OSIPP Discussion Paper: DP-2024-E-001

Why Does Euro’s Survival Matter?
Financial Integration in East Asia and European Union
May 9, 2024
Akira Kohsaka
Professor Emeritus
Osaka School of International Public Policy (OSIPP) , Osaka University[JEL codes] E5, F3, F41, G15, O11, O16, P51[Keywords] regional integration, East Asia, Euro Zone, financial globalization .
[Abstract] A breakup of Euro Zone appeared likely in the aftermath of the Global
Financial Crisis (GFC), while EU has long been model regional integration to East
Asia. Recognizing different political-economic contexts between East Asia and EU,
what can we learn from the experiences of Euro Zone so far? This paper tries to answer
the question by examining regional financial integration in two regions in view ofinternational macroeconomics. Financial globalization since the 1990s plays the keyrole there. We can summarize our observations as follows:
East Asia’s fundamental strength shown throughout GFC implies weak motivation
to promote further regional financial integration toward a monetary/fiscal union as
EU. The global sudden stop of capital inflow by GFC seriously damaged vulnerable
links in Euro Zone, although crisis-driven policy innovations seem to strengthen its
macro-financial policy framework. As to the future role of Euro Zone, at issue is thevolatility intrinsic to the global financial market, which would aggravate theasymmetry across currencies, potentially harming resource allocation and growth.
Post-Bretton Woods flexible exchange rates could not wipe away, but magnify thisasymmetry (i.e. US dollar dominance). The Euro and Euro Zone could challenge thisfundamental flaw of the present international monetary system.

E-mail: kohsaka@osipp.osaka-u.ac.jp
This is part of the book to be published as REGIONAL INTEGRATION AND
INSTITUTIONAL CHANGE IN TIMES OF CRISES IN EAST ASIA AND THE
EUROPEAN UNION: A Study of some drivers of Regionalism and Regionalization andtheir limits, edited by Herman Voogsgeerd and Shigeru Akita, forthcomin g 2024.
We gratefully acknowledge financial support s from Grant-in-Aid for Scientific
Research T20K01670a and T20K207580.

Introduction
A breakup of the Euro Zone appeared likely in 2011-12, although this regional
institution may be too big to fail. In fact, the Euro Zone is also known to have poorly
performed as an optimal currency area and something has to be done for better
adjustment between its member economies. This line of arguments has become moreacute since the Global Financial Crisis (GFC) 1 erupted in 2008. 2
Looking back, EU used to have been model regional integration. Somewhat similarideas in East Asia, apparently provoked by EU, can be found in various forums within
the Asia Pacific region such as PAFTAD, EAEC, PECC, APEC, etc. 3 They all aim at
promoting regional integration through trade and direct investment. There, financial
integration had been out of sight. In the context, monetary integration or the creationof currency union such as the Euro Zone was not even a remote goal in East Asia.
Meanwhile, more than decade-old efforts toward regional financial cooperation in
East Asia originated from the Asian Financial Crisis (AFC) in 1997. In order first to
alleviate the disastrous outcome of the crisis and then to avoid its repetition, a numberof proposals were advocated by government officials, business people and academic
scholars. The Asian Monetary Fund (AMF) and the Chiang Mai Initiative (CMI) areamong them. They are not, however, to propose any alternative exchange rate regimes
such as a common currency or full monetary integration like the Euro Zone.
How is this regional financial cooperation in East Asia related to monetary
integration in EU, then? Regional financial cooperation preconditions both free capital
mobility and monetary policy autonomy and intends to prevent from destabilizing
exchange rate volatility and to minimize its impact. In contrast, monetary integration
pursues for regional exchange rate stability at the cost of individual monetary policy
autonomy, which implies a total regime change from one to the other from the1

As of now, the Great Financial Crisis appeared to replace the Global Financial Crisis.
Fortunately, both will go with GFC.
2 Shambaugh (2012) discussed three interlocking crises in the Euro Zone, i.e. a banking crisis, asovereign debt crisis and a growth crisis, and O ’Rourke and Taylor (2013) analyze the crisis in thecontext of the history of monetary unions.
3 PAFTAD (Pacific Forum for Trade and Development) was formed in 1968 by a group ofacademics, EAEC (East Asian Economic Caucus) proposed in 1990 by then Prime Minister of
Malaysia, PECC (Pacific Economic Cooperation Council) established in 1980 by business,academic and governmental people, and APEC (Asia-Pacific Economic Cooperation) established in
1989 as an inter-governmental forum.

1viewpoint of East Asia.
Now, observing the EU currency unification and its impact on regional financial
integration, does this suggest the counterpart unification in East Asia? The rationale
for the EU regional integration has long been discussed from both economic andpolitical aspects. First, the EU integration intends to promote economic growth by
improving

microeconomic

resource

allocation

through

trade

and

investment

liberalization as well as capital market deregulation and to maintain macroeconomic
stability through imposing policy disciplines under currency unification . Second, theEU integration also intends not only to maintain regional security through closer
economic interdependence within the r egion 4 , but also to intensify the presence andpower of EU in the international political economic systems.
Recognizing very different economic and political contexts between East Asia andEU, what can we learn from the experiences of the Euro Zone so far? Is it possible tocreate a common currency such as the Euro in East Asia? Noting that AFC in 1997
started from plummeting Thai bahts. if we have a common currency in East Asia, could
we have prevented from the

Crisis?

Indeed, the closely knitted econo mic

interdependence through trade and direct investment or real (non-financial) integrationin the region might provide some rationales for even monetary integration. In order toachieve this monetary integration, what conditions must be met in East Asia?
On the other hand, many economists argue that , as told from the start, the Euro
crisis such as the one after GFC will co ntinue, without far more labor mobility andlarger fiscal transfers across member economies (e.g. Feldstein, 2015). Against th ispessimism, are there any possibility for the Euro Zone to strengthen economic union
through wider and thicker trade and investment integration in regional productmarkets? Particularly, if we look at the far larger political economic differences across
East Asia as compared to the Euro Zone, can this surviving large monetary union
overcome their political economic diversities with structural reforms as US has done
since the 19 t h century? 5 And further on, what is the implication for their future

45“Nations with a common currency never went to war against each other (Helmut Kohl).”
Particularly when we notice the significant political economic chasm in the present US itself.

