Europe an Optimum currency area

Europe an Optimum currency area

• An optimal currency area is a region in which the benefits of forming a monetary union outweigh the costs. The states of the United States of America are often thought of as an optimal currency area.

The theory of the optimal currency area was pioneered by economist Robert Mundell. Credit often goes to Mundell as the originator of the idea, but others point to earlier work done in the area by Abba Lerner.

The main point of an OCA is how well a region or country can handle asymmetric shocks without its own exchange rate. • Example – shocks when a country has its own exchange rate. • If a group of countries is truly an OCA, internal and external balance can be maintained in the face of asymmetric shocks. o Example • If a group of countries is not an OCA, internal balance is not obtained across the monetary union in the face of asymmetric shocks. o Example • If a group of countries is not an OCA, union-wide monetary policy cannot address each country’s needs – leading to greater reliance on fiscal policy. A country with a negative asymmetric shock often ends up with budget deficits and political pressure to remove oneself from the union.

The European Monetary Union looks suboptimal. Although the euro area can boast of a single currency, a single central bank committed to price stability (too committed, some say) and free trade among its members, it lacks labor mobility, mechanisms for fiscal transfers in the case of shocks to individual countries, and a common federal fiscal policy. With the minuses offsetting the plusses, one wonders why he was so keen on the idea.

The real problem, of course, is that the euro area was always a political ideal designed to constrain Germany’s imperialist tendencies and prevent World War III. To a certain extent, the economic justifications were just that, nothing more.

By linking Optimum Currency Area (OCA) theory with European Union characteristics I will try to explore the flaws and explain why EU is not an OCA.

An OCA (Robert Mundell, 1961) is defined by a group of regions with large trading size and factor mobility. Let’s now see why Europe doesn’t fit this definition:

Trading size: The majority of European countries only exports between 10% and 20% of their GDP for other European countries, which are small numbers compared to USA inter-states trading percentages. Moreover, prices of goods and services differ among EU countries, for instance, a car in Spain is cheaper than a car in Netherlands or Portugal.

Factor mobility: Capital circulation works fine, due to Maastricht Treaty and the introduction of the Euro there was an improvement of financial assets flow. However, we cannot say the same about labor: Employment laws are heterogeneous among EU countries and furthermore different cultures and languages complicate citizens’ circulation. Once more, mobility between USA states is higher than in EU, as table suggests.

Asymmetric Macroeconomic Shocks: The ECB’s monetary policy has different consequences among countries (mainly between southern and northern countries). The main two are, heterogeneous real interest rates, which are lower in southern countries due to higher inflation rate

. Fiscal Federalism and Economic integration: These two points are not in OCA definition, however they are essential for an healthy Economic system. Fiscal federalism helps to offset the economic stability loss due to fixed exchange rates regime (countries no longer are able to loosely use monetary policy). Economic integration is fundamental for long run sustainability of the system, it has to exist convergence of ideas and policies, in the sense that countries will help and balance each other.

Furthermore, this analysis is just on the economic side, we also have to take in consideration the political and social view. For instance, Portugal may thought that joining EU would strengthen economic characteristics as lower inflation, lower interest rates and higher GDP growth. However, until now this integration is not being that successful, lack of convergence is intensifying the economic flaws and social/ political tensions. In that sense, as mentioned by Francisco Torres in his paper , politics have a really important role on countries integration and mutual aid to reach the proposed goals.

European Union The theory has been most frequently applied in recent years 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 Euro Area's economic difficulties in part to continued failure to do so. While Europe scores well on some of the measures characterizing an OCA, it has lower labor mobility than the United States and cannot rely on fiscal federalism to smooth out regional economic disturbances.

• in Europe, the low labor mobility between and within the EU countries implies a high risk of economic stability loss from Eurozone membership. Additionally, the European Union is because of its limited fiscal powers not able to support a European country in economic difficulties.

Why do EU countries not meet the criteria as well as the states of the US? • Language and cultural barriers make it harder for a worker to move from one European country to another Labor mobility is limited. • Wages in Europe are not determined as much by the market as they are by labor unions and wage bargaining agreements with the government. Wages are less responsive to economic fluctuations, making it harder to induce labor movement. • Each country in the EMU maintains individual control over tax collection and government spending; there is no EMU level fiscal authority. Contrast this to the US where the Federal Government has an enormous budget and taxes and spends at a national level. The EMU cannot transfer funds or adjust taxes from one region to another.

O Looking at our analysis of the European economic structure we can conclude that the EU economies are open to trade and that capital is highly mobile. Likewise however, we must agree that labor is largely immobile for linguistic and cultural reasons, as well as for personal and social costs of migration.