29 Apr 2016

Flexibility versus Stability: A difficult trade-off in the eurozone

Paul De Grauwe / Yuemei Ji

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Authors: Paul De Grauwe and Yuemei Ji

Series: CEPS Working Document No. 422    No of pp: 34

Optimal currency area (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. This paper provides 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 business cycles should be strengthened relative to the efforts that have been made to impose structural reforms, with consideration given to the implications for the governance of the eurozone.

Paul De Grauwe is Professor of international economics, London School of Economics and Yuemei Ji is Lecturer, Brunel University London. This paper was first prepared as a contribution to the Firstrun project, funded under the European Commission’s Horizon 2020 programme.