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OPTIMAL CURRENCY AREA AND
THE EUROZONE
Prepared
by LINO BRIGUGLIO
Professor of Economics
University of Malta
April 2012
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Layout of the Presentation
1.
2.
3.
4.
5.
The OCA Theory
The OCA Criteria
OCA and the EMU
Comparing the USA and the Euro Area
The Prospects of the Euro Area as an OCA
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The OCA Theory
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The Theory…1
► An optimum currency area (OCA) is a geographical
region which, if sharing a single currency, would
maximize economic efficiency in that area. The theory
is associated with the writings of Robert Mundell[1],
although earlier Abba Lerner also wrote about this
subject.
► This theory relates to the argument as to whether or
not a group of countries would benefit by having a
single currency. A single currency is associated with
monetary union, which itself is an advanced stage of
economic integration. For this reason, this theory is
often mentioned when discussing the euro area.
[1] Mundell, Robert (1961), “A Theory of Optimum Currency Areas”, American
Economic Review, 51, pp. 657–665. McKinnon (1063), building on Mundell,
argued that that the more open economies are in trade with one another, the
more output fluctuations will be synchronised between countries.
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The Theory …2
► In 1961, Mundell identified the conditions for an OCA
with stationary expectations. His main arguments is
that for a currency area to operate properly, member
countries of the OCA must have have similar economic
conditions and have sufficiently flexible labour, capital
and product market to permit adjustment in the face
of an external shock.
► The basic questions that this theory tries to answer is
“what conditions must be present for two or more
countries to use the same currency instead of
separate?” In the context of the euro area, is it
advantageous for 17 countries to to abandon their
own currencies and adopt the Euro as their common
currency?
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2
The OCA Criteria
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The OCA Criteria
► The OCA theory leads to the conclusion that a group
of countries would benefit by using a common
currency if three basic conditions are satisfied. These
are:
1. Economic or real convergence
2. Factor (especially labour) mobility across the area
3. Market adjustment with regard to capital, prices
and wages in all members of the area
4. Fiscal harmonisation
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1. Economic convergence
► This criteria implies that members of the area should
should not be subject to asymmetric shocks.
► Member countries must have similar business cycles
which means that they should experience econo0mic
ups and downs at the same time, so that countercyclical measures adopted by the area central bank
will have positive effects on all members.
► This criteria also requires that members of the area
should not be significantly different in terms of
economic development in terms of level and growth.
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2. Factor Mobility
► This criteria implies that countries with good
opportunities should attract factors of production,
including labour, from those with few employment
opportunities.
► This does not only require absence of visas and ease
of obtaining work permits but also absence of cultural
and institutions barriers (e.g. language barriers,
different pension schemes, etc).
► The labour mobility criteria can be considered as an
extension of the economic convergence criteria in that
if member countries in a currency area are hit by an
asymmetric shocks they should have a high degree of
labor mobility so as not to create gross disparities
between the member states.
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3. Market adjustment
► The market adjustment criteria requires wage
flexibility. If workers in a given country member of the
area are affected by loss of jobs, and this leads to a
lowering of wage rates, then unemployment would be
reduced as labour demand would respond to a lower
cost of hiring labour.
► This could also lead to lower prices and therefore to
an improvement in competitiveness.
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4. Fiscal harmonisation
► For a currency area to operate optimally there should
be a harmonised fiscal policy. Thus if a country in the
area suffers an asymmetric shock a central fiscal
authority would transfer tax revenue collected form
the countries that are not adversely affected to that
which is adversely affected.
► In this way, the central fiscal authority would
redistribute income across the different member
states.
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OCA and the EMU
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The Economic and Monetary Union (EMU)
► It should be noted that the criteria established for
members of the EU than can join the euro area are
not the same as the criteria established by Mundell for
an Optimal Currency Area.
► The so called Maastricht criteria require that a country
intending to join the euro area must converge with the
rest on the basis of inflation, interest rates, deficits
and debt and must also have exchange rate stability.
► These criteria are not the same as those required by
the Optimal Currency Criteria described above, and
there is now considerable debate as to whether the
euro area is optimal in terms of a common currency.
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Asymmetry in the EMU
► To answer the question as to whether the EMU is an
OCA we will consider the criteria one by one.
► Asymmetry. Although the member states are all
European, and share common cultural traits, they are
very diverse in their business cycle and trade
partners.
► By way of example, Ireland is likely to be more
synchronised with the UK than with Eastern and
Central European countries.
► Also the level of GDP per capita and the growth
patterns of the members of the EMU vary
considerably.
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Labour Mobility in the EMU
► The rate of Labour mobility in the euro area is low
due to various barriers.
► Although travel within Europe is relatively easy,
requiring no visas, especially within the Schengen
area, there are various barriers relating to work
permits, language requirements, pension schemes,
work practices, and others.
