Take Home Portion of Final Exam, Essay Example

Paul DeGrauwe argues that the fundamental issue causing the problems in the Euro-zone today is that countries cannot borrow in their own currencies. The ability for each country to do so was removed upon entering the monetary union in Europe. Since a monetary union is more than a single currency and a central bank, member countries are unable to issue debt in a currency format that is under their individual control. Ultimately, this indicates that when investors lose confidence in the economy of a particular nation, the country could be driven to default. Allowing a country to issue debt in their own currency alleviates this problem because the central bank is able to help avoid default by providing liquidity to the sovereign.

The weakness of monetary unions is apparent primarily when a member country is experiencing an economic recession. This creates a loss in confidence of investors, which has the potential for raising the interest rate, furthering the severity of the economic situation. This is problematic in the Euro-zone primarily because these high interest rates are felt by other countries in the union. Therefore, the responsibility of restoring one country’s economy typically falls to another. If the other member countries are unable to restore the economy of the failing country, then it is likely that the member countries will enter an economic recession as well.

The author argues that monetary unions could function properly only if there is a collective mechanism of mutual support and control due to the fact that each member country of the union has an economy that is linked to the others. Since there is not a political union between these countries, only financial, it is difficult to coordinate the necessary support. As a result, it is not surprising that several countries of the Euro-zone are currently in crisis. In particular, Spain is currently suffering from this negative consequence of participation in monetary unions.

It is important to understand the financial situation in the United Kingdom with the understanding that this is a stand-alone country that therefore has control over the currency that its debt is issued in. As a consequence, if investors believed that the UK would potentially default on its debts, they would sell their government bonds, which would in turn increase interest rates. Since the interest rates will increase, investors will want to exchange their currency from pounds and the price of this currency would drop until another investor is willing to purchase the currency. However, the United Kingdom remains protected against a recession in this situation because it can allow the Bank of England to buy up government securities.

On the other hand, countries that are in a monetary union, such as Spain, have no control over the currency that they issue their debt in. Therefore, when investors sell government bonds in this country, the interest rate will raise because the national bank is unable to buy government securities using the same currency. When investors wish to sell the money they retrieve from the bonds, rather than selling the currency back to Spain, they will be able to reinvest money elsewhere in the monetary union. If this situation is bad enough, the government can be forced into default.

In conclusion, the major weakness of monetary unions is that during periods of recession, it is impossible to ensure the economic stability of a nation due to an individual country’s inability to control the currency that their debt is issued in. As a consequence, individuals who originally invested in one country are free to switch to support of another one in the union, which will damage the economy of the original nation. In times of economic prowess, monetary unions are useful, but it is important for member countries to cooperate in order to alleviate the economic stress that results in times of economic collapse.