Optimal Currency Area Theories

Was joining the euro area beneficial for the eleven countries in 1999, or the 19 countries today? After all, many economists think that the economic case for the EMU was weak and that the decision was taken on strictly political grounds. Contrary to this opinion, Thygesen (2016) well explains that there was both a strong economic justification for moving towards a single currency and a rare political opportunity to begin that process in around 1990.

Various explanations, more or less theoretically sound, have been put forward in the literature. Here we prefer to start from an established economic theory: the Optimal Currency Area (OCA) theory, initially propounded by

Mundell (1961) and then developed by other authors. It simply maintains that a group of countries belong to an ‘optimal’ currency area if the benefits deriving from participation in the monetary union are greater than the implied costs.

The costs are mainly macroeconomic, namely the abdication of an autonomous (national) monetary policy and of use of the exchange-rate instru- ment.⁷ In general, there may be also some macroeconomic benefits (the forced monetary discipline with lower inflation, the credibility ‘imported’ from high-reputation economies, the decreasing interest rates in the transition to the new currency), but the OCA theory focuses on benefits of a microeconomic nature. The two most important of them are the removal of transaction costs and the elimination of the exchange-rate risk (EC 1990). Thus, not only internal trade would be increased, but also the free movement of people and capitals; the lesser segmentation of national markets would reduce price discrimination and strengthen competition. The reduction of inflation and interest rates would spur investment and reinforce economic growth. The mentioned benefits accrue in particular to the well-integrated economies, i.e. to the countries which are ‘open’ and characterized by a high proportion of reciprocal trade (McKinnon 1963).

How important is the chief cost of the monetary union, i.e. the loss of the exchange-rate instrument? The OCA theories maintain that this cost is high: (i) when the economic shocks are ‘asymmetric’ and (ii) when the adjustment mechanisms (alternative to the exchange-rate manoeuvre) are not available or do not work properly.

As regards point (i), it has been shown that the probability of asymmetric shocks occurring is higher when the countries are dissimilar, i.e. not homogeneous primarily from the point of view of economic structure and productive specialization (Kenen 1969). Differences in fiscal systems and institutions are important as well. Apart from the static heterogeneities in the variables mentioned, it is even more important to investigate how they may change over time. According to an optimistic view, economically integrated countries tend to become more similar also in terms of productive specialization, because international trade will become to a greater extent ‘intra-industry trade’, i.e. imports and exports of similar products (Eichengreen 1993). A pessimistic view maintains, on the contrary, that the increased international trade will lead to a heightened concentration of production (also in order to exploit scale economies), more specialization, and thus to ‘inter-industry trade’, so that the productive structures become more dissimilar (Krugman 1993). The optimistic view has been further developed within the ‘OCA criteria endogeneity’ proposition, according to which - even if we admit that the OCA’s requirements (in particular the similarity of productions) are not satisfied ex ante - it is the introduction itself of the common money that may lead to intensified trade and more similar productions, thus fulfilling such requirements ex-post (Frankel and Rose 1998; Rose 2000).

Regarding point (ii), i.e. adjustment mechanisms alternative to devaluation, Mundell (1961) argued that, when an asymmetric shock occurs in a monetary union (e.g. an increase of aggregate demand in one country and a contemporaneous decrease in another country following a shift in preferences), an adjustment mechanism can be found in the market if prices and wages are flexible, and labour is mobile across countries. In the country adversely affected by the shock, prices and wages will start to fall, thus improving competitiveness, net exports and income; at the same time, out-migration will reduce unemployment and help labour-market adjustment. Opposite adjustments will occur in the country positively affected by the asymmetric shock, favouring the overall rebalancing.

We can now more precisely conclude that the cost of monetary unions relates to the deflation, recession and unemployment hurting the country penalized by the adverse asymmetric shock, for which a devaluation is not possible: outside the monetary union, an exchange-rate manoeuvre would be a simpler and more effective adjustment mechanism.⁸ These macroeconomic costs - deflation, recession and unemployment - would be higher and more persistent if the market adjustment mechanisms do not work properly; for example, in the presence of fixed (or not fully flexible) prices, sticky wages and obstacles to labour mobility.

Nevertheless, in addition to the mentioned market adjustment mechanisms, the subsequent OCA literature has discovered some additional ‘insurance systems’ that can mitigate the negative impact of asymmetric shocks. A first important insurance system is provided by the public budget, of which two kinds can be theoretically identified: a centralized public budget and many public budgets decentralized at the national level. In the former case, there is a unique budget centralized for the entire union or at least an important central budget accompanied by individual national budgets: this is the case of the United States (see Fig. 2.1 for an international comparison on the incidence of the central/federal level over total expenses). When an asymmetric shock occurs, there will be automatic fiscal transfers from the countries positively affected by the shock to the ones penalized by it: in the former countries more taxes will be raised and

2 THE EUROPEAN MONETARY UNION AND OCA THEORIES 23

Fig. 2.1 Central (or federal)-level public expenses versus regional (or country)- level public expenses in some federal unions/countries (2013)

Source: Our elaboration on IMF database

less expenditure (unemployment benefits) will be needed; in the latter countries, opposite evolutions will occur. The centralized (or ‘federal’) budget will be barely affected if the shock is asymmetric.

The second-best solution is to have budgets that are decentralized at the national level but fully flexible in order to let the ‘automatic stabilizers’ (progressive taxation, unemployment subsidies, etc.) entirely operate, in addition - if necessary - to proactive expansionary fiscal policy. This means that public deficits and debts temporarily increase after the shock; in a certain sense, the intergenerational redistribution is a substitute for the international one (De Grauwe 2016a). As we shall explain in the next section, the EMU has maintained decentralized budgets, but these cannot be manoeuvred in a flexible way because of the rules that have been introduced on the public accounts [Stability and Growth Pact (SGP) and more recently the Fiscal Compact].

More recent OCA theories have stressed the role that a private insurance system can play after asymmetric shocks. It essentially works through well-integrated capital markets where private agents hold financial instruments (bonds and equities) issued in other countries of the union. The asymmetric shock will cause a collapse of production and bankruptcies in the damaged countries, and the opposite will occur in benefited countries. The wealth ( financial capital) will fall in the former countries, hurting the private holders everywhere - if financial markets are integrated - so that gains and losses will not be restricted to the countries originally hit.⁹