2

survival to ongoing global economic integration?
In this chapter, we would like to put some thoughts to these questions, based on
several frameworks for regional financial integration from the viewpoint ofinternational macroeconomics. Financial globalization, i.e. increasing cross-borderholdings of financial assets/liabilities (such as foreign direct investment, bonds andequities, and bank assets and liabilities) since the 1990s is the key to the following
arguments. In fact, this concept was not familiar, or more exactly, not well recognizedwhen regional integration was planned in EU and even when AFC hit East Asia.
Entering the 21 st century, “the signs of financial globalization are everywhere.
Cross-border financial capital flows grow decade by decade ..... Intere st rates seem tomove in near lockstep ..... few countries enjoy financial autonomy . (Chinn and Ito,2023)” Figure 1 shows that the value of world gross financial assets and liabilities has
increased dramatically in the last decades, to more than twice as large as world GDP in
2020. Notice that this very recent history of financial globalization is al so the historyof world–wide financial crises, which characterize the macroeconomic turbulences ofEast Asia and Euro Zone, on which we are going to discuss.

3

Textbook economics tells us that, in a perfect capital market, international capital
flows could improve economic welfare through intertemporal trade and asset trade.
First, intertemporal trade through net capital flows enables domestic investment withhigher returns to be financed by foreign savings at lower interest rates, enhancing
dynamic (over time) efficiency of resource allocation on one hand, and enables
consumers to smooth their consumption levels despite income fluctuations again overtime on the other. Second, international asset trade through gross capital flows enables
risk diversification, enhancing static (cross country) efficiency of global resource
allocation and minimizing fluctuations in income and consumption.
In reality, however, net capital flows often do not finance domestic investment withhigher returns (Gourinchas and Jeanne, 2007, and Rodrik, 2009). Volatile net flows
often do not contribute to consumption smoothing, and rather often generate negative
shocks to domestic consumption. Similarly, gross capital flows often do not diversify
investment risks, and rather magnify risks with their pro-cyclicality, generatingbooms-and-busts accompanied with serious sustained stagnation (Prasad , 2009).
Figure 2 shows a brief history of economic development in selected economies inthe Euro Zone and East Asia since 1960 by their GDP per capita. Two observations
come up. First, apparently the two are distinct groups in that the Euro Zone is a richcountries club at the level of beyond US$10, 000 (constant 2015 US$) in 1990 withmodest economic growth and East Asia here is an emerging markets club at less than
US$10,000 with exceptionally rapid growth. Second, we detect a sharp regionallycommon economic downturn in 1997-1998 in East Asia, and, in 2008-2009, a sharp
and prolonged downturn in the Euro Zone and a less sharp and short -lived one in East
Asia.

4

In the following, Section 1 reviews why AFC led to these frameworks for regional
financial cooperation by clarifying how exchange rate regimes interacted withfinancial globalization in East Asia, and then narrates more in detail how international
financial flows affected East Asia in terms of both international financial linkages anddomestic financial intermediation, respectively. Section 2 overviews a short history ofregional financial cooperation in East Asia, its implication for macro -financial
systems and the perceptions of international policy advisors on financial globalization.
Then, we move from regional financial cooperation in E ast Asia to regionalmonetary integration. After reviewing a conceptual framework of optimal currency
area (OCA), Section 3 sketches how some preconditions for OCA are met in the caseof US, EU and East Asia before the introduction of the Euro. US is better fit asexpected, but we see little difference between EU and East Asia. In Section 4,
achievements and limits of the Euro Zone before GFC are discussed. We reaffirm goodnews on financial front and bad news on non -financial front (economic growth), while
noting a constraint on monetary policy and fiscal policy .

5Section 5 summarizes the impacts of GFC on both Euro Zone and East Asia,
highlighting their contrasting performances in view of financial globalization. The
global sudden stop seriously damaged vulnerable links in Euro Zone, while East Asia
recovered quickly under their un -orthodox policy frameworks. Whether crisis -driven
policy innovations in Euro Zone could help strengthen its macro-financial policy
framework remains to be seen. Section 6 sheds light on the impact of GFC on the Euroas an international currency. The Euro is not just a common currency, but a challenge
to the US dollar’s dominance in the international financial system. Finally, Section 7
summarizes the lessons learnt from EU by East Asia and then considers the future roleof the Euro and Euro Zone in the context of global economic integration.

1. Asian Financial Crisis
The Asian financial crisis (AFC) was distinct from previous currency crises
repeated in Latin American and other emerging market economies since the 1980s.
These crises came from almost chronic macroeconomic instability in these economies.
Both persistent fiscal and current account deficits, chronic domestic inflation andoccasional currency overvaluation eventually induced currency speculation and capitalflights, resulting in relatively low and volatile economic growth. By contrast, in AFC,their sustained high economic growth and macroeconomic stability ironically aroused
two problems.
First, not current account deficit, but excessive financial account surplus (or foreign
capital inflow) ultimately called on reversals of foreign capital flows. That is,excessive capital inflows well over current account deficits seemed to finance eveninefficient domestic investments, which turned into non-performing loans. Figure 3
shows that the financial account surplus (FAY in the Figure) in Indonesia, Korea,
Malaysia and Thailand kept exceeding the current account deficit (CADY) before the
Crisis in 1997. Under the circumstance, the monetary authorities were forced to keep
fending off the pressure for currency appreciation through foreign exchange ma rket
intervention and accumulation of foreign reserves.

6Second, these excessive capital inflows were enabled by the ir (officially flexible)
exchange regimes. In view of several real (i.e. excluding the effect of inflationdifferences) exchange rate indicators, we do not see significant overvaluations in East
Asian currencies, so that overvaluation could not be the cause of capital rev ersals
through expected depreciation. Rather, at issue is not the exchange rate levels, but
their being maintained virtually constant for a long while since the early 1980s (Figure4), whose exchange rate regimes were called as a virtual dollar peg 6 . For example, theThai bahts had been maintained at 25 bahts per US dollar for almost 15 years since thelast devaluation in 1983 before the crisis 7 . Along with the deregulation of capital

6

Officially, their exchange rate regimes were announced as flexible exchange rates .
Note here that the exchange rate stability is only with the US dollar. As Figure 4 shows, theJapanese yen exchange rate against the US dollar fluctuated to a significant degree. More or lessexchange rate stability of East Asian currencies implies that they floated with the US dollar against
other major currencies including the Euro and the Japanese yen.
7

7

(financial) account started in the 1990s, this exchange rate stability un der the virtual
dollar peg had given wrong signals to the market, inducing excessive risk taking, i.e.
excessive unhedged external borrowing in foreign currencies, specifically in US
dollar.

