The Euro as a Diverse Monetary Union
We analyze the political economy causes and consequences of a monetary unification among countries with different institutional quality. Before a common currency countries with stronger institutions have more efficient public spending and lower taxes, leading to better productive incentives and a stronger currency, while governments under weaker institutions spend more and occasionally devalue to ensure nominal solvency. In a diverse monetary union (DMU) prices and flows adjust while institutional differences persist, so a common exchange rate involves implicit re- and devaluations. As a result both productive and fiscal capacity improve in stronger countries, while public spending becomes less constrained in weaker countries just as their fiscal capacity is reduced. Firms and employment gain in stronger countries, along with savers in weaker countries. In bad times maintaining a common currency may require a fiscal transfer, balancing the ex ante shift in fiscal capacity. When the probability of a transfer is sufficiently low, production in all member states benefit. Still, a weak country government may agree to join a DMU as it enables more public spending, even though its productive capacity suffers.
Co-Author(s): Enrico Perotti and Oscar Soons