The following paper will discuss what conditions are required to gain from forming a monetary union, with a structure based around the Optimal Currency Area (OCA) theory. By firstly introducing the theory and some of its criterions followed by explaining how said criterions create an environment in which forming a monetary union would be beneficial. Following this an analysis of the euro-zone will take place using evidence to see whether it does truly meet OCA criteria.
An optimal currency area is a geographic region in which a single currency would create economic gains to those involved. The theory was introduced by Robert Mundell whom stated that integration between nations with closely related economies would see great economic benefit despite having to give up independence of monetary and fiscal policy. However, the theory states that the benefits of creating a monetary union (MU) will only outweigh the costs if certain economic criteria are satisfied. Such criteria being met will lead to economic gains from creating a MU as they help to either reduce the probability of asymmetric shocks occurring or act as alternative mechanisms of adjustment to asymmetric shocks. An asymmetric shock is an external shock which has varying negative impacts on economies including increased unemployment and inflation rates, but if OCA criteria is fulfilled then such shocks have a reduced impact on country’s who have formed a monetary union.
Labour mobility throughout the area is the first factor to be analysed. Suppose that Germany and France form a monetary union and that labour is free to move between nations due to an integrated labour market, lack of cultural barriers and institutional arrangements including the ability to have pensions transferred for example. Assume that output and unemployment are equal in both countries, an asymmetric shock hits Germany only, causing output to fall and unemployment to rise, because of high labour mobility labour will begin to migrate to France where unemployment is lower and there’s greater chance of economic prosperity. Consequently, the asymmetric shock in Germany creates less economic damage due to the ability of excess supply of labour being able to migrate to a new region meaning there’s less need for Germany to implement independent policy to re-stabilize the economy.
Labour mobility allows for adjustment to asymmetric shocks in a monetary union through migration. Although in the modern day geographical labour mobility has less importance compared to occupational mobility due to the growth of information technology. Wage flexibility is also a key criterion and allows for adjustment to asymmetric shocks when labour mobility is poor and there is lack of fiscal transfers between members. Again, take Germany and France with a negative demand shock in France and a rise in German demand from SRAD to SRAD 1 creating a fall in GDP in France, shown by movement from Q to Q1 and an increase inflationary pressure in Germany shown by increase of ? to ?2. The shock to France leads to a rise in real wages as prices have fell whilst nominal wages have stayed constant.
Because of wage flexibility in France the economy can begin to adjust, for example French workers and trade unions accept a fall in nominal wages allowing for the real wage to adjust too, consequently causing inflation to fall to ?2. As a result, the French economy is relatively more competitive compared to Germany allowing for increased demand in France whilst simultaneously lowering inflationary pressure in Germany. Due to wage flexibility, both nations can slowly adjust back to their original equilibriums. Figure 1- Wage Flexibility (Crowley 2013a, p. 17) In practice the effectiveness of wage flexibility may be restricted, and adjustment may be slow, especially in the euro-zone which will be evidenced later in this paper.
Another criterion closely related to Labour mobility and Wage flexibility is Capital mobility. Capital flows have the role of facilitating temporary payment adjustments between countries and longer-term role of providing investment in underdeveloped regions. By having integrated capital markets and thus high capital mobility the burden of shocks is eased via allowing for structural changes to occur over longer periods. Any structural changes must be financed so mobility of capital is key to ensuring finance is able to move freely and quickly to member states for ease of adjustment.
Proving that the role of capital mobility is vital for a successful monetary union in both the short-term but also the long-run. This is where capital mobility differs, its impact on adjustment can be quicker compared to that of labour and wage flexibility and as it also offers long term benefits it can be said to be a vital cornerstone in OCA theory. One of the more modern elements of OCA theory is synchronization of business cycles, the idea here is that participants in the MU should share booms and recessions so that the OCA’s central bank can alleviate and reduce economic downturns by promoting growth and restricting inflation through a common monetary policy. If business cycles are idiosyncratic then effectiveness of optimal monetary policy will vary in different member states thus creating further divergences between them. Synchronised business cycles help shocks become more symmetric across a MU and can reduce the probability of occurrence of asymmetric shocks. However, shocks can be symmetric but the way in which they’re transmitted can be asymmetric due to structural differences and as a result having synchronised business cycles won’t always reduce the probability of asymmetric shocks occurring.