External financing
With the help of the financial deregulation trend in both host and investor countries,
foreign capital explosively flowed into emerging markets including East Asia in the
1990s. The size of the foreign capital inflow relative to GDP in the mid -1990s tripled
since the 1980s. After AFC in 1997, their composition shows a long-term shift fromother investments (loans) to foreign direct investment ( FDI) primarily, and thenportfolio investment secondly 8 . The factors behind the trend include liberalization
policies on capital account and economic growth in host countries on one hand, and8Among the three main categories of financial flows, FDI (foreign direct investment) is regarded
as most stable and least volatile, while portfolio i nvestment and other invest ment including bankloans could be volatile depending on investors’ risk perception and bank profitab ility,
respectively.

8the globalization of production networks of multinational corporations , the growth of
institutional investors due to capital accumulation, and the global securitization trend
and business cycles in investor countries on the other hand.
Capital inflows to East Asia in the 1990s, however, were excessive in dual senses.
First, East Asian domestic saving rates had been at 30 to 40 percent of GDP then,being significantly higher (roughly by 10 percent) than in other emerging market
economies in Europe and Latin America (Figure 5). Second, since current accountdeficits simply suggest their domestic investment exceeded domestic saving, thisfinancial account surplus beyond current account deficit went beyond already highdomestic investment, up to even unproductive investment, fueling real estate bubbles.
In this sense, these capital inflows were excessive.

9

Macroeconomic policy trilemma
What was wrong with the choice of exchange rate regimes? It is well known thatamong three macroeconomic policy targets, i.e. exchange rate stability, perfect capital
mobility and autonomous monetary policy, only two can be simultaneously attained.
According to this macroeconomic policy trilemma, in order to maintain autonomy inmonetary policy, we must give up either exchange rate stability or perfect capital
mobility 9 . Namely, it follows that the Thai policy author ities had tried inconsistentpolicy management. There are reasons, however, to stick to the virtual dollar peg.
In the case of developing economies, it is generally difficult to borrow in local
currencies in the international capital market 10 , so that foreign currency borrowing
requires the stability of nominal exchange rate to minimize exchange rate risks tominimize the volatility of local currency values of external debt. In addition, effective
external debt management requires no small institutional cost s. Consequently, until
the Asian crisis in 1997, very few developing economies adopted pure floating(flexible) exchange rates in practice, which is called as fear of float (Alesina andWagner, 2003).
After a cascade of skyrocketing exchange rate depreciations in 1997-1998 shown in
Figure 4, emerging markets in East Asia had to choose between capital controls (China
and Malaysia) and floating exchange rates (the rest) in order to maintain monetary
autonomy, out of this macroeconomic policy trilemma . After the crisis, the net debt
flows (i.e. portfolio and other investments) to East Asia turned negative (total net
financial outflow), but non debt flows (FDI) have kept supplementing their ever highdomestic saving (Enya, Kohsaka and Sugimoto, 2019) . Since East Asia required lessnet foreign saving, it resumed a virtuous cycle of investment and growth with fairly
high investment, domestically financed after AFC.
9

The trilemma results from an interest rate arbitrage between domestic and foreign financial
assets. With perfect capital mobility, i f investors are risk-neutral on exchange rate changes, theywould invest in both domestic and foreign assets until when a domestic interest rate (a rate of
return on domestic investment in domestic currency) becomes equal to the s um of a foreign interest
rate (a rate of return on foreign investment in foreign currency) and an expected depreciation rateof an exchange rate between the two currencies. Then, if the exchange rate is fixed and does notchange, both domestic and foreign interest become equal each other. Therefore, given the foreigninterest rate, there would be no room for the monetary authorities to control the domestic interest
rate in an open economy under perfect capital mobility .
10 This characteristics is called as o riginal sin (Eichengreen and Hausmann, 1999).

10

Domestic financing
Until AFC, these ample domestic savings had financed corporate business
investments

almostexclusively

throughfinancialintermediaries,

particularlycommercial banks rather than through alternative channels of inve stment finance, i.e.
capital markets for corporate stocks and debentures. Generally, in developing
economies,

capitalmarkets

areunderdevelopedascomparedtofinancialintermediaries with various institutional reasons (Levine, 1997) as discussed toward
the end of this Section. As a matter of fact, before AFC, the degrees of financial
intermediation, measured by domestic cred it to the private sector, reached more than
160 percent of GDP in Malaysia and Thailand and more than 60 percent of GDP in theother East Asian countries, which were exceptional in developing economies .
Then, AFC hit hard the very channel of domestic financing for investment.
Because banks themselves and/or their customers (corporate firms) borrowed fromabroad in foreign currencies, the reversal of capital flows (sudden stops) as well as theresulting deterioration of their balance sheets due to abrupt a nd large exchange rate
depreciation pushed them to the brink of bankruptcy, because these foreign currency
debts were not hedged against exchange risks.
Coping with this emergency, financial intermediaries disposed of nonperforming
loans, wrote off own capital and stopped supplying new cred its.

Thus, the post-crisis

recovery of economic growth was realized virtually without private credits. Namely,
despite this financial disintermediation, the corporate business sector resumed
investment and growth through retained earnings from favorable export sales and/or
through burgeoning bond issuance in the underdeveloped capital market s.
Financial markets in East Asia have mostly recovered their overall pre -crisis levels
by 2007, although with some significant differences across sectors and economies.
Banks have been restructured and prudential regulations have been strengthened.
Meanwhile, one-time post-crisis developments of private bond markets have beenslowed down.
Banks have become healthier and more eff icient and corporate firms have improved
their balance sheets significantly (Gill and Kharas , 2007). This has not led to the11recovery of bank loans to firms, however. Banks have remained risk -averse since thecrisis so that corporate firms cannot but resort to either internal self-finance or capital
markets. Capital markets in East Asia have yet been characterized by the deficiencies
in information for accurate pricing, the high transaction costs and the lack of adiversified investor base. Institutional reform needed includes shareholder protection,
creditor rights, regulatory capacity, legal infrastructure and the lack of credit rating
agencies.

