Who can adjust to the Euro?

Abstract: This study estimates potential exchange rate variation among 26 European countries during 1992–1998, as a proxy for the potential magnitude of adjustment they face to euro-block membership, using the instrumental variable (IV) method, applying least squares cross-section regression analysis based on optimal currency area theory. A currency union among Belgium, Denmark, France, Germany, Ireland, Malta, the Netherlands and Slovenia is found to entail a relatively light burden of adjustment for its members. The current membership of other countries in the euro-block is potentially very demanding on their societies in the long term. This study also compares currency boards and independent central banks as alternative monetary frameworks for disinflation policies. Based on a pooled time-series, cross-section dataset of the same countries and years currency boards are found to be more effective in reducing inflation in all countries except Belgium. Balancing EMU's credibility gains against its adjustment costs, Finland, Greece, Italy, Portugal and Spain seem like unstable members of the euro-block. For all new EU member states except the Czech Republic, Malta, Slovenia and Slovakia the advice is to stay out of the euro-block until their economies are liberalised and flexible enough to withstand major adjustments, and their societal interest groups supportive enough of these adjustments.