OPTIMUM CURRENCY AREA

Soyisile Dlulane 201127781

0

OPTIMUM CURRENCY AREA: Lessons from

the European Monetary Union (EMU)

Report submitted in partial fulfilment of a B com honours

In

INVESTMENT MANAGEMENT

In the

DEPARTMENT OF FINANCE AND INVESTMENT MANAGEMENT

Of the

UNIVERSITY OF JOHANNESBURG

By

Soyisile Dlulane

(201127781)

19 October 2012

http://www.uj.ac.za/


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Abstract:

The theory of optimum currency area (OCA) has been a study of monetary

integration since the 1960s. The theory tries to answer an exchange rate based

question; what is an optimum currency area and/or what is a decision process for

defining such an area. Since the developments of economic and monetary

integration in the European region, the theory of optimum currency area has been

revisited and referenced with the ambitions to address a number of questions,

including whether a single European currency will ever come to operation. Post 1999

after the succession of the last stage towards the European Monetary Union (EMU)

this theory has been applied in defining the sustainability of the EMU, whether the

EMU is an optimum currency area.

This study objectively address the very same question, is the European monetary

union an optimum currency area? The motivation for this study has been the

transpired European debt crisis of 2008-2011. We develop our arguments by

comparing the construction and operation of the EMU (which is filled with flaws that

are believed to have led to the continuous spreading of the Euro debt crisis) to the

history of monetary unions based on the theory of optimal currency union.

It has been noted that the OCA theory has evolved since the 1960s.Though the

pioneering views are still very applicable, the modern views suggest that the decision

process for defining an optimum currency area does not conclude with a yes or no

answer, but is a developing process that increasingly benefits the parties within the

union. This was supported by the history of the monetary unions (with reference to

the United States of America Monetary Union).

The European Monetary Union (EMU) was found to be aligned with this trend.


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Table of contents

Abstract........................................................................................................................1

Study objectives...........................................................................................................3

Relevance of the study................................................................................................3

Methodology................................................................................................................3

Chapter 1: Theory of optimum currency

1.1 Introduction.................................................................................................5

1.2 The history of optimum currency area........................................................6

1.3 The pioneering phase.................................................................................7

1.4 The modern phase......................................................................................9

1.5 The benefits and costs of joining a monetary union..................................11

1.6 Summary...................................................................................................12

Chapter 2: The creation of monetary unions (lessons from history)

2.1 Introduction...............................................................................................13

2.2 National monetary unions.........................................................................13

2.3 Multinational monetary unions..................................................................14

2.4 Why are monetary unions created and dissolved.....................................14

2.5 Summary...................................................................................................15

Chapter 3: European monetary union

3.1 Introduction...............................................................................................16

3.2 The construction and operation of EMU...................................................17

3.3 The observations of the EMU with reference to the OCA theory..............21

3.4 The future of the EMU (The lessons from creation of monetary unions).25

3.5 Summary...................................................................................................26

Chapter 4: Conclusion............................................................................................27

Bibliography


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Study objectives:

The objective of this study is to discuss the lessons from the shortcomings (costs

and benefits) in the construction and operation of European Monetary Union (EMU)

and thus use the lessons to discover if EMU is an optimum currency area.

In this study the costs and benefits of a monetary union are defined by the theory of

Optimum Currency Area (OCA). A benefiting monetary integration is one that its

construction and operations fulfil the following OCA properties; price and wage

flexibility, production and mobility factors, the degree of economic openness, the

diversification in production and consumption, fiscal integration, and political

integration. Such a currency area is thus deemed an optimum currency area.

Relevance of the study:

The world has been operating under globalised production processes. Many

commentators see a future of global finance and resulting into a global currency. The

creation of the European Monetary Union, after it had been opposed by many

because it is not an optimum currency area, has sparked views that a global

currency will soon two follow even though the world is not an optimum currency area.

Hence the question to be answered is whether there will be benefits for joining a

non optimum currency area, and will it converge to an optimum currency area in

future. The European Monetary Union is the perfect set-up to answer these

questions.

Methodology:

As mentioned above, the objective of this study is to discuss the lessons from the

shortcomings (costs and benefits) in the construction and operation of European

Monetary Union (EMU) and thus use the lessons to discover if EMU is an optimum

currency area. A wide range of literature was the source of this study.

In chapter one, the theory of optimum currency area is discussed. The chapter is

divided into four sections. Section two is the history of optimum currency, where we

discuss the pioneers of the theory. Section three discusses the first developments of

the theory. Section four presents the modern phase of the theory where we discuss


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how the theory has evolved. The last section of the chapter discusses the benefits

and costs of joining a monetary union as suggested by the theory.

Chapter two presents the history of monetary unions, aimed at discussing the

lessons from the historical monetary unions those that have been created and

dissolved, and as well as distinguishing between the two types of monetary unions

(national and multinational monetary unions). The chapter is divided into three

sections. Section two present the national monetary unions, where the United States

monetary union is discussed. Section three presents multinational monetary unions.