2. Regional Financial Cooperation
Immediately after the 1997 Asian financial crisis (AFC), several frameworks forregional financial cooperation have been pursued and realized.

Among them are the

Asian Monetary Fund (AMF, 1997), the Chang -Mai Initiative (CMI, 2000), and the
Asian Bond Market Initiative (ABMI, 2002).
Among these three, the AMF was not materialized. Like the IMF, the AMF was tomaintain the stability and sound management of monetary and financial systems in theregion and to support macroeconomic adjustments in regional economies in trouble.
Some worried about the duplication with the IMF and possible moral hazard ofborrowing economies, and others were reluctant because of some other geopoliticalreasons.
Over some time, however, key functions presumed in the AMF, i.e. swap
agreements of official foreign exchange reserves, macroeconomic policy dialog ues,
and monitoring of short term capital flows, were instituted within the CMI. The CMI,
which is of short-run nature, is a framework for regional financial cooperation toprevent the resurgence of the Asian crisis. On the other hand, the ABMI is aframework of long-run nature, which is to nurture the regional capital market(corporate stocks and bonds) in order to circulate existing a mple savings in local
currencies as an alternative to financial intermediaries such as banks within the region
without exchange rate risks.
Restructuring regional financial systems
AFC exposed several weaknesses of the macro -financial systems in East Asia,

12

despite their exceptionally high economic growth. The regional financial cooperation
is to tackle these weaknesses by restructuring microeconomic structures andmacroeconomic management (IMF, 2000). As to microeconomic aspects, efforts havebeen made, particularly focusing on underdeveloped capital markets along the line of
ABMI to enhance transparency and accountability of financial transactions, to assess
their standards and codes, and to better identify financial sector vulnerabilities.
Generally, they are intended to contribute to better -informed decision-makings forlending (financial intermediaries) and investment (capital market).
Restructuring macroeconomic management includes external debt management andalternative exchange rate regimes. Before the Asian crisis, the policy authorities in
East Asia had not exactly grasped who borrowed how much in what terms from abr oad,which helped generating maturity and currency mismatches in external borrowing,
unexpected reversals of foreign capital flows an d excessive currency depreciation. In
addition to external debt management, exchange rate regimes had to be fundamentally
reshaped. It has become well known that their virtual dollar peg regime suffers fromfundamental flaws as explained below.
In the 2000s before GFC, the persistent U.S. external imbalance and the possible
dollar crash aroused worries, expressed in such terms as saving glut and/or the global
imbalance. (IMF, 2005). The saving glut is nothing but investment shortage in otherwords, and the global imbalance stands for persistent current account deficit of theUnited States on one hand and persistent current account surplus in Germany, Japan,
East Asia and oil exporters on the other. Particularly, in post-AFC East Asia, thepersistent external surplus (current account surplus) resulted not from excess saving
but from underinvestment constrained by the malfunctioning domestic financial
system.
As such, AFC made one big epoch in the history of the international financial
market, which embodied opportunities and risks of financial globalization toward theend of the 20 t h century. The crisis exposed intrinsic vulnerabilities of the global
capital market under the globalization trend, and resulted in income losses, job losses
and bankruptcies in a number of nations in East Asia, accompanying some spillovers

13to Latin America as well as Russia. The regional financial cooperation in East Asia isan effort to compensate for these vulnerabilities intrinsic to the international capital
market (Obstfeld, 2015), to bring back to the original track the most dynamicallygrowing and changing region in the world, i.e. East Asia, and to build up a regionalsafety net to preempt similar crises.
Market fundamentalism
Since the 1980s, developing economies have bee n advised to liberalize financial
markets and to open up capital (financial) accounts to accept foreign investments. It
had been said that capital flows are productive, while capital controls are bothinefficient and ineffective (Forbes et al., 2015).
International capital flows could finance domestic investment beyond domestic
saving constraints, but they could also magnify economic fluctuations andbooms-and-busts, as already warned in the 1980s by Diaz-Alejandro (1985) 11 .
Throughout the lost decade of Latin America in the 1980s and the AFC in the 1990s,
however, IMF has kept insisting financial liberalization, capital accoun t opening-up
and exchange rate flexibility as part of the mantra of general market liberalization(Kohsaka 2022). In the AFC in 1997, to be blamed was not financial liberalization, but
fixed exchange rates and crony capitalism (Krueger 2004).
Eventually, after the GFC, they admit that international capital flows could lead toeconomic disasters. Nowadays, they support policy measures to restrain the volatilityof capital flows by capital controls and foreign exchange market interventions, butwith some conditions, reluctantly (IMF 2013, p. 113). The empirical literature has notbeen able to conclusively establish the presumed growth bene fits of financial
integration. (Kose et al. 2009).
Even though IMF admitted the danger of excessive capital inflows and the necessityof capital flow management (Ostry et al. 2011), they still believe that the basic priorityof macroeconomic policies should be flexible exchange rates, minimum public debt
and macro-prudence, not selective policy tools such as foreign exchange m arket

11

In the context of financial liberalization in Chile in the 1970s as well as in the Mexican crisis in
1982-83.

14

intervention nor capital controls. Policy authorities could fail, but markets could aswell. Particularly, financial markets could fail and, in fact, have failed from time totime. Actually, they tend to magnify the volatility of financial flows to emerging
market economies (EMEs) 12 .

3. Monetary Integration
How is the current regional financial cooperation related to monetary int egration,
then? We must remember the macroeconomic policy trilemma discussed earlier. Oneof the three targets among exchange rate stability, perfect capital mobility andmonetary policy autonomy must be given up.

