Optimum Currency Areas – Are They Sustainable?

Introduction/background

An optimal currency area is a geographical region whose sharing of a common currency would bring about maximum economic benefits to the individual and collective countries. The optimum currency area theory was developed by the separate works of Robert Mundell in 1961, McKinnon in 1963 and Kenen in 1969. In this theory, they identified the general characteristics that individual countries coming together to form an optimum currency area by dropping their individual national monetary policy should possess. However, the quest for an optimum currency area dates way back before the inputs of Mundell, McKinnon, and Kenen. Milton Friedman’s monetary integration works at the 1950s provided a good basis for future optimum currency area works (Dellas and Tavlas, 2009).

During the last stage of economic integration, regions adopt a common currency by abolishing their individual countries’ currencies. This move is informed by the underlying optimum currency area theory. Traditionally, each country had maintained its own national currency. However, in1960s, Robert Mundell’s theorized that this arrangement was not the most appropriate as countries sharing solid economic ties would benefit more from a common currency. From Mundell’s theory, there are four main thresholds to be met in an optimum currency area namely: A currency risk sharing formula in a currency union, similar business cycles, mobility of labor across the currency union, easy movement of financial resources, fiscal and political integration, and correlation of inflation rates (Jones, Kelemen & Meunier, 2015).

In 1973, Mundell amended his theory by arguing that for optimum currency areas to succeed, a risk sharing system among member countries was inevitable. The well-performing countries should mitigate market shocks through pooling and sharing of revenue. Failure to collectively share the risk or leaving an individual country to absorb the economic shock alone would render the optimum currency area unsustainable.

The European monetary union was created in 1999 and the euro currency introduced in 2002 (Berend, 2014). This study seeks to explore the sustainability and the practicability of the European Monetary Union by analyzing the optimum currency area theory and to highlight the failures of the European monetary union architecture to meet the basic thresholds of an ideal optimum currency area. This study will be conducted by analyzing and providing answers to two questions relating to the sustainability of the European Monetary Union as an optimum currency area. The subject questions to be analyzed are; the criteria for an optimum currency area and whether or not the Eurozone is an optimum currency area. After the adoption of the European monetary integration policy, fixed exchange rates between trading member countries hindered capital mobility (Howarth & Quaglia, 2013).

Source of data/methodology

Therefore, there was a need for a creation of a monetary union to decrease the currency volatility risks. The theory of optimum currency describes the risks to individual member countries being involved in a monetary union and the criteria for its sustainability. The continued existence of a monetary union with no political and fiscal integration in the Eurozone can only lead to a state where member states continuously suffer the problem of asymmetric shocks amongst themselves. The persistence of this problem would force the member countries to resign back to their own individual national currency rendering the optimum currency area unsustainable (Matthijs & Blyth, 2015).

The concept of sustainability is pivotal for any decision makers in an industry. Indicators of sustainability in an optimum currency area may be used to form a basis for decision making on a long-term or short-term perspective. This paper will employ the top-down approach by first looking into the factors and conditions leading to an optimum currency area status and the sustainability of this status once attained in the sense of what should be done to attain and retain sustainability (Singh et al, 2009).

This study seeks to explore the sustainability of the European monetary union by analyzing the criteria for an optimum currency area. Although the optimum currency area theory has been subjected to a lot of criticism, it remains an important framework to examine the Eurozone’s failures and successes (Snaith, 2014). This paper will employ the use of secondary data sources to identify the imperfections of the Eurozone’s design.  Using the optimum currency theory as the leading tool, we will identify how these imperfections have contributed to the failure of the European monetary union and the possible remedies.

We will explore the merits and demerits of a common currency with respect to benefits and costs in an optimum currency region. We will also examine the dynamic attributes of the specialization hypothesis and the endogeneity of an optimum currency area hypothesis. Using three optimum currency area measurement criterions namely: flexibility, openness and symmetry, we will explore the development in Eurozone since its formation in 1999. For the Eurozone to attain the status of the optimum currency area, integrations in the banking, fiscal and economic fields will have to be achieved. We will look into the possibility of having a Eurozone well adhered to the requirements of an OCA through fiscal and political integration, economic integrations and incorporation of the lender of the last resort position for all member countries (Levitt, 2012).