Section three we discuss lessons from history why are monetary unions created and

dissolved.

In chapter three, the European Monetary Union (EMU) is discussed with a focus on

its construction and operation. The aim of the chapter is to reflect the set-up of the

EMU (construction and operation) to the OCA theory and the lessons from the

history of monetary unions, while providing empirical evidence from the Euro depth

crisis. Section two presents the construction and operation of the EMU according to

the Maastricht treaty convergence criteria. The shortcomings to the construction are

discussed and evidenced by discussing the impact of the debt crisis. Section three is

the observation of the EMU according to the properties of the OCA theory. We

discuss how the EMU has achieved these properties in order to define if it is an

optimum currency area. Section four is the future of EMU as per lessons from the

history of monetary unions. This section we discuss if the EMU will converge to an

optimum currency area.

Chapter four presents the conclusions.


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Chapter 1: Theory of Optimum Currency Area

1.1 Introduction

Optimum currency area (OCA) is a term that was first introduced in Mundell 1961 to

define a geographical region that would maximize economic efficiency through

integration of monetary operations. The integration of monetary operations is defined

by Mundell as the adoption of a single currency or several currencies whose

exchange rates are pegged. The theory of optimum currency area presents

properties which are used as gauge measures for determining the probability of a

geographic region (optimum currency area) forming a successful monetary

integration and hence maximizing economically, by reducing shocks impact

(economic disequilibrium) to the region. The probability of success for a monetary

integrated geographic region is based on the regions balance of benefits and costs

and measured by the properties of OCA theory.

The theory relating to monetary integration was first talked about around 1950 during

the debates of fixed versus floating exchange rate regimes. Economist such as

Mundell, Friedman and Meade debated the benefits and cost of alternative exchange

rate regimes to achieve external balances, free policy tools, obsolete of trading and

exchange controls. These discussions presented two types of regional monetary

integration (1) national and (2) multinational monetary integration.

However as was in 1950, an optimum currency area (as defined above) is still a

very ambiguous region even with today’s developments of the theory referencing the

practicality of European Monetary Union (EMU).

This chapter discusses the theory of Optimum Currency Area. The chapter is divided

into four sections. The first section overviews the history of the OCA theory. The

second section discusses the pioneering phase of the OCA theory. The third section

discusses the new views of the OCA properties, and finally from the development of

the OCA theory we present the benefits and costs of joining a monetary union.


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1.2 The history of Optimum Currency Area.

In 1950 under the Bretton Woods system of fixed exchange rates began the debates

by economists such as James Meade (1957), Milton Friedman (1953), Robert

Mundell (1961) McKinnon (1963) and Kenen (1969). The debates were encouraged

by the need for free policing and free capital controls for better balance of payments,

free trading and exchange rate controls. Pegged and adjustable exchange rates

were some of the characteristics of the Bretton Woods exchange rate regime. Hence

the question of optimum national and multinational exchange rate regimes was

asked.

James Meade (1957) and Milton Friedman (1953) both endorsed the idea of flexible

exchange rates suggesting that flexible exchange rates are a device for achieving

external balance while freeing policy tools for the implementation of nation planning

objectives and getting rid of exchange rate and trade controls (Mundell, 1997).

Robert Mundell however disagreed with the idea of using exchange rates as a

mechanism of economic management, suggesting a need for mechanism that

results into minimum adjustment of exchange rates. Mundell, 1958 argued that the

Canadian dollar which was then floating was still implicated by the United States of

America’s (USA) business cycle.

In 1953 Maltin Friedman published his paper “the case for flexible exchange rates”

which is attributed to have influenced the exchange rate views to be latter known as

OCA theory.

In 1961 Robert Mundell published his work titled “the optimum currency area”. In this

paper Mundell proposed the joining of countries by a single currency or by fixed

exchange rate regime (several currencies pegged), but only for those countries that

fit a set of properties that he named the OCA theory.

The development of OCA theory is divided into two phases, the pioneering phase

(1950), and the Morden phase of starting from early 1990.


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1.3 The pioneering phase

The pioneering phase is the period between the mid 1950s and the late 1970s. This

period in the history of economics was characterised by debates of fixed versus

flexible exchange rate regimes. The division between those who endorsed fixed

exchange rates (Milton Friedman) and those who endorsed flexible exchange rate

regimes (Robert Mundell) encouraged the question of “what is the optimum

exchange rate regime for a given country”.

Mundell 1961 was the first to suggest that the currency area does not necessary

have to be a country but a geographic region whose borders need not necessary

coincide with country boarders and such a region would have permanently fixed

exchange rates, hence achieve economic rebalancing following disturbance (shock)

without the use of exchange rate policy adjustment instead using OCA properties.