Regional financial cooperationpreconditions capital mobility and monetary policy autonomy and intends to preventfrom destabilizing exchange rate volatility and to minimize its impact. In contrast,
monetary integration pursues for regional exchange rate stability in exchange forindividual monetary policy autonomy, which is a total regime change. Of course,
regional exchange rate stability does not mean exchange rat e stability with major
currencies outside the region such as the US dollar. How large is the cost of giving up
the monetary policy autonomy in exchange for regional exchange rate stability?
Optimum Currency Area (OCA)
The theory of optimum currency area discusses conditions which determine thescope of an area best for one currency. Through changing a relative price of domestic
goods to foreign goods, exchange rate changes help equilibrate domestic demand andsupply (expenditure switching). We trade off between the transaction cost to havemultiple currencies and exchange rate changes, and the benefit to allow for exchange
rate adjustments among the currencies. If the cost is larger, a common currency could
be preferable, but, if the benefit is larger, we had better maintain monetary policy
autonomy or exchange rate policy with multiple currencies.
Alternatively, focusing on macroecono mic linkages within the area, we may put it as
12

Policy authorities of EMEs know this very well, particularly those in East Asia. Making betteruse of tactics and euphemis m, they manage to control tools and channels of international investors
under the name of capital flow management measures, not of capital controls (Qureshi et al., 2011).
This is really a clever way of handling both international business persons insistin g vested
interests and policy advisors insisting perfect market myth (Kohsaka, 2022).

15

follows: First, the higher the positive correlation (symmetry) of demand and supply
shocks within the area, the less needed exchange rate adjustments (expenditureswitching), thus a common currency is desirabl e. Second, the faster the adjustment tothe shocks through factor markets as well as policy responses within the area, the lessneeded exchange rate adjustments, then a common currency is preferable.
Comparative macroeconomic linkages by region before AFC
Using a multi-country (region) structural Vector Autoregression (VAR) model 13 ,Kohsaka (2000) compared estimated intra-regional (within an area) macroeconomic
shocks in real GDP and GDP deflator and simulated after-shock adjustment speeds
across three areas, i.e. the United States (8 sub-regions), EU (7 countries) and East
Asia (7 countries) during the period of 1970-95 14 .
The result can be summarized as follows: 1) The correlations of shocks weresignificantly higher in the United States (as large as 0.6-0.8) than in the other twoareas (0.2-0.4). 2) The speeds of adjustments after shocks were significantly larger in
the US than in the other two areas. 3) As to both the correlations and the speeds, there
were not much difference between EU and East Asia.
If we interpret the above result straightforwardly, it follows that the US is more fit
to common currency compared to the other two areas.

However, since the US has

established itself as a common currency area for a long while, it may not be adequate
to directly compare with the other two areas that had never experienced a common
currency. More interesting is the third point above, which suggests that there was no
significant difference in shock correlations as well as after-shock adjustment speeds
within the areas between EU and East Asia before the Euro zone. In other words, if EU
is eligible for a common currency, why not East Asia?

13

Based on the framework of Blanchard and Quah (1989). By identifying aggregate output andprice as stochastic autoregressive processes, both supply and demand shocks are estimated and theimpulse responses of output/price to the shocks are shown for individual countries (regions). Then,
their correlations across countries (regions) are calculated and their adjustment speeds arecompared. Comparin g 11 EU countries for 1962-88 and 8 US regions for 1966-86, Bayoumi and
Eichengreen (1993) conclude that EU may not suit to monetary union, but that only its core
members surrounding Germany could do, being as comparable to US regions in terms of both lessasymmetric shocks and larger after-shock adjustment speeds.
14 EU, here, includes Austria, Finland, France, Italy, Ireland, Spain, Sweden and United Kingdom.
East Asia includes Indonesia, Japan, Korea, Malaysia, Singapore, Philippines, Thailand.

16

4. Monetary Integration in European Union
Now, does the EU currency unification suggest the counterpart one in East Asia? To
answer the question, we, first of all, need to examine the performance of the EU
currency unification.
The rationale for the EU regional integration has been discussed from both
economic and political aspects. First, the EU integration intends to promote e conomic
growth by improving microeconomic resource allocation through trade and investment
liberalization as well as capital market deregulation and to maintain macroeconomic
stabilization through imposing policy disciplines under currency unification. Second,
the EU integration also intends to intensify the presence and power of EU in theinternational economic systems. We focus, here, on the first economic aspect of theintegration, among which we particularly try to examine the sustainability of Euro as
the core of the EU monetary integration.
The Euro Zone: pre-GFC developments
Let us briefly review macroeconomic developments of the Euro Zone, i.e. the twelve
EU economies before the global financial crisis (GFC), in comparison with the otherindustrial economies including the United States.

Since the introduction of the Euro

as a single currency for the Zone in 1999, we may be able to summarize that it was
successful in financial aspects, but not that much in real (non-financial) aspects.
First, we can observe significant achievements in inflation control and financial
integration. Indeed, the Euro Zone has witnessed closer linkages of interest rates andstock prices and the home bias in portfolio selection rapidly faded away, whichsuggests that financial markets are being more closely linked one another and financial
deepening proceeded further in the Zone.
Second, on the other hand, the real sector achievements in terms of economic
growth remained less than those in previous periods and those in non-Euro Zone EU
members. In addition, the growth differences among Euro Zone economies were
non-negligible and even tended to increase further. Of course, we note that we musttake into account of the influence of cyclical factor s due to the IT bubble burst of theWorld economy in the year 2000. Nevertheless, the relatively weak achievements in

17

comparison with non-Euro Zone EU members appear to imply some policy agenda to
be considered below.
Structural Problems
Structural problems in labor market and fiscal po licy have long been among the top
priorities in macroeconomic policy agenda in EU. Usually in comparison with theUnited States, such structural characteristics of the EU economies as strong labor
unions and extravagant social welfare systems have been pointed to bring alongrigidities in real wages and fiscal expenditures, supposedly hampering adjustments
needed for cyclical and structural impediments.
In addition, related to macroeconomic management, despite the achievements ininflation control, we may better look at the risk of inflation targets being too low. If
this is the case, it may have deflationary impact on some member economies andconstrain their investments, leading to weak overall growth. More importantly, thevery adoption of a common currency may significantly constrain macroeconomic
management in monetary and fiscal policies. We consider this next.
Constraint on monetary policy
Since the introduction of a common currency successfully unified interest rates inthe Euro Zone, the European Central Bank (ECB) manage the short term interest rate
(Euro interbank rate) as a monetary policy instrument to attain macroeconomic
stability in the Zone. This is parallel to the Federal Reserve Board (FRB) managing theFederal Fund (FF) rate in the Unite d States.
Their ways of monetary policy management contrasted to some extent when facing
the IT bubble burst, though. While both the EU and the United States experienced
rapid macroeconomic slowdowns in the period of 2000-2001, the FRB lowered the FF
rate by 4.5 percent quickly and actively on the one hand, the ECB did the same only by
1.5 percent and that less quickly and actively on the other 15 . Of course we cannot
claim that this difference in monetary policy management is all to blame for thedifference in economic growth performance, but, if the contrasting monetary

