The Over-Promised and Over-Threatened Impacts of Eurozone Membership

The Over-Promised and Over-Threatened Impacts of Eurozone Membership - Gabor Debreczeni


There is no definitive answer as to the impact on a country’s macroeconomic indicators of joining the Eurozone. There is little impact on a country’s trade dependence. Peripheral countries suffered in terms of unemployment, but weakly gained in terms of incomes. However, no doomsday image emerges. While this appears to limit the short-term economic upside of the currency union project, it brings into the forefront the Eurozone’s aforementioned political considerations: eliminating competitive devaluations, having a common European monetary voice and tightening economic and political bonds within Europe. If this appeals to a prospective Eurozone member, they should not hold back for economic fears.

Then came actual euro notes – and they all lived happily ever after, for values of ‘ever after’ < 11 years.
– Paul Krugman


Ever since the founding of the eurozone in 1999, the economic distinctions between being a member of the currency union and remaining outside of it have been dramatized by politicians, the media, and economists. The hype has extended in both directions, fueling guilds of doomsayers on both sides to predict economic disaster if a country should either enter, or refrain from entering the currency union. This paper looks for evidence of such extreme divergences between the fates of the countries that joined the eurozone versus those that did not. This is done first by considering how distortionary the euro is as a currency for its weakest and strongest members, and second by comparing the economic fates of comparable countries that made different decisions regarding their entry into the eurozone. To tease a bit of the conclusion: there are few dramatic differences using either approach.

The Optimum Currency Area

Academics and politicians have debated the economic advantages of a common currency for decades. To quote Paul Krugman, they are “reduced transaction costs, elimination of currency risk, greater transparency and possibly greater competition because prices are easier to compare.”[1] Of course, while the economic considerations were equally trumpeted, the EU’s primary consideration in the establishment of the eurozone was always politics, and even geopolitics – the EU sought primarily to tie the region together both economically and politically to ensure peace, and also hoped to prevent economic warfare via competitive devaluations.

There are, of course, arguments for keeping currency areas small. The obvious gain is the ability to cater monetary policy to local economic conditions, but Krugman argues that an even more important function of a small currency is to give the region the ability to adjust its wages via depreciation in the currency. Because of human psychology and the nature of contracts, it is extremely difficult to adjust wages downward without such currency depreciation. Krugman gives Spain as an example of when this might be desirable – for it is a place where wages were driven high by an unsustainable property bubble and the resulting full employment, and are now inefficiently stuck there with few options for downward adjustment. Of course, this type of thinking does broach dangerously close to the type of competitive devaluing the EU tried to avoid with the institution of the eurozone. Nationalists continue to rue the loss of the option to devalue.[2] It is logically clear that there is a limit to the arguments for small currency areas, as Snider has argued, among others, because otherwise the result would be the reduction ad absurdum argument that every person should have their own currency.[3] So, some aggregation into a common currency area is clearly warranted, and the outstanding questions are: how to balance the costs and the gains, and how big is best?

Much ink has been spilled on discussing whether the eurozone is an optimum currency area, with the main criteria for this determination being that it be “composed of regions affected symmetrically by disturbances and between which labor and other factors of productivity flow freely.”[4] This paper seeks to deal with marginal cases – what countries have gained and lost in a comparative context by joining or refusing to join the eurozone, and what countries could expect should they do so going forward.

The Misalignment Problem

One issue present in currency unions of any size is the problem of misalignment – that the value of the currency is not representative of, or optimal for, all of the diverse economic conditions of the union’s sub-regions. Although this problem is very much not unique to the eurozone, it is frequently brought up in the context of the eurozone because those examples are so intuitive, and resonate with the overarching European economic narrative. It’s told as follows. If they had separate currencies, Germany’s currency would be stronger than the euro, and peripheral countries’ currencies would be weaker than the euro. The status quo helps German exporters, and by extension the German economy. The status quo also hurts peripheral exporters, and by extension the peripheral economies. End of story.