The theory of optimum currency area is the decision to form a currency area by

adopting a single currency or several currencies whose exchange rates are pegged.

The optimality of a currency area is the degree to which it satisfies the following

proprieties;

a. Price and wage flexibility.

Price and wage flexibility defines the stickiness of trading between countries, and

the determining factor of inflation and employment balances. Mongelli 2002

suggest when nominal prices and wages are downward flexible between and

among countries contemplating a monetary integration, the transition towards

adjustment is less likely to be associated with sustained unemployment in one

country and/or inflation in another. According to Friedman 1953 achieving price

and wage flexibility between two countries would in turn diminish the need for

exchange rate adjustment.

b. Mobility factors (labour and production).

Mundell emphasised on labour mobility as the most important mechanism to

restore equilibrium in a monetary integrated region, and very dependent on the

size of the region. He illustrates factor mobility with the used of an example

between two regions (region A and region B) by suggesting, at prevailing market


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shocks there is a shift in demand for region A products towards region B

products, therefore creating inflation in region B and unemployment in region A.

Using exchange rate regimes to restore equilibrium sacrifices one region for the

other, while using labour mobility would only need a shift of region A’s labour to

region B. Corden 1972 questioned the practicality of labour mobility based on

cost, and difference in language and culture between the two regions.

Further development of this property was presented by McKinnon (1963) by

distinguishing mobility into labour and production. Suggesting production mobility

would restore equilibrium in regions A and B, by developing region B products in

region A.

c. The degree of economic openness.

Broz 2005 defines economic openness as the enabling factor for transmission of

international exchange rates to domestic cost of living, hence reducing money

illusion in the wages contracts and prices given that the currency regions are at

flexible exchange rate regime with the world.

Economic openness according to Broz (2005) can fully be achieved to the degree

required for fixing exchange rates (or monetary integrating), only by small

economies. He argues, it is often inefficient for a small economy to produce all it

needs, and advantageous to engage in foreign trade and produce only those

goods in which it has a competitive advantage, while this may create

specialisation. On the other hand, a large economy is more self sufficient and

usually marginally engaged in foreign trade, hence minimum economic openness

or less influence by international exchange rates.

d. Fiscal integration.

Fiscal integration is a public risk sharing arrangement. Public risk sharing allows

transfer of funds to a member of currency area affected by an adverse shock and

hence facilitating in the adjustment process that requires less monetary policy

(interest rate) variation. Bordo and Markeiwicz (2011) suggest that such

integration would require an advance degree of political integration and

willingness to undertake risk sharing withstanding possible moral hazards and

other operational difficulties.


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e. Political integration.

The political will to integrate is regarded as the stem of monetary unification. It is

defined as the similarity of policy attitudes among partner countries, including

monetary and fiscal policies. The imperial observations from the recent European

Monetary Union have streaked a new direction in political integration as a result

of its unique arrangement. This new direction calls for a new benchmark for

assessing the satisfaction of political integration. Mongelli 2002 presented this

new assessing benchmark as; (1) functional political integration, (2) transferred

sovereignty over several elements of the member’s economy, and (3) Increased

need for policy co-ordination.

1.4 The modern phase

Remarks on the pioneering theory of optimum currency area have been made, many

questioning the practicality of the monetary unification decision process proposed by

the theory. There questioning mainly due to the suggested ambiguousness of the

properties, the highly diverse economies of countries and hence a lack of practical

examples. Tavlas 1994 observed the problem of inconsistency and inconclusiveness

of the properties, Mongelli 2002, observed the problem of measuring and evaluating

the properties. Due to the above shortcomings of the OCA theory the 1960s to

1970s initial research interest decreased to a level of almost forgotten in the

literature of economics.

The birth of the European Monetary Union (EMU) in the 1990s brought back the

research interest on the topic of monetary integration, mainly to determine the cost

and benefits of countries joining the EMU.

The modern phase became an in-depth study of the application of the pioneering

phase Theory. “These economic developments (the EMU) have allowed the original

optimum currency area approach to be cast in a new light” (Tavlas, 1993). The

difference between the views about the OCA theory in the pioneering phase and the

modern phase is that the pioneering phase was a debated theory on potential cost of

monetary unification, while the latter is an empirical test on potential benefits of

monetary unification referred to as the endogeneity of OCA. Frankel and Rose


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(1997) are attributed as the biggest influence of what has evolved to modern OCA

theory.

There are multiple issues that the modern phase theory of optimum currency tries to

address in attempts to optimise the decision process of monetary unification,

including; endogeneity of OCA theory, effectiveness of monetary policy, credibility of

monetary policy, political factors. This study will focus on the endogeneity of OCA.