15

Even with this quick and active monetary policy, FRB, admittedly, failed to contain thefinancial bubble generated by subprime loans, which triggered GFC.

18

management comes from the currency unification, this may suggest no small problem.
When we look at the economic growth performance and the real interest rates in theEuro Zone in 2000, the interest rate was the highest in the lowest growing Germany,
while it was the lowest in the highest growing Ireland. Just like this, we can find someother cases where slower growing economies faced higher real interest rates, andfaster growing economies faced lower real interest rates. This simply suggests that ,despite increasing importance of common shocks among member econ omies (Stravrev,
2007) 16 , there is institutional reasons for monetary policy in the Euro Zone to be slow
and inactive.
Constraint on fiscal policy
Naturally, our next question is if fiscal policy as an alternative policy instrument for
macroeconomic stabilization compensates for the constraint of monetary policy. Fiscal
consolidation in EU went over the peak in the mid -1990s (IMF, 2001). Indeed, theintroduction of a common currency intends to bring in disciplines to macroeconomic
policies among member economies and to constrain the policy authorities (or politicalsystems) from indulgent and myopic monetary and fiscal policies. Despite m uch
progress in fiscal consolidation in the 1990s, however, fiscal indicators such as fiscal
deficits and government debts have not been strong enough to substitute for monetary
policy. Namely, fiscal policies cannot well afford to cope with individual
macroeconomic shocks even in a complementary way to monetary policy , particularly
in some troubled economies.
As a matter of fact, the policy authorities in the Euro Zone have been under the
Growth and Stability Pact (GSP) which constrains a room for fiscal p olicy so that
there is little scope for active fiscal management. Incipiently, as far as the GSP is tointroduce a rule-based macroeconomic management instead of discretionary one, theresulting fiscal constraint remains non-negligible part of the common currency regime.
The cost of EU currency unification

16

Stavrev (2007) found that, since the introduction of the Euro, common macroeconomic shocks
became dominant among members on one hand, and idiosyncratic shocks remained generating
persistent dispersions on the other. It might suggest that a common monetary policy effectively
coped with common shocks, while individual fiscal policy struggled with idiosyncratic shocks.

19Nobody can tell for sure that the frustrating macroeconomic performanc e in theEuro Zone since the currency unification has something to do with the currency
unification itself. But, presuming a common currency, it is apparent for monetary
policy not to be able to cope with asymmetric shocks among member economies, sothat the fiscal transfers under region -wise aggregate fiscal policy are indispensable(Feldstein, 2015). In addition to harmonize fiscal institutions such as expenditurecompositions, taxation, social welfare, and to accelerate fiscal consolidation, it would
be necessary to enlarge the inter-country transfers and to introduce the fiscal
federalism 17 .

5. Global Financial Crisis
The Global Financial Crisis (GFC) since 2007 has played a profound impact not
only on economic performance of economies including East Asia and EU, but also on
their economic policy frameworks. In fact, its disastrous effect on EU reminded us of
the repetition of a type of the Asian Financial Crisis (AFC) in 1997 even in the context
of advanced economies on the one hand, 18 while the resilience of East Asia this time
led to new insights for future policy management under financial globalization on theother.
Sudden stop in advanced economies
Prior to GFC, later hard-hit economies in EU, i.e. Greece, Ireland, Italy, Portugal
and Spain (GIIPS), witnessed vigorous domestic credit growth as well as hugeinternational banking inflows (“other investments”). Although some economists ininternational financial institutions put or praise it before GFC as an income
convergence, it turned out to have been based on irrational exuberance, feeling freefrom exchange rate risks due to a common currency. As a matter of fact, after the
Lehman collapse in 2008, we did observe how a sudden stop of international financial

17

Fiscal federalism denotes here the system of transfer payments by which a central or
centralized government shares its revenues with local or lower levels of decentralized
government for their expenditures.
18

Identifying the root cause of the EU crisis as “financial integration and excessive credit flows ”,
Rey (2012) wrote, “What happened next followed a scenario well known to economists familiar
with crises in emerging markets with hard currency pegs. ”

20

flows could occur even in advanced economies, particularly in those with somefinancial and other vulnerabilities (Figure 6).

Figure 6 shows that gross financial inflows to advanced economies witnessed asheer sudden stop and/or a reversal of financial inflows led by “Other bank andprivate” investments and then by portfolio investments. As often seen in emerging
market economies in the past, the inflows were simply dried up by a half in the firsthalf of 2008, then totally changed their directions back home in the latter half andremained so until two years later, called as the Great Retrenchment (Milesi-Ferretti
and Tille, 2011).
This sudden stop harshly exposed nightmarish worsening of financial accountbalances due to free falls of portfolio and other investment inflows and resulting in21

growth slowdowns as in Greece, Italy and Spain (Figure 7), which remind us thesituation of East Asia during AFC in Figure 1 vividly. Again, we are reminded that
this is the shadowy side of financial globalization.

On top of this, we realized that a common currency, without a policy option ofcurrency depreciation within the Euro zone, enforces harsh austerity measures througha painful and long real adjustment in employment, particularly under fiscal tightness
and low inflation imposed by the EU policy authorities.
Even though AFC gave us an appropriate chance to reappraise the cost and benefitof financial globalization, it was po stponed until GFC. In fact, the “deeper” financial
integration was still believed to alleviate real economic adjustments to cope with suchexternal shocks as AFC (Fisher, 2003). Truth is, GFC was born out of financial
globalization itself, which without doubt enhanced access to foreign finance for22domestic investment. It turned out, however, that increasing foreign finance did notnecessarily improved productivity growth, nor stabilize macroeconomic fluctuation.
We should remember what happened in East Asia in the late 1990s.

