Saturday, January 01, 2011

What's with the Eurozone?

Estonia has become the 17th country to join the euro-zone today despite the crisis. Some might find it surprising given the inherent rigidities involved in being part of such a union. There is some talk of one in two Germans wanting to return to the Deutsche Mark. So what exactly are these rigidities? As part of the euro-zone, there are certain constraints placed on the member countries. They are

1. Countries cannot unilaterally devalue the exchange rate. Duh!
2. Restrictions related to monetary and fiscal policies.

These do cause hardships to economies under crisis like Greece. For example, if the Greeks were out of the zone, they could have used a combination of exchange rate devaluation and lower interest rates to stimulate demand and employment and also set right the external imbalances.So, why do some countries still want to join the zone. There are some benefits involved such as

1. Member countries would not be exposed to severe exchange rate volatility in this age of easy cross border capital flows
2. Reduced transaction costs for all the cross border economic activities.

The above would particularly induce additional investments in the member countries.

So, will the euro-zone stay or break up? It's difficult to answer given that it involves both advantages and disadvantages but in my opinion the eurozone is not sustainable. Any such economic union has to be preceded by a political union.

One other thing that it surprising is why there is no price equalization across countries in the zone. Shouldn't trade arbitrage equalize the prices? That is something for the economists to ponder over.