1.4.1 Endogeneity of OCA theory

The endogeneity of OCA theory is defined as a correlation study between countries

economic factors that are said to inspire monetary integration. These factors include;

the level of trade between the countries, the similarity of the stocks and business

cycles experienced between the countries, the degree of labour mobility, fiscal and

political will. The endogeneity of OCA theory concludes that there is an existing

interaction process or correlation between these factors, which suggests that

monetary integration is a self reinforcing process and hence the optimality/benefits of

a currency area increase with time. Frankel and Rose 1996 studied trade integration

and income correlation, see Figure 1.

Figure 1: Trade integration, income correction and OCA line

Source: Tanja Broz 2005

Sweden, UK,

Denmark

Advantages of

monetary

independence

dominate

Advantages of

common currency

dominate

EMU

US States

OCA line

Extent of trade among

members of group (x-axis)

Correlation of

income among

members of

group (y-axis)


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The downward sloping OCA line indicates that the advantages of adopting a

common currency depend positively on the level of trade and income correlation

between countries. Thus meaning if countries that trade a lot between them and

have a high income correlation they might find it advantageous to form a currency

area, and for those countries that are not advantageous to form a currency area

(below the OCA line) once they join the currency area further trade integration will

increase the income correlation and become an optimum currency area (move

above the OCA line). They concluded that countries could satisfy the OCA criteria

ex-post, even though they did not ex-ante.

1.5 The Benefits and costs of joining a monetary union

In the introduction of this chapter it was noted that OCA theory is a framework that

tries to systematically define the benefits and costs of joining a monetary union. The

depth of the chapter presented views from both the pioneering era and the modern

era of OCA theory. The difference and broadness of the views, regarding the correct

properties for measuring the optimality of a region, suggest that benefits and costs

are of varying profiles over time and thus cannot be measured statistically. However

the main benefits and costs can be classified as follows:

1.5.1 Benefits;

a. Benefits from improvements in microeconomic efficiency. This is a result of

one currency circulating over a wider area as a unit of account, medium of

exchange, standard of deferred payments and store of value. Thus increasing

liquidity, price transparency, while discouraging price discrimination and

promoting markets competition. Effectively the microeconomic

competitiveness strengthens the internal market for goods and services,

promotes trading, while lowering investment risks.

b. Benefits from increased macroeconomic stability. This is a result of improved

overall price stability, the access to broader and more transparent financial

markets increasing the availability of external financing. The increase of

symmetric shock within different markets of the currency area.

c. Benefits from positive external effects, as a result of savings on transaction

costs due to a wider international circulation of the single currency.


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1.5.2 Cost;

a. Costs from the deterioration in macroeconomic efficiency. The primary

objective of monetary unification is to share risk and reduce asymmetric

shocks. Hence it is only normal that a supra-national central bank is

established to manage monetary policies for the currency area. In the

presents of a central bank, therefore the main cost to national governments is

relinquishing monetary policy independence. In a monetary unification, no

country can pursue some real adjustment in the wake of asymmetric

disturbance. Therefore the cost of relinquishing monetary policy

independence depends critically on the nature of future shocks and

characteristics of the new economy.

1.5 Summary

The chapter presented the theory of optimum currency area, highlighting five

properties for the monetary integration decision process, and the modern theory. The

benefits and costs to members, in terms of OCA theory are defined as; benefits from

savings on transaction costs as a result of wider international circulation of the single

currency, and costs from giving up national monetary sovereignty.

Over the past 51 years since the pioneering views by Robert Mundell, the theory has

evolved and focused on the empirical evidence from the European Monetary Union.

The pioneering theory is still adopted in defining currency areas. The overall OCA

theory is still very limited, ambiguous and thus still much challenged in its application

to measure the cost and benefits for joining a currency area. The modern phase

theory has discovered that even non optimum countries wanting to form a monetary

integration can proceed and form a currency area as their optimality will increase

with time, due to increased correlation between members economic factors.


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Chapter 2: The creation of monetary unions (Lessons from history)

2.1 Introduction

A monetary union or currency area is the extreme version of a fixed exchange rate

regime. The essence of a monetary union is that all the member states adopt the

same currency as a unit of account, medium of exchange and store of value. This

implies that the monetary union has one exchange rate towards the rest of the world.

The history of monetary unification dates back to the 19th century and is rooted in the

history of political cohesion. For example after the American revolutionary war which

generated problems of exchange rate risk, and high transactions cots, led to the

creation of the US monetary union. The political will to create an independent

Germany resulting from the creation of a German currency.

The history of monetary unions is best understood by making a distinction between

national and multinational monetary unions.

2.2 National monetary unions

A national monetary union can be distinguished by the rule of single monetary

authority, usually a central bank. In a national monetary union political and monetary

sovereignty are the basis rational for wanting to establish a monetary union, and

hence national monetary union is mostly at best interest for the parties.

a. The united states of monetary union (USMU)

The United States of America is often forgotten that it is a monetary union, which has

been through multiple shocks resulting to its dissolution (1861) and finally reuniting in

1879. The sustaining of the union from a non optimum currency area to an optimum

currency as we know it today is attributed to integrated political will.

