by Roger Vicquéry (London School of Economics)
Is the euro area sustainable in its current membership form? My research provides new lessons from past examples of monetary integration, looking at the monetary unification of Italy and Germany in the second half of the nineteenth century.
Currency areas’ optimal membership has recently been at the forefront of the policy debate, as the original choice of letting peripheral countries join the euro was widely blamed for the common currency existential crisis. Academic work on ‘optimum currency areas’ (OCA) traditionally warned against the risk of adopting a ‘one size fits all’ monetary policy for regions with differing business cycles.
Krugman (1993) even argued that monetary unification in itself might increase its own costs over time, as regions are encouraged to specialise and thus become more different to one another. But those concerns were dismissed by Frankel and Rose’s (1998) influential ‘OCA endogeneity’ theory: once regions with ex-ante diverging paths join a common currency, they will see their business cycle synchronise progressively ex-post.
My findings question the consensus view in favour of ‘OCA endogeneity’ and raise the issue of the adverse effects of monetary integration on regional inequality. I argue that the Italian monetary unification played a role in the emergence of the regional divide between Italy’s Northern and Southern regions by the turn of the twentieth century.
I find that pre-unification Italian regions experienced largely asymmetric shocks, pointing to high economic costs stemming from the 1862 Italian monetary unification. While money markets in Northern Italy were synchronised with the core of the European monetary system, Southern Italian regions tended to move together with the European periphery.
The Italian unification is an exception in this respect, as I show that other major monetary arrangements in this period, particularly the German monetary union but also the Latin Monetary Convention and the Gold Standard, occurred among regions experiencing high shock synchronisation.
Contrary to what ‘OCA endogeneity’ would imply, shock asymmetry among Italian regions actually increased following monetary unification. I estimate that pairs of Italian provinces that came to be integrated following unification became, over four decades, up to 15% more dissimilar to one another in their economic structure compared to pairs of provinces that already belonged to the same monetary union. This means that, in line with Krugman’s pessimistic take on currency areas, economic integration in itself increased the likelihood of asymmetric shocks.
In this respect, the global grain crisis of the 1880s, disproportionally affecting the agricultural South while Italy pursued a restrictive monetary policy, might have laid the foundations for the Italian ‘Southern Question’. As pointed out by Krugman, asymmetric shocks in a currency area with low transaction costs can lead to permanent loss in regional income, as prices are unable to adjust fast enough to prevent factors of production to permanently leave the affected region.
The policy implications of this research are twofold.
First, the results caution against the prevalent view that cyclical symmetry within a currency area is bound to improve by itself over time. In particular, the role of specialisation and factor mobility in driving cyclical divergence needs to be reassessed. As the euro area moves towards more integration, additional specialisation of its regions could further magnify – by increasing the likelihood of asymmetric shocks – the challenges posed by the ‘one size fits all’ policy of the European Central Bank on the periphery.
Second, the Italian experience of monetary unification underlines how the sustainability of currency areas is chiefly related to political will rather than economic costs. Despite the fact that the Italian monetary union has been sub-optimal from the start and to a large extent remained so, it has managed to survive unscathed for the last century and a half. While the OCA framework is a good predictor of currency areas’ membership and economic performance, their sustainability is likely to be a matter of political integration.