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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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1. The OCA Theory 2. The OCA Criteria 3. OCA and the EMU 4. Comparing the USA and the Euro Area 5. The Prospects of the Euro Area as an OCA

Layout of the Presentation

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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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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 counter-cyclical 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!