Prior the revolutionary war (1776 – 1783) the currency of the United States varied in

every state. After the war, as a result of exchange rate risk and high transactions

costs, states paper money was banded. In 1789 the United States Monetary Union

(USMU) was created by the signing of the constitution. The constitution gave the

congress the sole power to issue money and regulation of its value. The USMU

experienced are number of shocks, including 1837 banking crisis and 1839


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recession. It was only until 1861 during the Civil war that the USMU dissolved, and

reunited in 1879 to gold standards. After this period the USMU faced a number of

political related oppositions and economic pressures, the 1890 and 1930 great

depressions.

2.3 Multinational monetary unions

A multinational monetary union is an international monetary arrangement between

independent countries based on permanently fixed exchange rates between their

currencies. Multinational monetary unions occur when independent nation states link

their monies together through a perfectly fixed exchange rate so that one member’s

money is perfectly exchangeable for another member’s at a fixed price. An extreme

example of this would be that all member states use the same currency.

Some of the historical examples of multinational monetary unions are;

a. The Latin Monetary Union

b. The Scandinavian Monetary Union

2.4 Why are monetary unions created and dissolved

Monetary unions have been created and dissolved for a number of reasons this is

evident in the entire history of monetary unions. Multinational union brake ups have

been the most common. Multinational union brake ups cost less due to already

established members central banks and domestic currencies. The process proves to

be much costly for national unions and thus such brake ups have been minimal.

From the lessons in history of monetary unions, the creation of monetary unions is

inspired by one of the following factors (and thus dissolved when they are violated);

a. Political integration

Political integration is mainly the reason for national monetary unions.

b. Economic reasons

Economic reasons include transaction costs, trade benefits, and wider

markets. Economic reasons inspire both national and multinational monetary

unions.

c. Non economic reasons (demographics)

This includes, common history, a common language, culture and religion, and

greatly inspires multinational unions.


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2.5 Summary

In this chapter we presented the lessons from the history of monetary unions. The

main focus was to use the history of the United Sates monetary union to illustrate

how a monetary union evolves over time. The most important lesson from this

chapter is that, the difference between sustaining and dissolution of a monetary

union is positively related to the degree of political integration, economic reasons

and demographic reasons.

The history of the United States monetary union shows that benefits of monetary

integration increase with time, which is supportive of the OCA theory endogeneity

presented in section 1.4.1.


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Chapter 3: European Monetary Union

3.1 Introduction

The history of the European region up until the end of the Second World War was

dominated by power disputes over the countries. This era saw large areas of Europe

being united by empires built on force, such as the Roman Empire, Frankish Empire

and later the Nazi Germany. In many cases these power disputes resulted into wars

that would later have greater cost to the region. Thus unity by peace had been

inspired within many countries of the region before the idea of European region.

Post the Second World War, European leaders in many ways had acknowledged the

negative impact of non-unity in the region, including labour costs, industrial and food

costs and the future of monetary stability post the dissolving of the Brent Wood

standard of fixed rates.

The European leaders of the era 1945 – 1957 learning from the United States of

America (which post the Second World War dissolved its monetary unity but

remained politically united) were inspired to achieve political unity rather than

monetary unity. Effectively political unity would preserve peace and ensure to never

have wars. The first call for such action was the treaty of Paris (1951) creating the

European Coal and Steel Community and establishing the very first European unity

comprising six countries. The Merger treaty which was signed in 1965 creating a

community of shared courts and common assembly.

These are pioneering developments that have inspired the current European

Monetary Union. They signify how the construction and operation of unity has

evolved over time compared to the current Maastricht treaty (1993). The construction

and operation of treaty of Paris and Merger treaty called for political unity, but the

Maastricht treaty entitles political independency under monetary unity.


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3.2 Construction and operation of the European Monetary Union.

In its construction the EMU has been very unique compared to historical monetary

unions. The first stumble regarding the EMU is whether it should be classified as a

national or multinational monetary union. The European Monetary Union was

created by the signing of the Maastricht treaty in 1993. The Maastricht treaty is made

up of five convergence criteria, which defines the benchmark that only European

region countries must comply by in order to join the EMU.

Maastricht Treaty;

a. Each country's rate of inflation must be no more than 1.5 above the average

of the lowest three inflation rates in the European Monetary System (EMS).

b. Its long-term interest rates must be within 2% of the same three countries

chosen for the previous condition

c. It must have been a member of the narrow band of fluctuation of the ERM for

at least two years without realignment.

d. its budget deficit must not be regarded as 'excessive' by the European

Council, with 'excessive' defined to be where deficits are greater than 3% of

GDP for reasons other than those of a 'temporary' or 'exceptional' nature.

e. Its national debt must not be 'excessive', defined as where it is above 60% of

GDP and is not declining at a 'satisfactory' pace.