Foreignfinance tends to run away when in need, while it tends to flow in too much when not in
need, thus magnifying cyclical fluctuation. We should also remember that deeper
financial integration might not be a solution, because fina ncial markets are
intrinsically subject to information asymmetries, as well as being exposed tosubjective as well as objective risks.
The day after
Without enough fiscal space to support the financial system in trouble, those
GIIPS economies must confront doom loop, where governments tried to borrow to
support failing banks, while banks suffer from the falling value of the government
bonds they held. Until GFC, monetary integration succeeded in bringing about theconvergence of government bond yields, but they diverged significantly when heavy
external indebtedness and narrow fiscal space (as shown in Figure 8) suddenly aroused
skepticism about fiscal sustainability, for example, known as (possible) Grexit.

This capital flight was barely soothed down by some emergency measures and new
policy tools as quantitative easing (QE) or its unlimited purchase of sovereign bonds ,23

i.e. Outright Monetary Transaction (OMT) by ECB as well as strengthened sovereignbail-out fund, by 2015, as visible in Figure 8.
Indeed, change only happens during a crisis. The Euro is a survivor, when it enters
its third decade (Economist, 2019). As Mario Draghi said: First, the European Central
Bank has developed new policy tools on the monetary side to contain divergence
between member economies’ borrowing costs against asymmetric shocks among them.
Second, more often from now on, EU must confront common, external shocks, such asa pandemic, energy, war, or other disasters, as a stronger fiscal union, incentivizing
toward fiscal federalism, on the fiscal side (Economist, 2023).
But, we should note that the new policy tools are pure and simple monetization of
fiscal deficits which has been not only long abhorred by Bundesbank, but could
potentially undermine the credibility of Euro. The latter point is crucial, because it is
the ultimate raison d’etre of the Euro Zone as we will discuss in Section 6.
Comparative growth performances
Prior to GFC, AFC-hit emerging economies in East Asia had abandoned virtual US
dollar-peg exchange rates long ago, strengthened prudential policy on financial
institutions and disciplined macroeconomic management adopting inflatio n targeting.
Their policy management was, however, far from orthodox in the sense that they have
kept managing exchange rates with active foreign exchange market intervention andcontrolling the composition of international financial inflows sometimes with explicit
and implicit capital controls.
GFC hit hard East Asia, too. Economic downturns in the US and EU affected East
Asia significantly, mainly through trade flows, instead of capital flows. In fact, thesudden stop of international financial flows was more or less short-lived and East Asia
has relied less on such volatile financial inflows as portfolio and other investments.
Above all, they are net creditor economies, relying less on foreign saving(international financial inflows). They have more fiscal policy space and autonomousmonetary policy.
As already shown in Figure 1 in Introduction, emerging economies in East Asia
experienced sharp declines in GDP per capita due to AFC in 1997-98, which took them24

3 to 7 years to recover their previous peaks. This contrasts to their situation in GFC. It
took only 1 year for them to get back to the original growth path. Emerging economies
in East Asia have successfully coped with the global economic slowdown, using
unorthodox policy tools, i.e. managed float with capital controls. This time is very
different from that of 1997 (Kohsaka 2020). 19
What about the Euro Zone? Except for Germany and Austria who came back to theprevious peak of GDP per capita by 2012, most of them could barely do so in 2015 orlater. Particularly, while Spain came back as late as in 2017, Greece and Italy canhardly show even a symptom of recovery by 201 9 or before Covid-19. Then, what’s
the use of a common currency area?

6. Euro’s Survival
Since

GFC,

the

fall

of

the

Euro

as

international

currencies 20

started(Florez-Orrego,et al. 2018). Its global use since 1999 steadily grew in various aspects
of international transactions and became non-negligible in comparison with the US
dollar before GFC. The fall was relatively large in international financial asset trade,then in foreign exchange trading and relatively small in international trade and foreignexchange reserves. Its use as anchor currency remains about the same as in 1999 (55economies, 2015), while the dollar use increased from about twice as large to 14
economies more since GFC.
The trouble in the Euro zone, particularly in its sovereign debt markets , must havetriggered this fall of the Euro. The strong liquidity of the US dollar shown at the timeof GFC must have supported this shift. The fall of the Euro or the fact that global
investors voted for the dollar as the only safe currency , without doubt, strengthens
exorbitant privilege of the US economy, i.e. they could borrow at lower costs, being
less exposed to exchange rate risk than the rest of the world.

19

While they have minimized reliance on forei gn financial resources and diversified across
categories of capital toward less volatile flows, the private sectors have also done the same throughtheir financial internalization , i.e. less borrowing and more self-financing (Kohsaka, 2015).
20 Currencies which have large shares in use as in international trade, international finance,
foreign exchange reserves, foreign exchange trading and anchors for pegged or managed exchange
rate regimes.

25

We must note here that the fact above gives us one important raison d’etre of theEuro zone under financial globalization. As we have discussed so far, financial
globalization revealed that we are still living with very imperfect capital markets
across the globe.
In a perfect capital market, we would have real interest parity without default risk.
Then, physical capital would accumulate until the marginal productivity of capitalequals the real interest rate eventually. Without credit constraints and/or financial
frictions across borders, real interest rates would become equal everywhere on the
globe, i.e. real interest parity holds globally.
In practice, despite financial globalization, real interest rates generally differ to a
non-negligible degree across national borders. Remember that nominal government
bond yields of Euro zone economies had remained converged across borders before
GFC, although they diverged each other particularly in the post -GFC crisis, evenunder a single currency (Figure 8).
Three factors prevent real interests from parity across borders in general (Chinn andIto, 2023). First, political risk, i.e. the risk of imposition of capital controls and otherregulations on cross-border capital flows, can hamper capital mobility and then realinterest parity. Second, since investors are not risk-neutral against a perfect capital
market presumption, they show home biases in portfolio selection and demand risk
premium on foreign asset holding, which would hamper interest rate parity to hold.
Third, since real exchange rates are not constant as presumed by Purchasing Power
Parity (PPP), but co-vary with nominal rates in reality even in the long run, theresulting non-zero expected real exchange rate changes would intervene in realinterest rate parity. In a word, there are every reasons why real interest rate parity do
not hold across borders and/or why international investors try to minimize theexposure for the exchange rate volatility and seek for safe assets 21 . Thereby, theexorbitant privilege.
The Euro Zone enables regional investors to reap some exorbitant privilege. And
21

Itskhoki and Mukhin (2023) argued that the exchange rate disconnect or the lack of correlation
between exchange rates and other macro variables comes from the volatility of cross -border asset
demand.