While the issue of misalignments is obviously more complicated than that, the data does show the existence of misalignments. It must be said that given that the calculation of equilibrium exchange rates for non-existing currencies is a theoretical economic exercise, precise answers are difficult to pin down.[5] Coudert, Couharde, and Mignon find a shocking amount of volatility in the measurement of misalignments.[6] They consider the equilibrium value of the currency to be a function of a country’s productivity and its net foreign asset position, which is itself mostly a function of the country’s external deficits. They calculate that the euro has been too strong for peripheral countries as a collective since the common currency’s inception. If it is assumed that the euro is fairly valued for the eurozone as a whole, Coudert et al. calculate that in 2010 the currency was approximately 12% too strong for Greece, 6% too strong for Portugal, and about fair for Spain, Ireland, and Italy.[7] On the flip side, they calculate that the euro is too weak by 15% for Finland, and by about 8% for Germany and France. These numbers are non-negligible, though not particularly dramatic. By reference, in 2002, near the height of American hand-wringing about China’s undervalued currency, economists estimated that the renminbi was about 30-35% undervalued.[8]

Some studies have found substantially higher misalignments than Coudert et al., but have done so under the assumptions of a traumatic breakup of the monetary union, resulting in headlines as extreme as predictions of an 80% drop in the value of the Greek currency, and a 30% drop in the value of currencies on average across Europe. In that scenario, only Germany’s currency emerged stronger than the current euro, by 4%.[9] While this data isn’t very useful for the misalignment conversation, it is a useful illustration of the direness of the warnings out there about a eurozone breakup.

What is causing the misalignment? While lower productivity in peripheral countries is certainly a culprit, Coudert et al. actually find that the main mechanism for misalignment in the periphery is differential inflation. They find that inflation in the periphery was higher than in the core of the eurozone, driven by the overheating pre-crisis economy, especially via capital flows from the core into peripheral real estate. This mechanism worsens the periphery’s terms of trade, lowering competitiveness, and directly increasing the currency misalignment. As mentioned earlier, Krugman also focuses on the role of inflation as a culprit, going so far as to suggest that the clearest solution to the eurozone’s struggles would be a higher inflation target that would allow peripheral regions to lower real wages, as well as to lag the core countries’ inflation in order to lower the degree of currency misalignment.

Whither the U.K. and Sweden?

Given the prevalence of the rhetoric that Germany and the rest of the eurozone core profits from a euro artificially weakened by the periphery, it is surprising that the currency-weakening argument hasn’t been raised as a reason for the U.K. and Sweden to join the eurozone. While today’s political considerations would clearly prohibit either country from making a serious attempt, the lack of even light debate on the issue is surprising.[10]

While papers have been written arguing for the U.K. to join the eurozone, they have focused on traditional arguments. Willem Buiter focused on the recent convergence of the U.K. economy toward sufficient satisfaction of the optimal currency area conditions referred to earlier, as well as on an argument that the U.K. is more vulnerable to financial crisis without eurozone membership because it is a country that has “a large internationally exposed banking sector, a currency that is not a global reserve currency, and limited fiscal capacity relative to the possible size of the banking sector solvency gap.”[11] Patrick Minford similarly argues for the U.K. to join the eurozone for reasons enumerated earlier: lowered transaction costs, lowered exchange rate risk, and increased transparency in price comparison.[12] Similar conversations have occurred in Sweden. James Reade and Ulrich Volz focused on similar arguments for Sweden to join the Eurozone, highlighting that the country already lacks much monetary independence from the European Central Bank, and that it is worrying that Sweden is a “small open economy with an internationally exposed financial sector”.[13]

Recalling the above-mentioned theory that the two major theoretical determinants of an exchange rate are productivity and external deficits, it is possible to arrive at a guess of how misaligned the euro would be as a currency for Sweden and the U.K. Firstly, note that as of 2013 Sweden and the U.K. had productivity levels marginally above and marginally below the eurozone average respectively. This placed them about 10% below the eurozone core, and below Ireland, but substantially above the eurozone periphery.[14] [15] The two countries diverge significantly with regard to external deficits. The U.K., like the peripheral countries other than Ireland, is below the EU average, with an average deficit of 3% from 2010 to 2013. Sweden, on the other hand, has averaged a surplus of 6%, among the highest in the region, and comparable to the Netherlands and Germany.[0]

This exercise goes some ways toward justifying silence on the boost the economies of the U.K. and Sweden would receive from joining the eurozone via artificial weakening of their currencies. While currencies are capricious beasts, and as such firm predictions are foolish endeavors, this data suggests that the U.K. would not gain a substantially weaker currency by joining the eurozone, and might even receive a marginally stronger one. Sweden would probably weaken its currency somewhat by joining the eurozone, maybe by roughly 3-5%, placing it among the less misaligned of the core eurozone economies.