3.2.1 Shortcomings of the European Monetary Union

Economists have pointed to a number of shortcomings, also termed, flaws or

potential fault lines in the construction of EMU. There are by now a multiply areas of

concern in the EMU that have become transparent as the result of the European

debt crisis. In this study we only focus on the most common flaws, those that pertain

to the EMU once it was established and are believed to have resulted to the

spreading of the European debt crisis.

a. Lack of authoritative power.

EMU lacks a central authority to supervise the financial systems, including the

commercial banks, of Europe. The Maastricht treaty gives the ECB some


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supervisory functions but they are primarily the task of the union members.

This state of affairs remarks that a European financial crisis may not be

efficiently resolved, consequently threatening the sustainability of the

European Monetary Union. Lessons from the recent European debt crisis the

inefficiency of resolving was evident when it took months for a consensus

decision among national leaders to be reached and prevent the asymmetric

shock spread.

b. Lack of lender of last resort

The ECB has not been granted power by the Maastricht treaty to serve as a

central lender of last resort. This stands in sharp contrast with modern central

banks, which exercise lender of last resort responsibilities to guarantee the

liquidity and functioning of the payments system. During the out brake of the

European debt crisis in 2010 the European Financial Stability facility (EFSF) was

created with €1 trillion aimed to prevent the collapse of member’s economy, and

future shadowing the accountability of the ECB.

c. Danger of members political interest

According to the Maastricht treaty the exchange rate policies for the EMU are

to be set by the council of the European Union which is made up off the

financial ministers of each member of the EMU. Bordo 1999 suggest that this

invites danger that will result in political discussion, tensions and political

pressure on monetary policies.

d. Lack of fiscal unity

The absence of central co-ordination of fiscal policies within EMU in

combination with strict convergence criteria for domestic debt and deficits, as

set out in the Maastricht rules implies that EMU will not be able to respond to

asymmetric shocks in a satisfactory way. In most cases in literature non fiscal

integration is referred to a lack of public risk sharing arrangement. According

to Bordo and Markeiwicz (2011) there is a positive relation between monetary

and fiscal policies, thus requiring a single independent body to manage both.

They argued that the arrangements of historical monetary unions have given


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the Central bank the responsibility of both monetary and fiscal policies, which

makes the European Monetary Union a unique and unprecedented set-up.

e. EMU not an optimum currency

This point has been acknowledged by most researches beyond 1999

highlighting that Europe is too large a geographical area to unify optimally

based on the theory of optimum currency. Yuceol, 2002 concluded that the

efficiency gains from increased trade do not outweigh the costs of

surrendering control over national monetary policies. Off course the European

Monetary union has expanded the membership post the European debt crisis,

to current 27 countries. However the point suggested by Yuceol (2002) was

very evident in the case of Ireland. Ireland achieved gains after joining the

EMU in the form of debt to GDP ratio declining steadily from 65% in 1997 to

25% in 2007, hence being one of the EMU countries with the lowest public

debt burden. In the pick of 2008 its debt to GDP ratio balloon from 25% in

2007 to 95% in 2010, proving to outweigh the early gains.

3.2.2 Empirical evidence from the 2008 – 2011 European debt crises.

It is often assumed that the European debt crisis was primarily a result of

government spending. Really, the origins of the European debt crisis can be directly

traced back to the global financial crisis of 2007-2010, which spilled over into a debt

crisis in several European countries in early 2008.

Based on this observation the interest of this section is to present the empirical

evidence of the theatrical flaws of the European Monetary Union presented above.

The most highlighted shortcoming of EMU in recent literature is the lack of unified

fiscal policy structures such as common taxations, budget, and pension and treasury

functions. The lack of such fiscal policy structures is argued to have been the reason

the global economic shock of 2007-2010 established it’s self in the European

economy as asymmetric shocks that resulted to different consequence to countries

within the EMU.

According to theory of optimum currency area integrated fiscal policies for adjusting

from asymmetric shocks is one of the main criteria for joining a monetary union,


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because it stems on political integration. As a result of lack of integrated fiscal

regulation, the member countries of EMU continue to exercise considerable

sovereignty in several economic areas. The most important ones are the budgetary

and taxation. As a result, asymmetric shocks were created that lead to inflated

budget deficits.

The increasing budget deficits

In the Maastricht treaty one of the convergence criteria is to limit budget deficit to not

exceed 3% GDP. However due to the independent fiscal regulation countries

including Greece and Italy, were able to by-pass these rules and hide their deficit

and debt levels through the use of complex currency and credit derivatives

structures. The structures were designed by prominent U.S. investment banks. As a

result, between 2007 and 2010, the debt to GDP ratio of the European region

increased from 66% to 85% (Figures 2)

Figure 2: Public debt as a percentage of the GDP (1995 – 2010)

Source: Ulrich Volz 2012

Figure 2 shows that the level of Greek debt was already very high before the global

crisis, at 105% of GDP in 1999. Greek debt, which has been on a continuous rise

http://en.wikipedia.org/wiki/Credit_derivative

http://en.wikipedia.org/wiki/Investment_banks


21

since 2003, reached a level of 150% of GDP in 2010. Similar to Greece, Italy had a

debt level above 100% of GDP prior to the crisis, but unlike in the case of Greece the

debt to GDP ratio of Italy fell between joining of the euro in 1999 and 2007.