The theory of Optimum Currency Area

However, our study will not only be limited to the Eurozone. We will compare and contrast the key metrics that have led to the success of the United States in achieving an optimum currency area status versus what the Eurozone has failed to achieve. The effects of divergence in the political and economic systems will be examined using qualitative secondary data sources (Svrtinov, Boskovska, Lozanoska & Trajkovska, 2015).

Our study will employ qualitative data analyzation methods to analyze data obtained from secondary sources such as the World Bank and the Eurozone statistics reports as we undertake to identify the whether the Eurozone qualifies to be an optimum currency area and the sustainability of this optimality both in the Eurozone and other areas like the US. We shall compare and contrast some prevalent currency area conditions in the Eurozone and the US to establish whether optimality has been achieved in the Eurozone currency area and if not what needs to be done to achieve it and make it sustainable. We will analyze the progress made in different individual areas of an optimum currency area theory and finally assess the overall progress of the Eurozone currency area based on this individual progress metrics (Gasparatos, El-Haram & Horner, 2008).

From the optimum currency area theory, a country or region wishing to join an OCA has to forego its national monetary policy to scale the monetary efficiency benefits created by a single currency. However, the loss of this national monetary policy sovereignty may impact negatively on the poorly integrated countries leading to economic asymmetric shocks. In the occurrence of these shocks, the poorly integrated countries suffer the effects more than the well-integrated countries. Therefore, when some countries in a single currency may be experiencing a low demand shock, others would still be experiencing positive demand shocks leading to disequilibrium due to variation in prices in different countries (Corsetti, 2008).

To mitigate this disequilibrium, the monetary union common central bank adds the money supply to help the less integrated countries regain economic strength. However, this poses an inflation risk in the overall currency region disadvantaging those countries that were still stable even after the occurrence of the asymmetric shock. The best way to regain equilibrium in a single currency would be by adjusting asymmetric shocks through the OCA criteria.

Removal of trade barriers increases the degree of industrial specialization in a country thereby increasing asymmetric business cycles. Trade integrations give rise to the correlation of business cycles due to a similarity in demand shocks and the interactions in the intra-trade (Lee & Azali, 2010). A single sovereign country may be considered a currency area due to the fixed exchange rates and single currency criteria. However, the optimality of this single country currency can only be gauged by weighing the political considerations informing the formation of the country against the economic standards of an optimum currency area. In a single country, there are no trade barriers and the internal trade interactions are similar in different regions of the country (Khan & Mohsin, 2009).

The European monetary union and the Optimum Currency Area

The OCA theory provides a set of criteria for how to determine a country’s suitability to be a member of a currency monetary union. The two set of criteria used are:

Reduction of exposure on member countries to asymmetric shocks- openness in trade, similar economic structures and lower levels of specialization.

Adjustment to asymmetric shocks- an easy movement of financial resources, factor mobility, and homogeneity of preferences

If the differences between member countries in a currency union are minimized then the exposure to asymmetric shocks is significantly reduced. This is because the effects of an economic shock are felt comparatively equally by all the member countries.

In the interregional trade criterion, the dropping of exchange rates doesn’t lead to loss of policy independence on the part of member countries engaged in international trade. Trade amongst member countries in a monetary union fosters strong trade links by enhancing economic integration in the product market.

In the lower levels of specialization criteria, the impact of occurrence of an economic shock in an economy where member countries are practicing production of a variety of products in different specific sectors is relatively small (Krugman, 2013).

The homogeneity of preferences criteria provides a guarantee to an effective crisis management by providing a consensual agreement on the way to deal with asymmetric shocks in a monetary union.

In the factor mobility criterion, free movement of labor and capital is guaranteed. People residing in the regions doing poorly can migrate to well-performing regions. International cash flows make it possible for investors to shift their money to more favorable investments. Transfer of payments also enhances the recovery of performance by countries that are on the verge of sliding into recession (Tavlas, 2009).