It seems then that joining the eurozone would have only small impacts on the values of the currencies of the U.K. and Sweden. The economic impacts of misalignment on current eurozone members are difficult to measure because there is no conclusive economic research on the impact of artificially weakened or strengthened currencies on economic activity. It is well-understood that a weak currency results in higher exports, but it is unclear how that is balanced out by barriers created for imports, by induced distortions in the domestic market, and by imported inflation. It is clear that misalignments in the eurozone are small compared to other recent cases of currency misalignment, including China over the last decade.

Pairwise Case Studies

The many EU member states that are not eurozone members provide us with convenient controls for analyzing the economic experiences of eurozone members since the introduction of the common currency. In this section, four sets of countries are analyzed. Each set was chosen because of their shared economic trajectories before a subset of the countries joined the eurozone. Their similarity was analyzed by comparing unemployment data, income data, economic size, and trade dependence for pairs of countries.[17] In the following sections, the numbers in parentheses denote difference scores, which range from the low teens for countries that had extremely similar economic experiences in the recent past to the low 1000s for countries that had very different economic experiences.

Cyprus, Slovenia and Malta, in Comparison with Hungary and the Czech Republic

Cyprus adopted the euro in 2008. During the preceding five years, by our similarity metric, its trajectory was least different to Slovenia (85), Malta (241), the Czech Republic (247), and Hungary (275), while it was most different to Germany (1055) and Poland (1002). Given that Cyprus and Malta entered the eurozone at the same time, and Slovenia had entered only the previous year, and given their low difference scores, it makes sense to consider the experiences of these five countries in unison.[18]

While Cyprus was clearly affected in an outsized way by Greece’s role in the last decade’s economic crises, the unemployment chart below still tells a cautionary tale about the experiences of the countries discussed in this section, as two of the three countries that joined the eurozone (Slovenia and Cyprus) saw spikes in unemployment that were not seen in their non-eurozone counterparts. By 2013, the new arrivals into the eurozone had lost an average of five places in the rank of EU countries by unemployment, while the two control countries had gained an average of four places.

Incomes, however, tell the opposite story, as Hungary has fallen away from what had been a relatively tight pack and Cyprus, Malta, and Slovenia have inched toward the median for per capita incomes for EU member states. There was no discernible trend as to whether entry into the eurozone increased or decreased trade prevalence for this set of countries.

The Core Experience: Sweden, Denmark and the UK in Comparison with Core Eurozone Countries

The core countries exhibit more similarity with each other than the set of enlargement countries discussed above, and as such, it requires a little more subjectivity to select a set of comparables. Given that most core countries joined the eurozone in 1999, the period under discussion in this section for the sake of finding comparables is 1994-1998. During this time, Sweden was least different from Denmark (102), the UK (123), Finland (130), Belgium (131) and Germany (141).[19] While at first glance, it might make sense to group the three core holdouts from the eurozone into one comparison, their comparables turn out to be strikingly different. At the time, the UK was least different from Germany (78), Italy (118), Sweden (123), France (145), and Denmark (162). In turn, Denmark was least different from Austria (37), Sweden (102), the Netherlands (146), the UK (162), and Germany (211). Some of the differences seen are clearly manifestations to different degrees of a small-country/big-country dichotomy. For the sake of clarity, then, the data is presented separately for the three holdouts.

Interestingly, the results here are inverted from those gathered from the enlargement countries considered above. In the case of Sweden, the unemployment data flatters the eurozone, as both Germany and Finland have seen meaningful falls in their comparative unemployment since joining the eurozone, while on average incomes Sweden has picked up ground in terms of its comparables, as it is now ranked second in the EU. Again, the picture on trade dependence is mixed, with Germany gaining substantially, but with Finland and Belgium losing ground.

The charts comparing Denmark to its comparables – Austria, the Netherlands, and Germany – are not included here because the results are largely inconclusive, and are similar to a muted version of Sweden’s case discussed above (with Denmark seeming to do marginally worse than the eurozone countries by unemployment, and seeming to do marginally better by income). The muted results shouldn’t be surprising since Denmark’s currency has been effectively pegged to the euro since the currency’s introduction in 1999.