Consequently, synchronised cycles allow for common policy by the central bank to be more effective in delivery leading to improved adjustment to said negative economic shocks. To accompany this, there should be Fiscal and Political integration when creating a MU so that preferences over inflation and unemployment levels are homogenous also creating effective monetary policy. Although in practice inflation differentials are unavoidable and desirable as they’re a product of an equilibrating adjustment process within a MU. (ECB, Monthly Bulletin, May 2005, p. 61).
The final OCA criteria to be analysed is that of a Risk-sharing system, this can come in both private and public form, however in this paper only public form will be analysed. In public form it’s an automatic fiscal transfer mechanism to redistribute money to regions within a monetary union which have been adversely affected by asymmetric shocks and thus acts as an adjustment mechanism. Regions with higher economic activity will have higher surpluses via greater taxation revenue and lower spending on unemployment benefit, as a result the excess capital would be transferred to suffering regions to help offset imbalances within the union. However, this idea is controversial and politically tricky as country’s with said surpluses are unlikely to be willing to give up their excess revenue.
Consequently, this concept is more of an income redistribution mechanism to subsidise regions with poor economic activity rather than a risk-sharing mechanism. Furthermore, regions experience varying times of economic prosperity and adversity. For example before the euro-zone crisis some of the GIPSI country’s such as Ireland and Spain had relatively stronger economic growth than that of Germany, if such a risk-sharing system was in place then these country’s would have given away their excess capital to a country who would have given it straight back to them post euro-zone crisis proving a fiscal union to some extent won’t prevent asymmetric shocks occurring. Once more proving that the idea is more a redistribution mechanism and therefore isn’t such a key OCA criterion, also one should appreciate that country-specific shocks will still occur regardless of forming a MU. In practice such a system isn’t a complete solution and would only be a temporary response to asymmetric shocks within the monetary union.
OCA theory outlines the requirements for a successful monetary union but in practice the euro-zone doesn’t quite meet all the mentioned conditions. Labour mobility in the euro-zone when compared to the USA is relatively poor as displayed in figure 2 it shows Annual US interstate labour mobility to sit at 2.3% which isn’t extremely high but when compared to that of cross-border labour mobility of the EU-15 which is equal to just 0.2% it’s clear there is a lack of migration between nations in the euro-zone, meaning that the ability to adjust to asymmetric shocks through migration in this region is in practice limited.
Figure 2- Labour Mobility US vs. Europe. (The Atlantic 2012).
This is due to many structural barriers remaining and preventing a large increase in intra-European labour mobility. One of the key factors limiting the increase is the need for language skills in certain occupations in countries, as a result euro-zone citizens are mostly migrating to countries with similar or the same languages thus restricting the migration to unrelated language nations and therefore overall labour mobility in the euro-zone. This issue was demonstrated between 2008-2013 in Spain, where the number of unemployed people rose 3.5 million, whereas there was net migration of just 180,000 people thus indicating that migration didn’t help Spain adjust to an asymmetric shock. (Ehmer 2017). Therefore, concluding that currently cross-border migration in the euro-zone isn’t high enough to have the adjustment impact desired, however in the future if structural and cultural barriers are alleviated it’s possible for labour mobility in the region to improve and therefore reduce the impact of asymmetric shocks here.
Wage and Price flexibility in practice in the euro-zone is varied between the nations inside. Due to a fixed nominal exchange rate, changes to the price level is the only way in which members of the euro-zone can correct real exchange rate misalignments. Crowley (2013b, p .32) looks at variation in wage flexibility across the euro-zone: Measuring based on nominal wage growth versus productivity growth in the period 2000-2008 mixed results are found for Euro-zone Members. In this period nominal wage growth for Greece, Ireland, Spain and Portugal was greater than their growth in productivity levels. Wage growth in Austria and Belgium was in line with productivity growth, German growth in productivity during this period outweighed its growth in nominal wages.
Proving that price and wage flexibility within the MU is truly varied. However, because of this when the 2008 crisis came around many peripheral nations had unit labour costs and prices out of line with that of core nations, consequently they faced tough adjustment issues and therefore responded to the asymmetric shock poorly. The cause of said variation is due to differences in labour markets and sticky wages meaning adjustment to shocks aren’t as rapid nor effective as desired. Furthermore, for flexible wage rates to be effective there must be two conditions satisfied, firstly if monetary policy cannot react appropriately due to there being centralised policy controlled by the European Central Bank (ECB), deflationary pressures from lower wages lead to higher real interest rates, secondly high debts and downward wages damage consumption and therefore they both collectively damage the economy.