On the brake of the Irish banking crisis in 2008 as a result of Irish government put

under pressure over €440 billion worth of liabilities. As a consequence, the Irish

deficit ballooned and the debt to GDP ratio shot up from 25% in 2007 to 95% in

2010. However in the history of Ireland there had never been any fiscal or debt

problem until 2008, which shows the cost of joining a monetary union. Accordingly

from figure 2 the Irish debt to GDP ratio declined steadily from 65% in 1997 to 25%

in 2007, hence being one of the EMU countries with the lowest public debt burden.

Spain very similar to Ireland it had never recorded fiscal or depth problem up until

2008. Spain was one of the countries at the time that had not violated the Maastricht

treaty rules, have an annual budget deficit no higher than 3% of GDP and a national

debt lower than 60% of GDP. The circumstance occurring in Spain could be

explained as the repercussions of the asymmetric shocks in the European economy

resulting from global crisis.

3.3 The observations of the EMU with reference to the OCA theory

In this section we discuss the construction of EMU with respect to the optimum

currency area presented in chapter 1. The objective of this study is based on this

section, to observe the EMU under the debt crisis circumstances with respect to the

OCA theory and compare with similar circumstances that the history of monetary

unions experienced.

a. Price wage flexibility

In chapter 1, Price and wage flexibility was defined as the stickiness of trading

between countries, and the determining factor of inflation and employment

balances. It was also noted that in the existence of price-wage flexibility, the

need of varying fiscal policies to adjust for shock is minimal.

The concept of price and wage flexibility can be better understood through

analysis of interest rates between the members of the Union. Figure 3 shows

long term interest rates between 2009 and 2012, and a reflection of the


22

attempt by the ECB to reduce the debt crisis through fiscal changes. The

proposed fiscal plan was to change tax and interest rate regulations to only

those countries that were suffering from budget deficits. In theory this plan

would increase trading or price wage stickiness between the members and

thus exacerbating the impact of asymmetric shock. This is because there is a

positive link between fiscal policies and employment legislations.

Comparing the EMU to historical monetary unions, Mongelli (2002) concluded

that the United States of America Monetary Union (USAMU) achieved a better

position in flexing prices and wages, while experiencing similar shocks, than

what the EMU has achieved.

Figure 3: Long-term interest rates (2009 – 2012)

b. Labour market integration

Labour mobility was defined as the ability of the currency area to migrate the

labour force from regions of low growth to regions of high growth, while in the

process off-setting shock impact, and minimising the need for fiscal

interventions. In the case of the EMU this factor is very unlikely to ever be

achieved. This is due to the lack of homogeneity in the demographics of the

http://en.wikipedia.org/wiki/File:Long_term_interest_rates.png


23

European Monetary Union. Language, wages and employment being the

most important factors towards achieving labour integration. Figure 4 shows

labour cost in the European Union and positively argues the point that labour

integration is unlikely to be achieved within the near future. For example

assuming homogeneity in other factors (including language) except for labour

costs, thus moving Italian labour force to Germany would prove more

problematic. The Contrast between the EMU and historical monetary unions

(USAMU) is that, the EMU was unable to make use of labour mobility to

manage the shock of debt crisis.

Figure 4: Labour cost among EMU members (2000 – 2010)

c. The degree of economic openness

Economic openness is a factor for transmitting international exchange rates to

domestic cost of living, hence reducing money illusion in the wages contracts and


24

prices given that the currency regions are at flexible exchange rate regime with

the world. Mongelli 2002 found that, economic openness as measured by the

ratio of exports plus imports of goods and services to GDP is quite high across all

European countries. De Grauwe 2011 reported that the ratio of exports plus

imports to GDP ranges from 40 percent in Spain, to over 150 percent in

Luxemburg, and compared with 65 percent to over 210 percent between the

states of USA.

d. Fiscal integration

Fiscal arrangement of the EMU has been under enormous heat ever since the

Euro-debt crisis. Prior to the Euro crisis some economist argued that the fiscal

integration of EMU was the best fitting arrangement for such a monetary

arrangement. These economists suggested that due to the type of

arrangement the EMU is, as set out in the Maastricht treaty. Therefore its

fiscal integration was of two folds; (1) fiscal convergence, and (2) fiscal unity

(public risk sharing factor). Fiscal convergence is the benchmark to be

satisfied in order to join the EMU, including having an annual budget deficit no

higher than 3% of GDP and a national debt lower than 60% of GDP. Thus

because of fiscal convergence fully achieved by members and continuously

monitored the latter (public risk sharing factor) could be a responsibility of

countries.