The comparison of the UK to the large core eurozone countries, Germany, Italy and France, yields similarly muted conclusions, though this example is more favorable to eurozone membership, as the UK seems to perform marginally worse than its eurozone comparators in both unemployment and income. The countries’ record on trade reliance is also inconclusive, with both the UK and Italy increasing their trade reliance, and with Germany’s increase continuing to look dramatic.

The Peripheral Experience: Portugal and Greece, in Comparison with the Czech Republic and Romania

Another interesting comparison made available by this data is between the eurozone countries that are today called peripheral (Greece, Spain, Portugal, and Ireland), and non-eurozone Eastern European countries in the late 1990s. Unfortunately, each of the peripheral countries has different Eastern European countries as their comparators, but the comparison is illuminating. At the time, among non-eurozone countries, Greece was least different from Poland (139) and Croatia (183), Spain was least different from Poland (188), Portugal was least different from the Czech Republic (87), Romania (146), Slovenia (187), and Croatia (196), while Ireland was least different from Slovakia (161), Hungary (225), and Slovenia (233), though it must be noted that with the exception of Portugal, all of the peripheral countries had better comparators among countries that joined the eurozone in 1999.

Looking at the experience of Spain, Greece, Poland, and Croatia, a similar story is seen as with the enlargement countries – the peripheral countries that have joined the eurozone have done poorly with regard to unemployment, but have done marginally better than the non-eurozone countries with regard to incomes. All four countries have increased their trade dependence in the recent past, but Poland’s increase is especially noteworthy.

While Portugal’s and Ireland’s comparables are quite different, the trends are similar enough to not be obscured when considered together. Similar to the case considered above, there is a pattern of worsening unemployment in the eurozone-joining peripheral economies that was not seen in the comparable non-eurozone economies. The picture of incomes is inconclusive, while the trend of trade dependence suggests light evidence that the non-eurozone countries gained some ground in trade.

Recent Eastern European Additions: Slovakia and Estonia

At the time of its addition to the eurozone in 2009, Slovakia was least different (in the entire EU) to Hungary (183), Croatia (272), the Czech Republic (283), and Bulgaria (287). Meanwhile, in 2011, Estonia was least different to Lithuania (33), Latvia (119), and Hungary (195). So, both are seemingly natural cases for study.

Interestingly, for Slovakia, the data does not lend further support to the earlier findings that less developed additions to the eurozone tend to struggle with unemployment, as the relationship between joining the eurozone and unemployment is inconclusive here. Furthermore, Slovakia seems to have done marginally better than its comparators by income, and its comparators have weakly increased their trade dependence relative to Slovakia. For the latter case, Estonia has tracked its comparators closely in both unemployment and incomes since joining the eurozone, providing little directional evidence.


While many weak conclusions were reached in the above sections, by far the clearest conclusion reached is that there is no definitive answer as to the impact on a country’s macroeconomic indicators of joining the eurozone, and that any impact is likely to be quite muted. This result is in direct contradiction to both the expectations of the promoters of the eurozone upon its inception (who foresaw rising prosperity within the eurozone) and to the dire predictions of prevalent doomsayers in the media, as well as politicians who engage in nationalist anti-euro and anti-EU debates. The most shocking non-effect found in this paper is that joining the eurozone seemed to have close to no impact on a country’s trade dependence, a metric that had been expected to be markedly impacted by decreasing transaction and risk-related costs to international corporations once a country joined the eurozone.

The most robust conclusion to be gleaned from the cases above has to do with the experience of peripheral countries when joining the eurozone. It seems clear that they suffered in terms of unemployment, but weakly gained it terms of incomes, when contrasted with comparable countries. This conclusion is particularly robust because it was previously theoretically justified – weakly rising incomes and falling employment is fully consistent with Krugman’s admonition that the peripheral eurozone countries’ problems are due to a combination of insufficient eurozone inflation and the resultant inability to adjust wages downward, which is a particularly worrying issue in the aftermath of an asset or economic bubble.

But, in the end, it is clear that no doomsday image emerges around entry into the eurozone. Denmark, the UK, and the enlargement countries should have no major economic qualms about entry. This makes it clear that the current state of extreme public negativity in most prospective eurozone entrants is a marketing issue. While this result and viewpoint might be disappointing as it seems to limit the short-term economic upside of the currency union project, it brings back into the forefront the aforementioned political considerations for the common currency project: the elimination of competitive devaluations, having Europe be able to speak as a common monetary voice and the tightening of economic and political bonds within Europe. If this appeals to a prospective eurozone member, they should not hold back for economic fears.

