this model is reached by changes in inventories which facilitate the adjustment process and put the economy back to equilibrium. For example, when an economy is not in equilibrium, firms experience unplanned changes in inventories and this causes them to change their production level which affects income and expenditure and the economy is moved back into equilibrium. (Dornbusch, Fischer and Startz, 2003) An assumption in the Keynesian cross is that the planned investment is fixed. With the addition of the relationship between interest rate and investment we can obtain the following equation: I = I (r) The graph on the next page represents this. 33
  34. 34. I (r)Interest rate, r Investment, I To combine the investment function with the Keynesian cross, we can take a simple example. Since interest rate and planned investment are inversely proportional so the investment function slopes downwards. (Mankiw 2009) A decrease in planed investment shifts planned expenditure function downwards because PE = C(Y – T) + I + G The shift in the planned expenditure from PE1 to PE2 as shown by the graph on the next page causes the income to fall from Y2 to Y1. Therefore it can be said that an increase in the interest rate lowers income. The IS curve can summarise the relationship between the interest rate and the level of income. It represents how an increase in the interest rate causes the planned investment and the equilibrium income to fall. It is for this reason that the IS curve slopes downwards. (Mankiw 2009) The graphs on the next page show how the IS curve can be derived from the Keynesian cross. The IS tells us that the interest rate and income are inversely proportional. 34
  35. 35. Expenditure, E Actual Expenditure, Y Planned expenditure, PE1 A PE2 B Y2 Y1 Income, Output, Y ISInterest rate, r r2 r1 Y2 Y1 Income, Output, Y 35
  36. 36. Going back to The General Theory (Keynes 1936), Keynes also talked about his view of how interest rate is determined in the short run. His explanation of this is called the theory of liquidity preference. I would develop this theory by explaining the supply of real money balances. The theory of liquidity preference assumes that there is a fixed supply of real money balances. The following expression illustrates this: (M/P)s = M / P M = supply of money P = price level (M/P) s = supply of real money balances The demand for real money balances can be written as: (M/P)d = L(r) L(r) shows that the quantity of money demanded depends on the interest rate. The graph below shows the theory of liquidity preference. Interest rate, r M / P L(r)Equilibrium interest rate M/P 36
  37. 37. The graph on the previous page has shown us that the supply and demand for the real money balances determine the equilibrium interest rate. The supply of real money balance is vertical as the supply does not depend on the interest rate but, the demand curve is downward sloping because a higher interest rate increases the opportunity cost for holding money and thus lowers the quantity demanded. (Mankiw 2009) Having discussed the theory of liquidity preference, I would derive the LM curve using this theory. When the income is high, expenditure is also high and therefore the demand for money is high. The following expression can be used to explain this: (M/P)d = L(r, Y) ‘The quantity of real money balances demanded is negatively related to the interest rate and positively related to the income.’ (Mankiw , 2009: p. 304) I would consider a simple example to derive the LM curve.Interest rate, r Interest rate, r M / P LM r2 r2 r1 r1 L(r, Y2) L(r, Y1) M/P Y1 Y2 Output, Y 37
  38. 38. An increase in income from Y1 to Y2 increases the demand for money and thus increasesthe interest rate from r1 to r2. The graph above shows how we derive the LM curve. TheLM curve shows that an increase in income leads to an increase in interest rate.The IS-LM model was introduced by Sir John Hicks in 1937. It has been criticized as anobsolete instrument in the academic community. The main criticism is that this modelcannot explain simultaneous occurrences of high inflation and high unemployment ratesin the economy. Moreover, the shift in central banks from targeting the money supply tofollowing an interest-rate rule also undermines the importance of this model as a policytool. (Chiba & Leong, 2007) The short-run IS-LM model has an assumption that pricelevel is fixed. Therefore classical economists would reject this short run IS-LM model asthey believe that wages and prices move rapidly to clear markets. However, IS-LMmodel is still widely used because of its practical application in understandingmacroeconomic policies.The IS-LM model shows how monetary and fiscal policy influences the equilibrium levelof income. The IS-LM curve has two parts, the IS curve and the LM curve. IS stands forinvestment and saving whereas LM stands for liquidity and money. The model isinterpreted as a graph where the horizontal axis represents the national income and thevertical axis represents the interest rate. The IS represents the market for goods andservices and the LM curve represents the supply and demand for money.I would now discuss The Mundell-Fleming model which is IS-LM for a small economy.It will display my arguments for fixed and floating exchange rates. In this section, myentire analysis on the single currency debate will be built on the assumption that a singlecurrency area represents a fixed exchange rate system and national currencies represent afloating exchange rate system.Before I begin explaining the model, I would go through the assumptions of this model.The small economy model used in Mundell-Fleming assumes perfect capital mobility.This means that the interest rate in the economy under consideration (r) is determined bythe world interest rate (r*). 38