Furthermore, this shows that the conditions for flexible wage rates in the euro-zone don’t exist enough and it isn’t correct to say flexible wages aren’t an effective adjustment mechanism it’s simply the case the euro-zone does not meet the conditions for this OCA criterion in practice.A risk-sharing system in the euro-zone is theoretically not possible as there is a no-bailout clause in the Stability and Growth Pact meaning fiscal transfers are not permitted. However, this policy soon became redundant in April of 2010 when the sovereign debt crisis arose and bailouts took place, thus giving evidence of the euro-zone failing to satisfy the criteria for a successful OCA. Because of the crisis there was discussion that the European Monetary Union (EMU) should account for risk-sharing policies much more than just the current bailout system given that the EU budget sits at just under 1.5% of GDP, when compared to the US federal budget of 33%.
(Crowley 2013c). It’s evident that the euro-zone lacks a risk-sharing system between member states but in practice asymmetry within nations is greater than the asymmetry between states therefore indicating that a national fiscal mechanism in each country should suffice in most cases but for when country’s suffer from asymmetric shocks on an extremely large scale such as in the sovereign debt crisis then fiscal transfers as a means of risk-sharing is permitted. Although it should be noted that the flexibility of national budgetary policies in the EMU is severely lacking and can therefore create further asymmetric risk within the MU. Consequently, it can be said that the euro-zone in practice doesn’t meet this criterion fully currently due to it only offering a bailout policy in times of extreme economic hardship, a lack of cross border fiscal federalism and the Stability and Growth Pact causing risk that capacity of national budgets to function as automatic stabilizers during recessions is hampered, collectively demonstrating the lack of a risk-sharing system within the MU.
In terms of synchronised business cycles this criterion is hard to fulfil especially in the euro-zone’s case where it’s a group of different nations with varying exports, labour flexibility and other structural differences. Figure 3- Change in GDP per capita, 2002-2011. (Koziara 2013) The data set shows growth or decline in GDP per capita, assuming constant prices in USD from 2002-2011. The data set shows there to be significant divergences in growth in this region despite an average at 5.76% there are differences of up to nearly 17% points as shown by Italy and Germany. This data set shows that on average the euro-zone isn’t too unsynchronised considering the type of MU it is, here only two out of nine nations experiencing a decline in GDP per capita thus indicating business cycles and growth in the euro-zone during this period was synchronised in terms of growth or decline however in terms of size of growth in GDP per capita this isn’t as synchronised.
Although it can be said that the euro-zone is relatively successful at meeting this criterion given each member state has such varying internal characteristics such as employment and export type, but when compared to the USA it can be said the EMU isn’t successfully meeting this criterion therefore it can be concluded that depending on how one compares the EMU is how one can determine how successful it is a meeting this specific criterion. When it’s analysed ignoring other MU’s and the degree of economic variation is considered it’s successful, when compared to another MU such as the USA it is said to be unsuccessful therefore one should be careful using said criterion to evaluate success of MU in question. Capital in the euro-zone is relatively mobile since the integration of capital markets throughout a currency area is required for correct transmission of monetary policy by the ECB.
Therefore, in conclusion when assessing OCA theory, it is clear there are several key criterions that must be met in order for the benefits to outweigh the costs although for some criterions such as wage flexibility and synchronised business cycles analysis should appreciate the type of MU the euro-zone is before saying whether it does successfully meet it to produce a more valuable conclusion. With this said on the evidence and analysis presented it indicates that the euro-zone is not a successful OCA due to continuing asymmetries between member states in terms of wage and price flexibility, poor labour mobility because of cultural and structures variations in the region, a lack of fiscal transfers and varying rates of economic growth. Consequently, mechanisms of adjustment are less effective in the euro-zone and initial conditions for making shocks more symmetric didn’t exist, this combined with greater industrial specialisation because of the common currency, collectively made the region prone to asymmetric shocks and furthermore slow to adjust to them if at all when they occur. The economic stability loss from forming this monetary union, foregoing exchange rates and national monetary policy is greater than the efficiency gains, this is especially true in European periphery nations.
For it to become more successful barriers prohibiting labour mobility must be removed and time must be allowed for economic integration to develop out of its infancy stage to help the euro-zone become more resistant to adverse macroeconomic disturbances in the future.