Is the Euro Area Converging or Diverging - Essay Example

Is the Euro area converging or diverging? Critically discuss whether the Euro becomes a vehicle for creating divisions in Europe. The European Union is a family of democratic countries in Europe committed to work together in order to achieve prosperity. This organization maintains cooperation among its member states in various sectors such as trade, conservation of the environment, job creation, and facilitating transport. Institutions that were concerned with preventing future conflicts in the continent developed the idea to form the European Union. The European Monetary Union was founded in the year 1999. It was expected to catalyze economic integration in Europe and promote convergence within the continent. The union has undeniably attained some of these targets. It has assured price stability, making a striking change to its inflation prone member states. Most of the countries within the Euro area benefited from an accountable nominal interest rate reduction (Blanchard 2007). Due to the changes experienced in terms of the major domestic demand expansion and the persistent deterioration of their current accounts, the member countries also enjoyed a reduction in real interest rates. The Euro area has increased trade intensity for all countries lying within its dynasty. Within the Euro area, states that are more economically advanced have witnessed the greater financial integration. The union has accelerated this change. Lastly, it has enhanced the level of business synchronization (Allington, Kattuman & Florian 2005). However, despite the major achievements, the performance of the economy of the Euro area over recent years has been on the decline. The debt crisis and specifically the slow recovery from the 2008-2009 recession in the core EU Member States, has triggered many questions on the capabilities of the Union (Estrada, López& Galí 2013). The higher number of cases of debt crisis and inflation amongst its member states has caused arguments whether the endorsement of a common currency, may be behind the scenario. The currency endorsement has acted as a factor of divergence in terms of growth and unemployment (Andrés, Eva & Javier, 2008). According to Estrada, López and Galí (2013), in order to examine the convergence and divergence of the countries, the performance of their labor markets, evolution of key competitiveness measures, current account imbalances and the factors affecting it such as productivity and wages have to be properly analyzed. All through the nine years of operation, the European Monetary Union was associated with a strong convergence in terms of lowering unemployment rates across the member countries. However, the process received a major setback when it was interrupted by the 2008-2009 financial crisis. From that point forward, there have been malignant inflation differentials leading to cumulative price variations within the area. This situation portrays the patterns of unit labor costs and wages in its member states (Engel & Rogers 2004). The incorporation of countries with lower income within the area has enabled them to enjoy growth in terms of productivity the tradable sector. This results in higher real and nominal wages for the sector. The varying unit labor costs for its members that are key measures of competitiveness has resulted in differential job creation opportunities within the Euro area. In this area, the countries also suffer from an enormous dispersion in current account balances (Estrada, López & Galí 2013) This current account imbalance dispersion is caused by the internal devaluation laws that limit success at curbing external imbalances unless accompanied by reforms that can boost some of the non-price factors (Alesina & Robert 2002). By 2012, the unemployment rate in the Euro area increased by four percent since early 2008.Countries such as Austria had an unemployment rate of 4.8% with Greece lagging behind at 26%. The large dispersion in unemployment rates within the member states is caused by the inability of the Euro area to boost factors such as labor mobility within its location. The Euro has also failed in developing an appropriate fiscal union, which could act well as a risk-sharing device. Instead, it has been marred by lack of transparency (Estrada, López & Galí 2013). However, the adoption of the Euro in itself has not been a source of divergence in unemployment rates. There are several other factors believed to be behind the divergence. The financial crisis that affected most of its members and the fact that the adoption of the Euro prevented the hardest hit countries from devaluing their currencies hindered any efforts aimed at job creation (Blanchard 2007). According to Wyplosz (2006), the Euro area could be a vehicle for creating divisions around Europe. Some of the European Monetary Union governance principles are outdated, and the erroneous policy making has often seen some of these principles that conflict economic realities ignored. Therefore, the state of transparency in terms of economic policy is not satisfactory to most of its members. The situation has been linked to the lack of explanations for and visibility of the fiscal and structural policies. The Euro area is already creating divisions in the continent by its susceptibility to political influence (Lenain, 2002). When it came to the transition from national currencies to a single currency, there was instability in terms of who would oversee the process. In the end, member states agreed that nominal convergence criteria would be imposed, rather than an optimal combination in accordance with optimal currency area principles. However, as Wyplosz (2006) argues, the agreement has been overshadowed by political influence where the original agreement has been breached. The messy state of the Euro area governance is also another instance where it is propagating divisions in the continent. The European Monetary Union, with its curious institutional structure, largely assumes that every member of the European Union is going to join the Euro area. It assumes that non-participation is mandatory in exception of two countries having an official opt-out clause. These are Denmark and the United Kingdom. According to, Estrada, López and Galí (2013), the existing Euro institutional setup facilitates the development of a non-cooperation game with its members. Consequently, the central bank does not work properly with the fiscal authorities. In reference to Wyplosz (2006), the Euro area has made very wise policy decisions and has not slavishly followed what it had stated earlier. Therefore, publicly stated principles and action have diverged causing transparency issues. In terms of positivity to Europe, the Euro area has enhanced a strong inflation rate convergence. With the information discussed above, we can conclude that the Euro area is becoming more of a divergence source rather than bringing the member states together. References Alesina, A., and Robert, J.B.2002, Currency Unions. Quarterly Journal of Economics, Volume 117, pp. 409-436.. Allington, N.F.B.,Kattuman, A.P, and Florian, A.W., 2005, One Market, One Money, One Price? Price Dispersion in the European Union. International Journal of Central Banking, 1(3), pp. 73-116. Andrés, J., Eva, O., and Javier, V., 2008, Competition and Inflation Differentials in EMU. Journal of Economic Dynamics and Control, 32(3), pp. 848-874. Blanchard, O., 2007, Adjustment within the euro. The difficult case of Portugal. Portuguese Economic Journal, 6(1), pp. 1-21. Engel, C., and Rogers, J.H 2004, European Market Integration after the Euro. Economic Policy, 19(39), pp. 347-384. Estrada, A., López, DS.,Galí J., 2013, PATTERNS OF CONVERGENCE AND DIVERGENCE IN THE EURO AREA. NBER WORKING PAPER SERIES, October. Lenain, P., 2002, Is The Euro Area Converging or Diverging? Implications For Policy Coordination, The World Economy. de Serres, 25(10), pp. 1501-19. Wyplosz, C., 2006, European Monetary Union: The Dark Sides of a Major Success. Economic Policy, 21(46), pp. 207-61. Read More