  39. 39. r = r*In the case of a domestic economic shock, the domestic interest rate is adjusted to theworld interest rate by the rapid international flow of capital. (Mankiw 2009)The expression developed using Mundell-Fleming is Y = C(Y – T) + I(r) + G + NX(e)We add a new term that is NX(e) (net exports) to the expression of total output in aneconomy. The net exports depend negatively on the exchange rate (e). In this model wecan call this expression the IS* equation. The graph below illustrates this.Exchange rate, e Net exports, NXThe graph above shows the net-exports schedule. It can be seen that an increase inexchange rate lowers the net exports. Going back to The Keynesian Cross discussedearlier, a decrease in net exports shifts the planned expenditure schedule downwards asshown in the graph on the next page. 39
  40. 40. Expenditure, E Actual Expenditure, Y Planned expenditure, PE1 A PE2 B Y2 Y1 Income, Output, YExchange rate, e IS* e2 e1 Y2 Y1 Income, Output, Y The graphs above show how the IS* curve is derived from the Keynesian cross. The IS* curve illustrates the relationship between exchange rate and level of income. The higher the exchange rate, the lower is the level of income in an economy. (Mankiw 2009) Furthermore, we call the money market equation discussed earlier, the LM* curve. The graphs on the next page illustrate how we arrive at a vertical LM* curve. 40
  41. 41. LMe r = r* Y LM*e YThe intersection of the LM and the horizontal line representing the world interest ratedetermines the level of income. The LM* derived is vertical because given r* there isonly one value of Y that equates money demand with supply, regardless of e. 41
  42. 42. Therefore the equations for IS* and LM* used in the Mundell-Fleming model represent the following expressions: IS* Y = C(Y – T) + I(r) + G + NX(e) LM* M/P = L(r*, Y) Where r* is the world interest rate So going back to the question: how the floating exchange rates help an economy overcome asymmetric shocks? Well, as we can see from the IS* equation, the output Y depends on the exchange rate e. So if we change the exchange rate, we can change output. Likewise, using the LM* equation, if we change in the money supply we can change Y (output). Finally I would illustrate the equilibrium in Mundell-Fleming model using the two expression described above and explain the outcomes of fixed and floating exchange rates.Equilibrium exchange rate LM* e IS* Y Equilibrium level of income 42
  43. 43. I would now compare the monetary policy under floating exchange rates (national currencies). LM1 LM2ee1e2 IS Y1 Y2 Y The graph above shows that an increase in the money supply shifts the LM curve to the right. This is because the output must increase to restore equilibrium in the money market. As the money supply increases, the nominal exchange rate falls and net exports increase. Therefore output increases. This shows that monetary policy affects output in a small open economy. It should be noted that expansionary monetary policy does not increase world aggregate demand. It only shifts the demand from foreign to domestic products. This increases income and employment at home at the expense of losses abroad. Moving on, I would now analyse the monetary policy under fixed exchange rates. We assume that a single currency is a way of fixing exchange rate. 43
  44. 44. LM1 LM2 e e1 IS Y1 YThe graph above demonstrates the impact of monetary policy under fixed exchange rates.When the central bank increases the money supply the LM curve shifts to the right whichlowers the exchange rate. Exchange rate is fixed so arbitrageurs quickly respond to thefalling exchange rate by selling domestic currency to the central bank. As a result, themoney supply and the LM curve return to their original positions as shown by the graphabove. Therefore, we can say that under fixed exchange rates, the monetary policy doesnot affect output.A government can repay its debt by seeking more debt, tax revenue or increasing moneysupply. After joining the Euro in 2001, the Greek government increased its spending. Atthe same time, the Greeks stopped paying taxes. Since Greece could previously increaseoutput by increasing money supply, it is unable to do so as being part of the singlecurrency. Therefore the only option available was to seek more debt.However, Germany is part of the Eurozone but does not hold large amounts of debt. Oneof the characteristic of the German economy that allows Germany to do this is greaterwage flexibility. The wage flexibility in Germany allows Germany to increaseproductivity and hence main high competitiveness. For example the German industry hasbeen very efficient and this has made Germany very effective with its exports over thepast decade. (Marin 2010) 44
