Objective: The objective of this paper is to analyze the long term dynamics of the real exchange rates in the individual Eurozone countries and to estimate their “equilibrium” values. It is today increasingly recognized that the diverging real exchange rates (i.e. the diverging competitiveness) between the Eurozone members are at the root of the current crisis. But the equilibrium real exchange rate dynamics during the common currency existence is seldom analyzed and compared, especially as far as the different groups of countries (and/or different areas within the Eurozone) are concerned. This paper aims to contribute to filling this gap.
Background: The frequency and nature of shocks impacting the individual countries is the one of major factors determining the success of a monetary union. Starting with the seminal work of Robert Mundell (1961), economic writers analyzed varying roles symmetric and asymmetric shocks played in the optimality and a success of currency unions both theoretically and practically.
However, it is equally important for the success of a monetary union to analyze the longer term trends. This is especially so in the organization like EMU (Eurozone), where the monetary centralization operates in the environment of decentralized fiscal structures, limited fiscal transfers between the participating entities (independent states) and very limited labor mobility.
In such an environment, the diverging trends between the participating entities (states) are unlikely to be compensated for by an induced factor movements and/or structural changes (not to mention fiscal transfers etc.), as happens in the similar dynamics within the centralized political entities (individual states).
Political response to the diverging trends (if such trends can be identified) is difficult to predict. On the extreme poles two responses are possible. On the one side radical structural reforms can be attempted to obtain the convergence processes, perhaps accompanied by an increase of both interstate fiscal transfers and (to a degree) political centralization in the decision making processes of EMU. On the other side the EMU in its current form can disintegrate. But, indeed, many “in between” results are certainly imaginable.
Method and Data: This paper endeavors to investigate the dynamics of the real exchange rates in the EMU. The BEER (behavioral equilibrium exchange rate) models are used to estimate the equilibrium real exchange rates for the Eurozone countries. Subsequently, the results are used to study the competitiveness stability of the Eurozone.
Expected Results: We expect to find that in the first 11 years of its existence the significant and rising divergences developed in the area most important for the long run economic performances of both Eurozone as a whole and individual countries – the competitiveness – if we evaluate the dynamic real exchange rate performance for the 12 original Eurozone countries. That conclusion is expected to hold for both the actual dynamics and the estimated equilibrium one. As recent developments demonstrated, unless addressed, this divergence trend may constitute a significant, and perhaps the ultimate, threat to the Eurozone cohesion and perhaps to its existence.