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Theory and Policy of International Economics

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The Euro Area (EA) shares several similarities with previous international monetary arrangements. However, the EA experiment is necessarily broader in scope than any similar attempt in the past for a number of reasons. One, the union is not just as a currency union, but as an economic and monetary union, where cooperation is pursued over a wide range of economic policies. Secondly, the central banks of the member states have not only ceded the power to maintain their external balances but have also somewhat ceded the power to affect their internal balances.

Monetary policy for the entire Euro Zone is the sole responsibility of the European Central Bank. The Euro was successfully introduced in so many countries despite not being an “ Optimal Currency Area” , is because of the political will to do so – the principle of limiting their annual deficits and public debt were not always followed, and this (as an example of countries following option 1) in turn has some role to play in the current crisis. However, in order to truly understand if history is merely repeating itself in the case of the Euro Zone crisis, it is worth looking at all of the potential causes for the crisis first.

Broadly speaking, there are three immediate causes for the Euro Crisis: The first being, unsustainable levels of debt taken on by some governments: The adoption of the common Euro by all EA member states resulted in countries of different credit-worthiness receiving loans at similarly low-interest rates. This “ Credibility Effect” has long been studied, and indeed, was foreseen as a potential problem of adopting a single currency. However, it was seen more as an advantage for the so-called “ peripheral nations, ” and seen as the mechanism by which the economies of the various nations would converge.

However, this reflected credibility was in some cases used to bail out banks burdened by the subprime mortgage crisis, and in other cases used imprudently towards unproductive welfare schemes.

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