Question

To what extent is OCA theory useful in explaining the membership of the eurozone?

Answer 1

OCA (Optimal Currency Area) theory states that if a geographical area passes a few criterions (discussed later), having a single currency in that area would benefit it greatly. Having a common currency would result in greater economic integration and boost in trade, but will also result in the loss of an individual country being able to control its monetary and fiscal policies and hence would not be able to manage the economy alone in case of an adversity.

OCA theory stipulates four main criterias which must be fulfilled if a geographical area is to be an ideal candidate for single currency. We will go through each of these are see how Eurozone members fit into each of these-

1. High Labor Mobility- The different countries in the geographical area mustve high labor mobility, i.e.- labor should be able to move easily between the countries and people are able to migrate easily. It turns out that Eurozone does not have a very high mobility. Due to cultural, language, opportunity and legal barriers, migration of citizens in between Euro countries remains low. If US was to be considered a single currency area with its different states acting as countries, it wouldve have far higher mobility. Around 40% of US citizens live in a state other than where they were born, the same figure for Eurozone countries is only 14%.
2. Capital Mobility- Just like labor, capital should be able to move freely between the countries. In an ideal world this would result in stabilization of wages and prices, as capital will move autmatically where its needed the most and supply and demand forces would do so. In this criteria the Eurozone fares better as they do indeed trade more with each other than internationally. It has been suggested that having a single currecy has increased trade between Euro nations by 5-15%.
3. Business Cycle Synchronization- The countries should have similary business cycles. When one is going thorugh a boom, others should not be going through a bust. Recessions and booms across countries should be in-tandem. On this score also the European countries score well. Their business cycles are well synchronized, especially for cycles shorter than 3 years. In fact, the business cycles have become more similar post the Eurozone and single currency.
4. Risk-sharing system- A single currency zone is vulnerable to asymmetric shocks (a shock that does not affect the whole geographical area but only some parts of it) and there must be a risk sharing system via payment transfers etc so that the part being affected by the shock can recover. Given the loss in fiscal and monetary control post single currency, this part becomes very critical. This was highlighted very clearly during the Greek crisis. The crisis in Greece worsened post 2010 and was threatening the whole Eurozone. A risk-sharing system wouldve mandated the European Central Bank (ECB) to control the downturn in Greece by strengthening its economy. For example, in the US, if a state's GDP drops by 1USD, it is offsetted by 28cents by the federal government. No such system was present in the EU, though they did try some bailouts later on. Still, most economist do not consider the occasional bailout as being most efficient.

We can see that based on OCA theory, Euro membership can be explained well only on 2 of its criterias (capital mbility and business cycle synchronization) while on other 2 EU remains wanting.