Why the Euro?

The second chapter of The Euro Crisis gives the reader some insight to both the political and economic reasons behind unifying the continent of Europe underneath one currency.  A Canadian Economist named Robert Mundell  first came up with the idea, known as an optimal currency area, in 1950. There are three factors to consider when determining whether or not two countries should share common currency:

1. Degree of integration – If two countries frequently trade and invest with each other, then a common currency reduces risks and conversion costs.

2. Degree of asymmetry – When two countries produce similar goods and services, they are likely to require similar economic policies.  If this is true, then they should consider using a common currency. However, if these two countries are asymmetric with regards to these factors, then they should avoid using a common currency.

3.  Mechanisms that correct for divergence – Countries can diverge in a variety of ways such as migration, capital flows, and internal price flexibility. If there are strong polices in place to counteract divergence, then countries should consider sharing a single currency.

There were differing opinions about whether or not the euro met this criteria.
People like Jeffrey Frankel of Harvard and Andrew Rose of the University of California, Berkely said unifying European countries underneath one currency would diminish asymmetries and strengthen correction mechanisms.  In other words, European countries did not meet the criteria for forming an optimum currency area, but the very act of doing so would make them eligible over time.  Others like MIT economist Paul Krugman disagreed saying companies in the same sector would moves so as to gather geographically in an area and strengthen asymmetry between countries(the book uses Silicon Valley and Wall Street as examples).

Policymakers chose to disregard advice against forming the euro for a number of economic reasons:

1.  Europeans do not like fluctuating exchange rates (A topic the book was not considerably helpful on except to say that monetary policy played a role in the disputes European countries has with each other).  The cause for a common currency was reinforced by the idea of an internal market for goods and services along with protection against competitive devaluations.

2. The second reason was the trilemma: Countries cannot have stable exchange rates , free capital movement, and independent monetary policy all at the same time.  Europeans generally wanted stable exchange rates and free capital movement, so they chose to give up independent monetary policy.In pursuing free capital movement and stable exchange rates, Europeans where left with fixing an exchange rate or developing a common currency.   Countries tried pegging their currencies to the German mark as it was seen as being the  superior currency (though the author does not clearly state why). However, the monetary policy set by the Bundesbank catered to Germany’s needs and not Europe’s.  Additionally, German monetary dominance was not likely to last forever, so the next logical step was to form a monetary union.

But there were also political reason for forming the euro.
French president Francois Mitterand wanted to ensure Germany did not dominant the continent in the post-Cold War era and thought that unifying Europe as whole would accomplish this.  Other European leaders also felt compelled to unify Europe in some way.  German Chancellor Helmut Kohl agreed to the euro project in the interest of showing that  unifying East Germany and West Germany would benefit Europe as a whole.