The European monetary union pioneers believed that a single common currency would enhance labor and capital mobility between member states. This in return would boost economic integration. However, the critiques of European monetary union had warned that the idea of creating the European monetary union was untimely. They argued that this idea would only end up intensifying the economic divergences between member countries (Matthes, 2009).

In this section, we will analyze the European monetary union based on the optimum currency area criteria.

Susceptibility to asymmetric shocks

Here, we will analyze members’ openness in trade, level of specialization and similarity in economic structure.

There exists disparity in the Eurozone member county’s income levels and growth rates.  For instance, in the year 2011, the Eurozone average income levels in Finland stood at 115% while that in Slovakia stood at 65% (see figure1 in the appendix). The growth rate in Estonia stood at 8.28% while the same was at -7.11% in Greece. The unemployment rate in Germany in the year 2012 declined to 6.5% while the same increased to 24.4 % in Spain (Heilmann, Müller & Sommer, 2012).

Criteria for an optimum currency area

There are great disparities in the labor productivity metrics between different European monetary union member countries. From the year 1995 to 2011, the labor productivity of Germany had doubled that of Portugal (see figure 2 in the appendix). The cost of labor in the Eurozone increased at a constant rate from 1995 to 2008 when the Eurozone went into a debt crisis. From the year 2008, the labor costs have stagnated in countries like Germany maintaining a stable state.

According to a study by Persson using Krugman’s index of specialization to examine if a common currency scaled upwards industrial specialization in the Eurozone and the US, countries in the Eurozone experienced a moderately increased level of specialization. The mean indices value increased from 0.39 to 0.43 in the years between 1993 and 2008. Persson notes in his conclusion that individual industries level of specialization in the Eurozone increased and production shifted to countries that had a relative advantage in the production of specific goods (Persson, 2011).

Resultantly, a disparity between different member countries was developed in the way the countries are affected by economic shocks. This in return had the effect of increasing the Eurozone’s susceptibility to asymmetric shocks. In comparison, however, the dollar in the US had no impact on the specialization tendencies. From Persson’s findings, the US had achieved a stable optimum currency area status while the Eurozone had not (Persson, 2011).

The openness in a country and is reflected by its level of participation in international trade. Data provided by the World Bank for the year 2000 to 2011 depicts small European countries such as Luxembourg and Malta to be very open. The Eurozone’s average amount of exports and imports exceeds that of the US almost three times more (Data.worldbank.org, 2013).

Between the year 1999 and 2011, the figure for the average exports to and imports to Eurozone 27 member countries increased by five percent. Although there was a steep drop in trade in the year 2009, the share of Eurozone 27 countries international trade has always been high dating way back even before the euro was launched. And although the launch had some positive impacts, it didn’t leave to meet the expectations of the optimists. The trade increase after the launch was by a margin of 8% to 16% (Augustyniak, Bistreanu and Knauth, 2013a).

In this section, we will look into a member countries ability to cope up with asymmetric shocks. Capital and labor mobility, homogeneity of preferences and transfer of payments will be delved into.

Sustainability of an optimum currency area status

A currency union is formed when participant member countries abandon their individual national currencies to follow a common objective. However, by the year 2009, at exactly ten years down the line, the European monetary union had not achieved this objective. Germany supports the idea of economic integration of the European monetary union so as to enable the union to transform into a fiscal union. On the contrary, the periphery countries are in support of the Eurobonds in order to make sure that the overall Eurozone debts are unified. This difference in opinion can be attributed to the debt crisis affecting some periphery countries. This in return affects the overall European monetary union preference for a fiscal policy. The inability to settle for a common fiscal policy limits the ability of the Eurozone to act (Ludwig, 2012).

A single currency strengthens the inter-country relationship between member countries. The belief that these countries are working towards a common goal and destiny guarantees the cost sharing when it comes to sharing the costs in the currency area. The occurrence of asymmetric shocks in a single currency union gives birth to a conflict of interest amongst member countries. However, due to the good inter-country relationships in the name of working for a common higher goal, the countries are able to share the costs. This is made even more possible by the sharing of a common currency (Alesina, Tabellini & Trebbi, 2017).

