David Pagnucco: The Eurozone and the Impossible Trinity

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I am pleased to host another student guest post, this time by David Pagnucco. This is the 13th student guest post this semester, rounding out the semester. You can see all the student guest posts from my “Monetary and Financial Theory” class at this link.

European Union countries considering to join the Eurozone must evaluate the major risk of forgoing their sovereign monetary policy before adopting the euro.

Joining the Eurozone poses numerous risks and benefits for European Union countries outside the zone. In Rick Lyman’s article, leaders from non-Eurozone countries evaluate the risks they face in joining the Eurozone. Some of the major recent factors countries are assessing include political attitudes, the Greek crisis, and domestic fiscal set backs. In order to weigh these risks and benefits, the impossible trinity can be used to describe them. The impossible trinity illustrates that a nation cannot have free capital flows, a sovereign monetary policy, and a fixed exchange rate at the same time. They must choose a position and sacrifice one of the policies.

For example, Eurozone members are at position a in which their single currency allows them to have free capital flows and a fixed exchange rate. On the other hand, European Union members not in the Eurozone are at position b, in which their differing domestic currencies allow them to have free capital flows and a sovereign monetary policy. One of the main goals in creating the European Union was to create a single unified market with free capital flows, and all European Union members share this aspect. However, with the creation of the euro, Eurozone members lose control of their domestic monetary policies. This is the greatest risk facing non-Eurozone members, as they no longer can change their money supply to stimulate or slow down their economies’ growth according to their own preferences.

The European Central Bank creates the central monetary policy for Eurozone members, and a governing council member, Philip Lane, stated that the ECB will continue to increase its government bond purchases. This will ultimately increase the supply of the euro and decrease interest rates, resulting in lower borrowing costs for households and firms that will help stimulate the economy. If the ECB sets the monetary policy for all Eurozone members, what happens if a country within the Eurozone does not want the ECB’s particular policy? This is a major dilemma for countries considering to join the Eurozone. Countries outside the Eurozone may have differing preferences on interest rates, inflation, and unemployment than the ECB’s established policy. For example, consider if Poland were to adopt the euro. If the ECB is using the expansionary monetary policy described by Philip Lane, Poland will be required to partake in it. If Poland does not want this policy, they will ultimately need to counter the ECB’s policy in a more complex way such as increasing taxes to deter economic growth.

Non-Eurozone countries, besides Britain, must adopt the euro at some point in the future, and the timing of the decision is critical because these countries’ economies must be stable and have basic economic convergence to have a successful change over to the euro. They need convergence in areas such as debt levels, GDP, and unemployment to ensure that the ECB’s policies are effective. Overall, the decision to switch to the euro is a major change, and new members must be sure their economies are ready for the switch.