Of course, it is necessary to be cautious about these results. In 1999, shortly after Sweden decided not to join the eurozone, Lars Heikensten, the First Deputy Governor of the Sveriges Riksbank, Sweden’s central bank, warned that analysts and politicians should be cautious that they remember that many of the economic advantages of being in the eurozone are likely to manifest themselves over the long term. At the time, he was particularly worried about access to capital markets and the locational choices of large multinational companies – the latter process can, of course, take decades to shake out.[20] As such, while we’ve yet to see consistent and meaningful impacts from the decisions made on whether or not to join the eurozone (with a few exceptions mentioned above), it cannot be ruled out that dramatic trends will emerge in the decades to come.

Notes & References

  1. Paul Krugman, “Revenge of the Optimum Currency Area,” [Online] The New York Times, 2012.
  2. Christopher Houseman. “UKIP, Nationalism, And The World Wars,” [Online] UKIPDAILY, 2014.
  3. Delbert Snider, “Optimum adjustment processes and currency areas, [Online] Essays in International Finance, 1967.
  4. Barry Eichengreen, “Is Europe an Optimum Currency Area?” [Online] NBER Working Papers, 1991.
  5. One might remember Youram Bauman’s quip that “the three most terrifying words in the English language are ‘macroeconomists agree that.’”
  6. Virginie Coudert, “On currency misalignments within the euro area,” [Online] CEPII Document de Travail, 2012.
  7. The authors do not assume this, and calculate that the euro is too strong for the eurozone by 8%. As such, they calculate all of the above-referenced numbers to be 8% higher than I am quoting.
  8. Bruce Stokes, “Why misaligned currencies matter,” [Online] National Journal,  2002.
  9. Mark Cliffe, “EMU Break-up,” [Online] ING Global Economics, 2011.
  10. In a recent Eurobarometer survey, 73% of Swedish respondents reported that they were against Sweden joining the eurozone. European Commission, “Standard Eurobarometer 82 / Autumn 2014 – TNS opinion & social,” [Online] 2014.
  11. Willem Buiter, “Why the United Kingdom Should Join the Eurozone,” [Online] 2008.
  12. Patrick Minford, “Should Britain Join the Euro?” [Online] 2002.
  13. James Reade & Ulrich Volz, “Should Sweden join the Eurozone?” [Online] VOX, 2008.
  14. Estonia brings up the rear; its productivity is about half of the eurozone average.
  15. OECD, “Level of GDP per capita and productivity,” [Online] OECD.StatExtracts, 2015.
  16. The World Bank, “Current account balance (% of GDP),” [Online] 2015.
  17. The unemployment, income, economic size, and trade dependence data is from the World Bank and can be found at GDP per capita is used as a proxy for income, GDP is used as a proxy for economic size, and exports/GDP is used as a proxy for trade dependence. Unemployment in this paper always refers to unemployment rate rather than the number of unemployed. The difference scores were calculated as follows. For each year from 1994 onwards, the current 28 members of the EU were ranked from 1 to 28 for each of the four metrics discussed above. For each pair of countries, the difference score for each year is the sum of the squares of the differences between their rankings in each of the four metrics. Squared differentials were used to emphasize extreme differences in any of the metrics. To arrive at the final difference score, the difference scores for each of the previous five years were averaged.
  18. As a sanity check, Malta in 2008 was least different from Estonia (102), Slovenia (105), Hungary (158), the Czech Republic (203), Lithuania (214), and Cyprus (241). In 2007, Slovenia was least different from Hungary (54), the Czech Republic (63), Cyprus (78), Malta (100), and Estonia (146).
  19. Just for the sake of curiosity, Sweden was most different from Bulgaria (936), Latvia (902), and Lithuania (870) at the time.
  20. Lars Heikensten, “Should Sweden join the euro area?” [Online] 1999.
Gabor Debreczeni is a first-year MA student in International Development. He was born in Hungary shortly before the fall of the Iron Curtain into an internationally-minded family, and as such has been fascinated by the European integration project ever since. He studied Economics at Yale University in the United States, worked in finance on three continents, and is now most interested in infrastructure development in developing countries, but continues to dabble in the areas of urban planning and international economic integration as well.