Ji, Y; De Grauwe, P; (2016) Flexibility versus stability: a difficult tradeoff in the Eurozone. Credit and Capital Markets , 49 (3) pp. 375-413.

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Abstract

The optimal currency areas (OCA) theory has been influential in pushing eurozone countries towards structural reforms to make product and labour markets more flexible. The underlying assumption of the OCA prescription for structural reform is that asymmetric shocks are permanent. However, when shocks are temporary it does not follow that more flexibility is the answer. When shocks are the result of business cycle movements, the way to deal with them is by stabilisation efforts. We provide empirical evidence that suggests that the biggest shocks in the eurozone were the result of business cycle movements. These were relatively well synchronised, except for their amplitude. We argue that efforts to stabilise the business cycles should be strengthened relative to the efforts that have been made to impose structural reforms, and consider the implications for the governance of the eurozone. We are grateful for the financial support provided by the European Commission’s Horizon 2020 Firstrun Project. We also gratefully acknowledge the comments and suggestions from Daniel Gros, Frank Vandenbroucke, and anonymous referees.

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