The geographical labor mobility across the Eurozone borders and within the Eurozone areas is relatively low compared to the US (Eurostat, 2013b). Higher employment rates are likely to be witnessed in the Eurozone more than in the US as a result of asymmetric shocks due to labor inflexibility around Eurozone countries (Eurostat, 2013c). A bigger share of the proceeds of direct foreign investment in the countries using the Euro in the Eurozone is relatively high compared to those not using the Euro currency. The member countries in the Eurozone enjoy the benefit of unified and integrated financial markets when it comes to foreign investments. In contrast, however, the US capital flows are way much higher than those in the Eurozone (Cuyvers, 2017).

A transfer payment system in a currency union helps in regaining of equilibrium after an asymmetric shock. Cross-border cash flows cause inflation in the recipient countries by creating disruption in the forces of supply.  In comparison, the US boasts of a long life of traditional fiscal federalism while in the Eurozone there is no comparable system of the sort (Eichengreen, 2014).

Possible remedies

Cutting off of transaction costs and easier price comparisons- elimination of exchange rates puts off the threat of market speculation.

Joining a single currency helps countries exercise restraint from printing more money before the adjustment of prices. This prevents the country from falling into the problem of high rates in interest and inflation.

A single currency acts as a building block for long-term bi-lateral relationships between member countries. This increases the confidence among countries to invest directly in foreign markets.

Micro-economic efficiency- a single currency harbors an increase in the usefulness for money. Price transparency is enhanced thereby mitigating market segmentation tendencies and price discrimination.  

The use of a common currency eliminates the cost of exchanging currencies in a single market. However, some costs are incurred due to change in exchange rates. A common currency brings about a greater market efficiency benefit due to a reduction in transaction costs, and a reduction in exchange risks. Although the benefits accruing from an extension of a currency area are mutual to all the countries, small countries with a higher degree of integration benefit more from the marginal utility of this extension. A common single currency increases the market transparency thereby lowering the operational costs incurred in gathering information (Silva & Tenreyro, 2010).

Lengthy mismatches of demand and supply due to the time is taken to adjust prices- the change in price may become a costly affair more so when those setting the price lack important information thereby slowing down the price readjustments in the market. An excess of supply not matched by the same demand in a market leads to a state of unemployment.

Due to the time taken by prices to readjust, some countries within the currency union may fall into the temptation of printing more money. This in return creates high rates of unemployment as the cost of labor becomes untenable.

A single currency implies a single lender of last resort equivalent to a central bank with powers of issuing notes and coins. In a currency area involving multiple currencies, making international payments relies heavily on the goodwill and urgency of multiple individual central banks. This means that no central bank can extend its liabilities ahead of the other central banks as doing so would put the countries reserves and the convertibility at stake. Although the exchange rates are constant, there will be a difference between international adjustment and the interregional adjustment (Silva & Tenreyro, 2010).

Comparison between the US and Eurozone

To demonstrate this disparity, we take two countries (X and Y) with an assumption that they possess a balance of payment equilibrium and a state of full employment. We observe the changes that occur when the balance of payment equilibrium is disturbed by a shift of the demand from the goods of country Y to the goods of country X. Supposing the two countries have different individual national currencies, the disturbance caused by a shift in demand from country Y to X results in an inflation pressure in X and a state of unemployment in Y. If X was to enforce credit restrictions to curb the rise in prices, the burden of adjustment would be shifted to Y. The policy of price restriction on countries with surplus results in recessive tendencies to a currency area with different national currencies.

Five Eurozone countries are faced with huge debts in the bond market due to inability to pay the debts in time and lack of substantial economic growth to aid in servicing the debts. Greece, Spain, Portugal, Italy, and Ireland are the Eurozone countries touched most by the debt crisis. This crisis cropped up from the financial crisis in the US between 2008 and 2009. Lack of a fiscal policy in the Eurozone exposed these countries to the financial crisis that was being witnessed in the US. What followed was a state of slow or no growth in the countries affected. This slow or no growth situation led to deficits in the countries budgets due to low levels of revenues (Lane & Philip, 2012).

