Exchange rate misalignments, fiscal federalism and redistribution

Summary The crisis in the euro zone illustrates the shortcomings of the adjustment mechanisms in a monetary union characterized by strong heterogeneity. This situation reflects a simple diagnosis. At the level of the zone as a whole, the euro is close to its equilibrium rate. But the euro is strongly overvalued for southern European countries, including France, and largely undervalued for northern European countries, especially Germany (Jeong et al., 2010). First, this article provides an assessment of these exchange rate misalignments within the euro area, using a FEER approach. Furthermore, using panel data over the period 1994-2010, we confirm that exchange rate misalignments have diverged, reflecting unsustainable developments. Finally, we estimate the cost increases or reductions as a percentage of GDP induced by these misalignments for the different European countries. In a second step, we use a two-country "stock-flow consistent" modeling of a monetary union in the tradition of Godley and Lavoie (2007) and Duwicquet and Mazier (2010). A federal budget is introduced with federal spending and social transfers financed by federal taxes and the issuance of Eurobonds. The stabilizing role of such a federal budget is confirmed in the face of asymmetric shocks within the union. At the same time, the stabilizing role of Eurobonds for investment projects is illustrated.