  45. 45. Furthermore, investors are more confident when investing in Germany because theGerman government has a reputation for addressing fiscal issues effectively. Germany isalso working on cutting its government spending. Other Eurozone countries have beenunable to make appropriate investments and reforms. (Cowen 2010)Therefore there are other mechanisms through which countries in a single currency areacan maintain competiveness.Example of UK’s quantitative easingAlthough it is part of the European Union, UK has not joined the Euro. Possible reasonsfor this are that by being part of the Euro, a country is unable to devalue if its currencybecomes uncompetitive. We have discussed problems with countries such as Greece whohave joined the Euro. If we compare Greece to Germany you see higher inflation andlower productivity. This means that the exports of Greece have become uncompetitivewhich results in lower demand and lower growth in Greece. The outcome of this is largecurrent account deficit in Greece. In contrast, UK has been able to devalue to restorecompetitiveness and giving the UK economy more flexibility. Secondly, UK is able tohave an independent monetary policy. For example in 2008 the UK was hit hard by thefinancial crisis and was able to pursue quantitative easing to stimulate economic growth.(Pettinger, 2011) In March 2009, the Monetary Policy Committee (MPC) announced thatit would start to inject money directly into the economy in order to meet the inflationtarget of 2% on the CPI measure of consumer prices. The MPC increases money supplyby purchasing assets like government and corporate bonds. This is known as quantitativeeasing. However, typical monetary policy is to lower the interest rates. But, if the interestrates are very low than this policy can no longer be used and quantitative easing may beused to stimulate the economy. ( Bank of England, 2009)I would illustrate the concept of quantitative easing using IS-LM and AS-AD graphs. Thenominal money supply is set by The Bank of England. So for a given price level, the realmoney supply is a fixed number so the money supply line is vertical. The money supply-money demand diagram on the next page shows that as MPC injects money in the 45
  46. 46. economy, there is an increase in the real money supply of money so the money supply curve (MS1) shifts to the right from MS1 to MS2. This means that the money supply is greater than the money demand (MD) so individuals prefer to buy bonds rather than hold B this extra cash. So the price of bonds increases and the interest rate (r1) falls from r1 to r2 to clear the market. The equilibrium shifts from point A to point B. The LM curve shows that for any level of output, the increase in the money supply from MS1 to MS2 causes the real interest rate to fall so the LM curve shifts to the right from LM1 to LM2. The effect that this has on the aggregate demand of goods and services is illustrated by the diagrams below. Real interest rate, r Real interest rate, r r Real interest rate, MS1 MS2 LM1 A A LM2 r1 B r2 B MD Real money supply and real money demand Output, YReal interest rate, r Price Level, P Price Level, P LM1 Ar1 LM2r2 PP B AD2 IS AD2 AD1 AD1 Y1 Y2 Output, Y Y1 Y2 46
  47. 47. Y1 Y2 Output, YThe increase in the money supply shifts the LM curve to the right and the incomeincreases for any given price level. The interest rates decrease from r1 to r2. Thereforeinvestment increases and the output increases from Y1 to Y2 at each value of P. So whenthe Bank of England increases the money supply, the aggregate demand increases in theshort run.The monetary policy multiplier illustrates how much an increase in the real money supplywould increase the equilibrium level of income, provided that the fiscal policy isunchanged.’ (Dornbusch, Fischer & Startz, 2003) The following equation examines theeffects of an increase in the real money supply on income. The  M P multiplier equalto: Y M PY Is the change in total income and  M P is the change in the real money supply.(Dornbusch, Fischer & Startz, 2003) 47
  48. 48. The rightwards shift of the LM curve due to the increase in the money supply causes theinterest rate to fall and this lower interest rate causes an increase in investment which, viathe multiplier effect, causes further increase in desired expenditure. IS LM1 Interest rate, r LM2 A B 1 2 Y Y Output, Y AD2 AD C Price Level, P P2 SRAS2 P1 SRAS1 A B 1 2 Y Y Output, Y 48