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Market Adjustment in the EMU
► Wage adjustment in the EMU country is generally
hindered by labour market regulations, including
minimum wages, and union activity.
► Thus one cannot expect wage rates to fall with excess
labour supply, and a high rate of unemployment does
not normally result in a significant reduction of the
cost of hiring labour.
► The product market is generally liberalised within the
euro area, but in the case of utilities, market
intervention is common place, even though there is a
competition law and policy in place.
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Fiscal Harmonisation in the EMU
► In Europe fiscal harmonisation is only now being seriously
considered as a requisite for the success of the euro.
Unlike the USA, the EU is made up of national
governments, all carefully guarding their sovereignty. Even
though there is an EU parliament, and there is a qualified
majority voting within the European Council, each country
is ultimately its own master. Each government depends on
the vote of its people for loss of national sovereignty often
leads to loss of electoral votes.
► Some examples: Germany was not very much willing to
tax its people to help Greece, while the French tax payers
will not relish the idea of helping Portuguese wine makers.
► In addition, in practice fiscal transfers might lead to moral
hazard and free riding, as does not motivate members to
be fiscally prudent.
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Comparing the USA and the Euro Area
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Comparing the Euro area and the USA
► When comparing the two major currency areas, namely
the USA and the EU, one immediately comes face to face
with the major difference: the USA is a sovereign state
with one central government and therefore fiscal and
monetary policies are by and large uniform in all states.
► Conversely, the euro area is composed of 17 sovereign
states with their fiscal policies to a large extent determined
by the national governments
► Each member country has different types of financial
exposure, so that a default of government debt is likely to
create different degrees of contagion. In the case of
Greece, even though we are here dealing with a small
country, its exposure was so large that if generated
negative contagion effects in many other countries.
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Comparing the Euro area and the USA … 2
► In the euro area fiscal profligacy, loose regulation on
banking sector and lack of competitiveness are
present to different degrees in the different member
countries.
► For example, Ireland suffered mostly from loose
banking regulation, Italy from low economic growth,
Greece from fiscal imprudence.
► In the USA differences between states exist as well,
but the fact that there is a federal government and
there is more uniformity.
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Comparing the Euro area and the USA … 2
► In the USA factor mobility is easier than is the case in
the EU
► In particular, the degrees of labour productivity, labour
mobility and wage flexibility are higher than those
existing in the euro area.
► One reason for this is that union density is much lower
in USA than in the euro area.
► Thus the USA is nearer to an “optimum currency area”
than the euro area.
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The Prospects of the Euro Area as an OCA
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Over and Under Estimations
► The Security and Growth Pact may have
underestimated the differences between national
governance practices and economic realities.
► There was over-reliance on market forces, based on
the idea that the market would lead to self-regulation
and that the interaction of supply and demand would
automatically create a level playing field. The global
financial crises has shown otherwise, particularly with
regard to the financial market.
► There is now a worldwide call for stronger regulatory
frameworks and more enforcement relating to fiscal
prudence.
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The Mood of the International Financial Markets
► On all this one has to consider the mood of the
international financial markets. When the going was
good, the yield spreads between Greece and Germany
were low, even though it was known that Greece’s
government finances were very shaky.
► Following the global recession, markets became very
agitated and even large countries such as Italy and
Spain were attacked, and the spreads on the soverign
bonds increased rapidly when compared to Germany’s.
► Italian and Spanish sovereign debt yields rose to over
6 percent.
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Lessons learned
► Now, basing on the experience of the Greek sovereign
debt, we learnt that the euro area had two major
problems, namely (1) weak fiscal governance and (2)
absence of crisis resolution arrangements.
► We have learnt also that given that member countries
lose their ability to adjust their imbalances through the
exchange rate mechanism, a rules-based arrangement
is necessary.
► This has led to reforms in economic and financial
governance, as is the case of the six-pack
arrangement approved by the European Parliament.
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Labour Immobility
► However the OCA criteria have still to be addressed,
particularly with regard to labour mobility.
► This is a major problem, given the many barriers that
exist, including those resulting from national labour
legislation.
► Some barriers are not very obvious, such as a
language requirements hidden in employment
conditions as is the case of notaries in Malta.
► There are also cultural barriers and work practices
which may discourage workers from moving from one
country to another.
► As a result, only a very small percentage of the
European workforce, possibly lower than 4%, has lived
and worked in a different member state.
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More needs to be done
► On a positive note, the current crises is leading to
more awareness of the need for labour mobility
between member states as well as to better financial
governance.
► Such changes should increase factor productivity,
better synchronization of the business cycles between
members states and more sustainable public finances.
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THANK YOU FOR YOUR ATTENTION!
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