 The debt crisis in Greece was so worse to the extent that it exceeded the entire national budget economy. The resultant effect was the foreign and local investors demanding for higher returns on the country’s bonds. The investors demand higher yields on bonds to compensate them for the high risks that come with investing in the country’s bond. This lack of confidence in the county’s bond leads to Filling of the price of the bonds in the world market. This problem is then replicated in the other countries with a huge debt crisis.  

In a move to mitigate the situation, the European Union in partnership with the International Monetary Fund has bailed out the affected countries. However, this move hasn’t addressed the root cause of the problem as the problem has always persisted even after the bailout. Therefore the European Union has initiated alternative measures to address this debt problem. This includes the creation of the European Financial Stability Facility to lend money to countries experiencing financial difficulties in times of need. The union also European central bank also moved to purchase the respective government bonds to cushion the bonds yields from increasing (Paul, 2010).  

Qualitative data analysis methods

The European central bank also moved in to strengthen the bank’s books of accounts to counter the slower loans growth rate in the economy of the countries affected by the debt crisis. In the year 2012, an announcement by the European central bank president (Mario Draghi) promising to do what it will take to prevent the disintegration of Eurozone reversed the falling trend of the troubled Eurozone countries when the world markets regained confidence in those countries bonds. Since then the high yields problem has been controlled. The European central bank has also slashed interest rates on loans thereby easing the problem of debt on the Eurozone (Paul, 2010).

The endogeneity hypothesis presumes an advantageous connection between trade integration and the income correlation. The monetary integration between countries scales down the cost of trading by burying the costs associated with exchange rates volatility. This in return boosts the economic integration and business cycles synchronization between member countries. The intra-trade within the Eurozone countries has increased although not as first as other currency unions like the US. This is can be blamed on the large size of the European countries making up the Eurozone currency and the endogeneity of the adoption of a single currency (Frankel, 2008).

A countries decision to enter into a currency area depends on the level of trade with other members wishing to join the union or already joined members and the correlation of the domestic business cycles to those of other potential countries. International business cycles correlations and trade patterns correlation are endogenous. A poor interpretation of available data when deciding to join or not to join a currency union leads to misjudgment on the country’s suitability (Misztal, 2013).

A country wishing to join the European monetary union will balance the benefits of joining the union against costs. Some of the benefits accrued in joining a currency union include; close international level trade links and lower transaction costs. However, some costs are incurred. Countries joining the European monetary currency union lose the ability to lessen business cycle fluctuations independently. Joining a currency union on the part of countries with idiosyncratic business cycles leads to them losing a crucial stabilizing tool (Kunroo, 2016).

Assuming a country decides to join a currency union, the international trade links are strengthened. However, this affects the national business cycles by either loosening or tightening the business cycles. Tighter trade ties increase specialization on the part of countries with a comparative advantage on the goods produced. Common shocks and the intra-regional trade may dominate the currency union leading to similar business cycles across countries when the countries trade for a long period (Berger & Nitsch, 2008).

OCA criteria for reducing exposure to asymmetric shocks

There exists a positive relationship between the bilateral cross-countries correlation of business cycle activities and the level of the bilateral trade. Some countries may be discouraged from entering into the European monetary union going by the historical data available. But their entry may provide an opportunity for them to expand their trade. This resultantly creates more correlated business cycles. Therefore a country may satisfy the criteria for an optimum currency area after entry into a currency union as opposed to doing so before entry (Schiavo, 2008).

As the level of openness in a currency union intensifies, countries find it more palatable and rewarding to engage in the production of goods that they possess a comparative advantage over other countries. This economic integration leads to increased specialization but the correlation on income levels between member states is reduced.

The optimum currency area theory theorizes that intra-industry trade eliminates the divergence in business cycles. However, there is no relationship between bilateral trade and the business cycles. This leads to the endogeneity of the optimum currency area theory (Athanasios, 2017).