  49. 49. An increase in the nominal money supply results in a rightward shift of the LM curve anda rightward shift in the AD curve. The UK economy will move to the intersection of thenew AD curve with SRAS curve, from point A to point B. The diagrams on the previouspage show how this happens. Initially the increase in the money supply means that peoplefind that they have excess money balances, so they all attempt to shift from money intobonds. This is shown in the IS-LM diagram by a rightward shift of the LM curve. Sincepeople have money to spend, the desired expenditure increases. This is shown by therightward shift of the AD curve. The price level does not change as it takes time forbusinesses to adjust the prices to changes in demand so firms are willing to supply anyamount of output at that price. For example, prices on menus for ‘fish and chips’ inrestaurants do not change instantaneously after an increase in demand. So prices aresticky in the short run.In the long run all firms in the economy will adjust their prices to changes in output so asto be able to produce their normal level of output. For example, when demand for ‘fishand chips’ is high day after day. The managers of the restaurants will increase the pricesof ‘fish and chips’ to reduce the quantity of ‘fish and chips’ demanded to a moremanageable level. The full employment level is the normal level of production for theeconomy so in the long run the aggregate amount of output supplied will equal the fullemployment level of the economy. Since produces will fully adjust prices to changes inthe level of demand for goods and services in UK, the long run aggregate supply curve(LRAS) curve will be vertical.Since the desired expenditure of goods and services exceeds the output, there is aninflationary gap. Inflationary gap is basically the excess of demand over the supply at agiven price (Walter, 1942). Hence there is an upward pressure on prices and SRAS1shifts to SRAS2. The price level increases from P1 to P2 and this rise in price levelreduces the real money supply so the LM2 curve shift back to LM1. The real money 49
  50. 50. supply returns to its original level and the equilibrium moves from point B to point C sothe national income returns to its potential level, Y1. In the long-run the initial increase inthe money supply only affects the nominal prices and does not affect output and theinterest rate so the real economy is returned exactly to its original point.The MPC’s objective of targeting inflation to 2% can therefore be achieved as prices willrise in the long run. As we have seen, UK can enjoy the benefits of having anindependent monetary system in the short run to overcome asymmetric shocks in theeconomy in difficult economic conditions.Is Eurozone an optimal currency area?We have now discussed the work of Mundell on optimal currency areas. But, is there anyevidence that supports either exchange rate systems?Mongelli (2002) concluded that the labour mobility and price and wage flexibility acrossEuropean countries is low. His conclusion was supported by the report of the EUCommission (2004). This report finds this flexibility to be reduced by slow competitionof the single market and by the slowness of dismantling some non-tariff barriers.Moreover, real wages are quite rigid in the majority of the European countries (OECD,1999).Figure 1 shows an estimate of the labour market responses to asymmetric shocks. (OECD1999) It can be concluded from this that the labour market responds slowly to suchshocks. 50
  51. 51. Figure 3: Source: OECD (1999)However, numerous studies have illustrated that the Eurozone is an optimal currencyarea. For example, ‘Issing (2000, cited in De Grauwe and Mongelli, 2005) observes anincreasing degree of financial markets integration in terms of fewer opportunities forarbitrage and smaller interest rates differentials’ (p 7. Petreski, 2007).Van Wincoop (2001) predicted an increase of the intra-euro-area trade of more than 50%.The intra trade before the advent of the Euro in 1998 was 41.1 % and 54.6 % in 2006.Although previous studies expected higher percentage increases, it is only an increase of13.5 percentage points. It still, however supports the Eurozone as an optimal currencyarea. (European Economy 2006)Furthermore, De Grauwe and Mongelli (2005) also assessed the Eurozone as an optimalcurrency area. They found that in the first two years HICP inflation significantlyconverged. However, the convergence started even before the advent of the euro.According to European Union (2006) the adoption of the euro has been associated withan extended period of price stability. The low level of inflation supports the credibility ofthe common monetary policy. In their study they also agree that financial integration wasstimulated, particularly in the money market segment. Also significant advances havebeen made on the bond market. Therefore, before the advent of the Euro the weakcurrency countries of Italy and Spain for example operated with higher interest ratescompared to Germany. However, after the advent of the Euro, there was a remarkable 51