26

when it could enlarge, it would compete with the dollar for the privilege. As aprecondition, then, EZ must prove to be a sustainable currency zone.
At least, in fact, the Euro Zone looks better shaped than East Asia to currency
unification. Look at Figure 9, which shows, EZ (France, Germany, Greece, Italy,
Netherland, Spain) has shown significant symmetry of macroeconomic fluctuations ,being better fit to a single currency area as compared to East Asia ( China, Indonesia,
Japan, Korea, Malaysia, Thailand).

27

Figure 9 also shows that, despite huge global macroeconomic shocks such as thoseof dot.com, GFC, and covid-19, EZ’s coherence in inflation is visibly stronger and thatin GDP per capita growth is also mostly stronger except for Greece than in East Asia.

28

Also, real effective exchange rates in East Asia fluctuate to a far larger extent as wellas in a far more asymmetric way compared to EZ, suggesting that monetary integration
is impossible in East Asia, at least for the time being. Referring to the previous result(section 4) on comparative macroeconomic shocks before the Euro, we can identify
some remarkable developments in the Euro zone both quantitatively and qualitatively
as a monetary union 22 .

7. Whither Financial Integration
After all, what can East Asia learn from the experiences of the Euro Zone? Point is
the motivation for economic management under the common currency 23 . In the past
decades, East Asia has demonstrated praiseworthy macroeconomic stability andgrowth. They have more or less successfully controlled inflation and attained
comparably high economic growth through individually pursuing own more or lessdisciplined policy managements. Although this very fact caused excessive capital
inflows to the region and the resulting AFC was regarded as most unexpected by therest of the world, the swift recovery from the crisis showed the fundamental strengthof East Asia.
This fundamental strength, however, implies weak motivation to improve economic
performance via regional integration as compared to EU. Even without monetary
integration, East Asia has shown unprecedented economic performances under de facto
regional integration through trade and foreign direct investments or wide and deep
regional value chains. Maybe they have incentives to prevent from recur rences ofcrises, but little motivation for monetary integration nor a fiscal union.
The most worrying would be the potential costs of losing individual monetary
autonomies under currency unification. East Asia contains members of different
22

Following Bayoumi and Eichengreen (1993), Bayoumi and Eichengreen (2017) find that, while
the US remains better suited to an optimal currency ar ea than the Euro Zone, the gap between EZ
core and its periphery (GIIPS) appears smaller than before the Euro. Nevertheless, they also warn
against the view that the EZ’s asymmetric -shocks problem will solve itself endogenously.
23 Furthermore, the coherenc e of political wills among members would be indispensable to therealization of monetary integration. The EU succeeded in establishing the resolute political will tohave a resolute presence as a group in the international economic system. Even the EU has taken
more than thirty years to attain the goal. There appears no condition for East Asia to spare time andenergy enough to attain the same goal.

29

development stages, divergent industrial and external trade structures. When they facediverse economic shocks, the cost of losing monetar y autonomies and effective policy
instruments might be large 24 .

Furthermore, the economic rationale of fiscal

federalism beyond sovereignty to compensate for the loss of monetary autonomy there
may be dubious, and its political feasibility looks nil.

The post-WWII world economic architecture, i.e. the Bretton Woods (BW) regime,
consisted of trade liberalization under fixed exchange rates (US dollar-gold standard)on one hand and constraints on capital flows on the other. Their founders were afraidthat free capital mobility tends to destabilize exchange rates and to magnify businesscycles in real economic activities. In fact, under the regime, many advanced and someemerging market economies enjoyed steady economic growth with expanding
international trade, while some suffered from occasional currency devaluations andmacroeconomic adjustments due to speculative capital flows despite capital controls.
When US suddenly and unilaterally gave up sustaining US dollar per gold due to her
own persistent economic over-expansion in the early 1970s, the BW regime collapsed
and the world economy plunged into floating exchange rate regimes. Th en, financial
liberalization started vigorously since the 1980s.
To think about the future role of the Euro or Euro Zone, at issue is the exchange
rate volatility, which is not necessarily related to macroeconomic fundamentals, called
as the exchange rate disconnect (Itskhoki and Mukhin 2023). It is an obstacle for realinterest rate parities to hold and to realize efficient c apital allocation across currency
areas. Post-BW flexible exchange rates could not wipe away the asymmetry acrosscurrencies, which had been intrinsic to the virtual dollar standard in the BW regime.
Financial globalization could not reduce this volatility, but sometimes aggravated it.
Financial globalization could not flatten the privilege of some currency, but

24

In the context of EU, however, losing monetary autonomy may NOT necessarily be a cost of
integration, but a gain (Fratzscher and Stracca [2008]). The constraints imposed by EMU on
domestic economic policies could even remove a source of uncertainty, i.e. policy shocks. We havewitnessed cases where domestic policies are more a source of shocks and uncertainty p articularly
in countries with institutional vulnerabilities.

30

strengthened it 25 . The birth of the Euro is to challenge this fundamental flaw of thepresent international monetary system.
Furthermore, the idea of one common currency is probably to go beyond Europe.
Fiscal federalism is, too. For global economic integration to lead to better g lobal
allocation of resources and then global economic growth, financial globalization had
better be managed by global monetary integration with the help of global fiscal
federalism across sovereign states (Rodrik, 2000). With this in mind in the long shot,
the Euro Zone could play a role of a pilot experiment and/or a special economic zoneof one currency across multiple fiscal entities (sovereign states). Hence, the Euro’s
survival matters.

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