Question

Using the GG-LL graph we covered in lecture, explain why the EU does not qualify as an optimal currency area. Your answer should include the factors necessary for a region to be a good candidate for adoption of a single currency.

Answer 1

1. What is an 'Optimal Currency Area'?

It is the geographic area in which a single currency would create the greatest economic benefit.

While traditionally each country has maintained its own separate, national currency, work by Robert Mundell in the 1960s theorized that this may not be the most efficient economic arrangement. In particular, countries that share strong economic ties may benefit from a common currency. This allows for closer integration of capital markets and facilitates trade. However, a common currency results in a loss of each country's ability to direct fiscal and monetary policy interventions to stabilize their individual economies.

OCA theory has been most frequently applied to discussions of the euro and the European Union. Many have argued that the EU did not actually meet the criteria for an OCA at the time the euro was adopted, and attribute the Eurozone's economic difficulties in part to continued failure to do so.

2. Europe does indeed score well on some of the measures characterising an OCA (such as symmetry of shocks). By looking at the correlation of a region's GDP growth rate with that of the entire zone, the Eurozone countries show slightly greater correlations compared to the U.S. states. However, it has lower labour mobility than the United States, possibly due to language and cultural differences. In O'Rourke's paper, more than 40% of U.S. residents were born outside the state in which they live. In the Eurozone, only 14% people were born in a different country than the one in which they live. In fact, the U.S. economy was approaching a single labor market in the nineteenth century. However, for most parts of the Eurozone, such levels of labour mobility and labor market integration remain a distant prospect.

Furthermore, the U.S. economy, with a central federal fiscal authority, has stabilization transfers. When a state in the U.S. is in recession, every $1 drop in that state’s GDP would have an offsetting transfer of 28 cents. Such stabilizing transfers are not present in both the Eurozone and EU; thus, they cannot rely on fiscal federalism to smooth out regional economic disturbances. The European crisis, however, may be pushing the EU towards more federal powers in fiscal policy.

3. According to Mundell, there are four main criteria for an optimal currency area:

i) Increased labor mobility throughout the area. Ease of labor mobility includes the ability to travel via simplified visas, a lack of cultural barriers that inhibit free movement such as different languages, and institutional policies such as the transfer of pensions or government benefits.

ii) Capital mobility and price and wage flexibility. If financial resources can move easily between areas that trade frequently with each other, this mobility can facilitate overall trade and boost economies. This also allows the market forces of supply and demand to distribute money where it is needed and maintain a balanced economic system.

iii) A currency risk-sharing system across countries. A risk-sharing system in a currency union requires the distribution of money to regions experiencing economic difficulties, whether due to the adoption of the first two traits or because these areas are less developed. This criteria is controversial as it is politically difficult to sell in individual countries, as such countries with surpluses are unwilling to give up their revenue. The European sovereign debt crisis of 2009-2015 is considered evidence of the failure of the European Economic and Monetary Union (EMU) to satisfy this criteria as original EMU policy instituted a no-bailout clause which soon became evident as unsustainable.

iv) Similar business cycles. All participants in the area must have similar business cycles so that economic booms are shared, and the OCA’s central bank can offset and diffuse economic recessions by promoting growth and containing inflation.