  52. 52. convergence of European interest rate at a lower average level compared to the averagelevel prior to the advent of the Euro. (McKinnon 2000)To summarize, the empirical evidence discussed above on Eurozone as an optimalcurrency area shows that advances have been made in the area of financial intergration,inflation convergence and intra-euro-zone trade. However, labour mobility and wageflexibility remained low.Has the single currency exacerbated the Greek debt crisis?I have now explained and compared effects of monetary policy in single and nationalcurrency areas using the Mundell-Fleming model. On the one hand, having monetaryindependence allows the government to respond to shocks such as a shift in theworldwide demand away from the goods it produces. With an independent monetarysystem, a country is able to prevent recession in such circumstances by means ofmonetary expansion and depreciation of the currency. This increases the demand fordomestic products and returns the economy to desired levels of employment and outputmore effectively than would the case under the automatic mechanisms of adjustment onwhich a single currency area must rely. For example, prior to joining the EurozoneGreece could alter its money supply and overcome such shocks. On the other hand, withfixed exchange rates, the monetary policy is always diverted to some extent to dealing tothe balance of payments. Under such conditions the monetary policy becomes completelyineffective. An example of this is the EMU. In a single currency area an expansion in themoney supply by a given country has no effect as ‘the new money flows out of thecountry, via a balance of payments deficit, just as quickly as it is created’ (Frankel, 1999:p. 12). In an event of an adverse shock, the country must bear the consequences andcannot take an action to prevent such disturbances with monetary expansion. Forexample, after the fall in demand, the recession may last until wages and prices are biddown, or until some other automatic adjustment process takes place. (Frankel 1999) 52
  53. 53. Going back to our question of whether or not the advent of the euro has exacerbated theeurozone crisis? To answer this question we must analyse the effectiveness of each typeof exchange rate system. The advantages of a fixed exchange rate are linked to theeconomic integration. For example if traded goods constitute a large proportion of theeconomy, then the uncertainty in exchange rate can be a cause of concern. However,under fixed exchange rates an economy is unable to pursue independent monetary policyand overcome domestic shocks that a country may suffer. This assumption can becritically analysed by a simple example. For instance variability in output under a fixedexchange rate is relatively low when the marginal propensity to import is high. If weconsider the ease of labour movement between the country in question and itsneighbours, we can illustrate that the workers may be able to respond to a domesticrecession by moving to neighbours in search for employment. This can be an alternativeto monetary expansion or devaluation. If the neighboring countries are also in recessionthey can share a monetary policy. This means that there is less need for independentmonetary policies and the countries may accommodate differences together. The labourmovement between countries can be criticized as the Euro is unlikely to increase mobilitybetween countries because of differences in language or culture. According to the theoryof optimum currency areas discussed earlier, the most important mechanism ofadjustment in avoiding unemployment and inflation following a regional asymmetricshock is geographical labour mobility (Mundell 1961). However, intra-EU mobility canresult in high costs in terms of getting information and moving houses. These costs arefurther increased by cultural and linguistic differences. For these reasons the inter-statemobility in US is higher compared to intra-EU mobility. Empirical evidence supports thisassumption and confirms that geographical labour mobility is important as an adjustmentmechanism for regional shocks within the US. In Europe however, this is hardly the case.(Commission of the EC 1990, Blanchard/Katz 1992, Eichengreen 1993, Bayoumi/Prasad1995, Obstfeld/Peri 1998).Furthermore, there may be the existence of a federal fiscal system to transfer funds toregions that suffer domestic shocks so monetary independence is less necessary. (Frankel1999) We can use the example of the Eurozone to explain this. In the Eurozone, 53
  54. 54. European Financial Stability Facility provides financial assistance to the Eurozoneeconomies facing economic difficulty. This is financed by members of the Eurozone.(Regling, 2010)Critical analysis and conclusionThe epitome of the Eurozone crisis is well explained by reverting to the Greek example.The Greek government has been spending more than the revenue it received. However, inthe past it could overcome this problem by printing more money and thereby reducedeficit. The Greek government has reduced the salaries of civil servants and pensions asit takes new austerity measures. As a result revenues and savings have reduced and theGreek economy is in crisis due to lack of money. France may be the next victim as inJanuary 2012, it lost its triple A rating from Standard and Poors. When Greece joined theEuropean Union in 2001, it borrowed Euros mostly from foreign investors. The bigEuropean investment banks were happy with lending Greece this money as they werepromised high interest rates on the loans that outweighed the risk attached. (Cabannes2011)Cabannes (2012) argues that the advent of the Euro has worsened the Eurozone