Conclusion

The Euro currency has failed to promote more economic integration within the European monetary union. The vulnerability of the Eurozone countries to asymmetric shocks remains high due to the divergence of economic structures and high levels of some countries industrial specialization. Low labor mobility coupled with the lack of a transfer of payment system aggravates the ability of the Eurozone currency union to recover from asymmetric shocks. Rescue programmes initiated can only address the inability of the Eurozone to adjust to asymmetric shocks. However, what is needed to fully address this problem is a fiscal federalism policy almost similar to the one in the US (Jager & Hafner, 2013).

The costs incurred by the Eurozone periphery countries supersede the economic benefits realized due to economic integration. Economic shocks in periphery countries remain rampant, this affects the overall currency union due to the problem of asymmetric shocks. The difference in geographical and production size of countries in the Eurozone affects the optimality of the currency area (Howarth & Quaglia, 2013). Currency transaction costs in small countries are relatively high than those in the larger countries. This presents a rather unpleasant situation that contradicts the criteria for an optimum currency area (Schelkle, 2016).

The drafting and adoption of a more rigid fiscal policy remain the best alternative to address the debt problems affecting the Eurozone currency union. For instance, the idea of involving the International Monetary Fund in the European monetary fund debt crisis increases the European monetary union strength to decentralize the institutional framework decision-making process. The involvement of the International monetary fund means that the Eurozone member countries have to adhere to the fiscal reform conditions by the IMF. If the Eurozone countries were to adopt and implement a fiscal reform policy, then they would be an edge closer to attaining the status of an optimum currency area (Gros et al., 2010).

Interregional trade criterion

Although the European monetary union has not attained the status of an optimum currency area, the increase in trade has led to more increased business cycle synchronization between member countries. This is seen as a positive stride towards the journey of attaining the status of an optimum currency area (Rose, 2008). However, due to symmetric shocks, the benefits vs the costs of involvement in the Eurozone currency union cannot be standardized. Some countries enjoy more benefits than costs while others bear the burden of costs more than they enjoy the benefits. This indifference places the reality of Eurozone attaining the status of an optimum currency area into disarray (Georgieva, 2015).

The disparities in the productivity of labor amongst different Eurozone countries points out to a scenario of economic divergence. This lack of uniformity means that the European central bank cannot take any action to rectify the disparities. In an ideal single currency situation, a country faced with low labor productivity would rectify the situation by instigating procedures that would lead to the depreciation of its currency. The lack of homogeneity in labor productivity and the degree of inflation across the Eurozone member countries disputes the criteria for an optimum currency area (De Grauwe, 2018).

Cases of macroeconomic divergence are very common in the Eurozone. This is clearly indicated by the rates of unemployment tendencies among different countries. Economic shocks to individual member countries lead to changes in unemployment rates and business cycles. Across board divergence of unemployment rates between countries in the Eurozone spells out a state of macroeconomic divergence. Owing to the fact that macroeconomic convergence is required in an optimum currency area casts the sustainability of the Eurozone currency union into aspersions (Thimann, 2015).

After closely assessing the underlying situation in the Eurozone currency area, we can unequivocally deduce that the Eurozone hasn’t attained the criteria of an optimum currency area and hence its sustainability is highly unlikely. To address the myriad of problems hindering the Eurozone from meeting the criteria for an optimum currency area, member countries can either adopt and implement the fiscal federal policy similar to the one used in the US or break down Eurozone into two categories namely, the periphery countries block and the core countries block. If the Eurozone decided to go with the second alternative, then each country would have to be carefully placed in the block that enables it to meet some convergence with the other currency area/ block countries. The fiscal federalism policy may be adopted and applied in a small region or the whole of the Eurozone (Pollin & Villieu, 2014).  The Eurozone needs to revisit their political integration policies.

Dropping of exchange rates criterion

In conclusion, the European monetary union should remedy its inability to take action in line with the theory of an optimum currency area and its vulnerability to asymmetric shocks. The union should work on promoting further economic integration, implement the debt crisis redemption formula and enhance adherence to the fiscal policy discipline. By doing so, the Eurozone will have edged closer to attaining the much-desired sustainability as a currency area (Christodoulakis, 2009).

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