The contrast to this is what transpired as a result of the Euro crisis. Firstly,

fiscal convergence was violated by many countries, and secondly the crisis

was managed through bailout (federal governmental budget), which is a form

of fiscal unity. This shows the significance of having a fiscal integration based

on fiscal unity. According to the history of monetary unions, monetary

unification does not best benefit member without fiscal unity.

e. Political integration

The history of monetary unions has shown that political integration is the most

important property of OCA theory. From the history of monetary unions we

concluded that, the sustaining and dissolving of monetary unions had been


25

mainly influenced by the political will. Political will in most cases insures,

compliance with joint commitments, sustains co-operation on various

economic policies, and encourages more institutional linkages.

The European Monetary Union has shown positives signs on political

integration, as a result of minimal differences in policy preferences to save

Greece, Ireland, Italy, Portugal and Spain from the Euro depth crisis.

According to Bordo and Jonung (1999), the convergence criteria set by the

Maastricht treaty is difficult for many countries to satisfy, thus needing political

integration. Base on this point Jonung (1999) concluded that the EMU

achieved political integration set out in the OCA theory.

In the introduction of this chapter we pointed that the desire for the European

Union had change since the pioneering fathers of the idea, from political will to

monetary will. This is due to the current framework governing the EMU, which

allows political sovereignty for joining members. Based on this, the degree to

which the EMU satisfies the political integration property has been

questioned. In resent literature political integration has since been assessed

different with different benchmarks.

3.4 The future of the EMU (The lessons from creation of monetary unions)

In the history of monetary unions we learnt that monetary unions are classified either

as national or multinational monetary unions. The case of the EMU was noted as

very unique and unprecedented in history of monetary unions. However the

Maastricht treaty criterion puts the EMU closer to a national monetary union than to a

multinational union. Most obvious reasons are, the EMU has a common central bank

(ECB) that issues the only circulating money in the Euro-region and holds

accountability for monetary policy. The previous central banks of the members of

EMU have been diminished and their membership is permanent.

Therefore we are more inclined to believe that the EMU holds close ties to the United

States monetary union.

a. The EMU will dissolve from major shocks

In the history of monetary unions we discussed that the United States

monetary union (USMU) went through a number of challenges, including


26

political disputes during the Civil war that resulted to it first dissolution, and

after reuniting was hit by the 1930s great recession. The USMU until this day

remains intact as a result of retained political integration. In that case the EMU

can as well with stand any shocks as long as they don’t result into political

disputes.

b. The EMU will not be an optimum currency area

In chapter one we learnt from the modern phase of OCA theory, that over time

the benefits of joining a monetary union will over weigh the costs, and thus

converging the union into an optimum currency area. This idea is very evident

in how the United States monetary union evolved over time to being classified

as an optimum currency area. Even though we classify the European

Monetary Union as a non optimum currency area, because it currently does

not achieve any of the OCA properties, we can argue that should it retain its

political integration and remain intact as the United States Monetary Union

did, it will converge to an optimum currency in the future.

3.5 Summary

In this chapter we have weighed the benefits to costs of the European Monetary

Unification, presented as the shortcomings of construction and operation of EMU,

based on the OCA theory and compared to the history of monetary unions. We

focused our analysis on the effects of the Euro-debt crisis to show the empirical

evidence of the shortcomings of EMU suggested in theory. The European Monetary

Union has been acknowledged as a very unique set-up and thus not obvious of

whether it is a national or multinational monetary union.

On its first economic shock what has been prevalent is the real existence of flaws in

the construction of the EMU. These include, the lack of authoritative power, fiscal

unity and not an optimum currency are. Evidence provided in section 3.2 where we

show how the Euro-depth crisis evolved as asymmetric shock thus spreading to

most parts of the European region as a result of lack in above monetary factors.

The optimally of the EMU in section 3.3 is discussed showing that, price wage

flexibility has not yet been achieved, labour mobility factor is very low compared to


27

the historical monetary unions as a result of heterogeneity in demographic factors.

Fiscal integration still lacks fiscal unity and thus not achieved. Similar political

integration lacks political will towards forming the EMU and thus also not achieved.

Chapter 4: Conclusion

The theory of optimum currency area lacks direction and clarity in measuring

benefits and costs from joining a monetary union.

The properties in the theory are still the only criteria for measuring benefits

and costs, and prove that benefits will over weigh cost over time.

The European Monetary union does not achieve any of the OCA theory

properties discussed in this study for defining a benefiting monetary

unification. Thus is not an optimum currency area.

The European Monetary Union will follow the history of monetary unions and

later become an optimum currency area.


28

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