crisis. Heuses the example of Germany and Argentina to support his conclusion. In 1990, Germanydecided to set the value of one Eastern Mark to one Deutsche Mark. As a result EastGermany went into a depression. To overcome this, West Germany poured money intothe eastern part. This pursuit is responsible for part of Germany’s public debt. Argentinain the 1990s was undergoing budget deficits and defaulted on $103 billion of debt.However In January 2002, Argentina un-pegged its Peso from the US dollar (this isequivalent to going back to a local currency).I am a proponent of Cabannes’s conclusion and believe that the single currency hasexacerbated the Greek debt crisis. However, my assumption suffers criticism as labourmobility may be higher in a single currency area as workers can shift if their country is inrecession. Also, the existence of a federal fiscal system to transfer funds to regions that 54
  55. 55. suffer domestic shocks such as the European Financial Stability Facility may help weakcountries such as Greece. Furthermore, Kaletsky (2012) argues that German politiciansand central bankers are responsible for the Eurozone crisis. Germany has time after timeprevented the policies that could have brought the Euro crisis under control. Also,Germany is responsible for the policies such as interest rate rises in 2011 by the ECB thatnow threaten Greece with default. Some writers believe that Germany should be takenout of the Eurozone as its policies are inappropriate for other Eurozone members.(Kaletsky, 2012). Also, dual currency (local domestic and USD for trade) or singlecurrency regimes may be irrelevant when we discuss the Eurozone crisis. The problemmay be a result of failure to adhere to macro-economic discipline revolving around Debt-GDP ratios, budget deficit management and interest rate.To strengthen my argument I would like to give a hypothetical example. Suppose Greecefaces a domestic shock that causes unemployment while scarcely affecting otherEurozone countries. If Greece had maintained monetary independence, it could lowerdomestic interest rates to stimulate the weak economy as well as let its currencydepreciate to increase foreigners demand for Greek products. However, this option is nolonger available to Greece. Furthermore, the ECB probably will not use monetary policyto address asymmetric economic shocks that only affect a certain country. As being partof the Eurozone, Greece cannot use monetary policy to solve domestic shocks. It is notlikely that the central bank for the European Monetary Union will use expansionarymonetary policy to help Greece, since doing so would cause inflation in those EMUcountries which are not in recession. However, if wage and price levels in Greece areflexible, then lower wage and price levels in Greece would have economic effects similarto those of a depreciation of the old Drachma. Moreover if capital can flow freely acrossthe Eurozone and workers are willing to relocate to countries where employment isavailable, then the asymmetric shocks can be overcome without the need of monetaryadjustments. Otherwise asymmetric shocks can cause recession. (Kiss 2004) 55
  56. 56. Data AnalysisIn this chapter I would like to analyse data from The International Monetary Fund ongeneral indicators of the Greek economy. The data of Greece for these indicators willthen be compared to other Eurozone countries and UK for comparison. I have oftencompared Greece with other troubled Eurozone countries such as Ireland, Portugal andSpain. Also, I have compared Greece with Germany which is a stronger Eurozoneeconomy. The data is analysed to identify the likely causes of the consequences of theGreek debt crisis.Greece’s economic performanceEconomic growth can be measured by the increase in gross domestic product (GDP).GDP measures the value of the final goods and services produced in an economy whereasGDP per capita measures the GDP per person. That said, for a given GDP, GDP percapita decreases as the population increases. Basically GDP per capita gives us anindication of the standard of living in an economy. (Mankiw 2011) However a problemwith GDP per capital is that standard of living in advanced countries is reflected less bythe GDP per capita and more by education, health and good family relations.Furthermore, taking reliable measures of the GDP is problematic because it is difficult tomeasure the output of services which is the largest share of GDP in advanced countries.This is because there is no physical output produced so productivity movements aredifficult to capture. Also, it is extremely difficult to combine the output of a variety ofgoods and services. The process of creating index numbers of output and weighting theitems together creates the problem of whether to use base year weights or current yearweights. Lastly, illegitimate financial transactions such as housework are ignored and notadded to the GDP. (Hall and Soskice (2001) The higher proportion of shadow economyas percentage of GDP in Greece compared with other Eurozone nations (CS Monitor2011) as discussed in the literature review might be a reason for lower GDP per capita inGreece. 56