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THE EUROZONE AND THE OPTIMAL CURRENCY AREA THEORY ERASMUS UNIVERSITY ROTTERDAM Erasmus School of Economics Department of Economics Supervisor: Prof.dr. Bas Jacobs Name: Shiny Yang Exam number: 358437 E-mail address: [email protected] Date: July 2015 Abstract In this paper it will be investigated whether the EMU currently is an OCA and if not whether it could become one. The OCA criteria will be defined and empirical findings from other researches will be used to conclude whether the EMU fulfills the OCA criteria. Additionally, it will be investigated how the EMU could become an OCA and also whether the Euro could be sustained if the EMU does not become an OCA at all. It can be concluded that the Euro zone is still not an OCA, but it is making progress towards one. There are several points of improvements for the EMU in order to become an OCA. However, it is not necessary for the EMU to become an OCA to stay sustainable. Table of Contents 1. Introduction ................................................................................................................. 3 2. Optimal Currency Area Theory .............................................................................. 5 2.1 Costs and advantages of a currency area .................................................................................... 5 2.2 OCA criteria................................................................................................................................................ 7 3. Is the Euro zone an OCA? ....................................................................................... 12 3.1 Similarities of national inflation rates and similarities of shocks and cycles .......... 13 3.2 Labor mobility................................................................................................................................ 18 3.3 Financial market integration and product diversification ............................................. 20 3.4 The degree of economic openness and the size of the economy .................................... 23 3.5 Fiscal and political integration ........................................................................................ 24 4. Can OCA theory explain the Eurozone crisis? And can the Eurozone survive if it's not an OCA? ............................................................................................. 25 5. Conclusion .................................................................................................................. 27 6. Bibliography ............................................................................................................. 29 2 1. Introduction In 1999, the Economic and Monetary Union (EMU) of the European Union was created for further economic integration and convergence within Europe. 11 of the 28 European Union countries changed their currency to the Euro at that time and agreed that the European Central Bank (ECB) determines the common monetary policy for these countries. Currently, the euro is used by 19 member states that have signed up to full Economic and Monetary Union. These countries belong to the euro area and the rest of the countries that joined the European Union but did not adopt the Euro are only part of the economic union. Most of these countries will probably join the euro zone eventually though. In order to analyze the feasibility of a Monetary Union usually the optimal currency area theory (OCA) is applied. This theory was written and developed by Mundell (Mundell, 1961), McKinnon (McKinnon, 1963) and Kenen (Kenen, 1969). They state that a monetary union is bound to work well if the criteria for an optimum currency area are met. The advantages of a single currency such as reduced transactions costs, elimination of currency risk come at a potentially high cost from a loss of flexibility (De Grauwe, 2011). The optimum currency area theory is about weighing the balance between these costs and advantages (Krugman, 2012). To evaluate whether the Euro zone is an OCA the extent to which the criteria for the OCA are met is investigated. The criteria for OCA are similarities of inflation rates and similarities of shocks and cycles, mobility of factors of production including labor, financial market integration and product diversification, the degree of economic openness and the size of the economy and the fiscal and political integration. The Euro zone was not an optimal currency area when the Euro was implemented and according to several studies it still is not one despite that the EMU has been strengthened in recent years. There is no consensus on whether the Euro zone is improving. Some researches conclude that the Euro zone is making progress towards an OCA, while others on the other hand state that the Euro zone is far from becoming an OCA though. 3 In this paper it will be investigated whether the Euro zone is an OCA and whether or not it could become one. This will be done by reviewing recent empirical studies on the Euro zone and the OCA. The research question will be: “Is the Euro zone an Optimal Currency Area? And if not, can it become one? “ Most researches agree that the EMU is not an OCA initially. De Grauwe and Mongelli agree with this and state that it could become one. The EMU could make improvements in meeting the requirements for the OCA. The countries that are part of a currency area integrate more after implementing a common currency (Grauwe & Mongelli, 2005). According to the OCA theory, the EMU would be the most efficient if the OCA criteria were met. The goal of the EMU was to integrate the economies in the Euro zone. However, more than ten years after the EMU was created, several Eurozone member states have been in a multi-year debt crisis known as the European debt crisis or the Eurozone crisis. The states in the crisis were unable to refinance their government debt or to bail out over-indebted banks under their national supervision without the support from third parties such as the ECB. Also, recently, because of the ongoing Greek crisis, Greece was on the verge of an economic collapse and a ‘Grexit’. Divergence across the euro area is significant and the crisis of recent years has further highlighted existing shortcomings of the EMU. One may think that the Euro zone not being an OCA causes the ongoing crisis. However, this is not necessarily the case. Historical events show that when there is high capital mobility, unexpected capital inflow breaks may occur, typically causing financial crises. Deeper analysis of the dynamics underlying the current Eurozone crisis shows that financial deregulation and liberalization was a major cause of the crisis in periphery countries in the Eurozone (Svrtinov, Temjanovski, & Trajkovska, 2014). 4 Moreover, some researchers claim that the OCA theory has numerous shortcomings and according to them the Euro zone does not have to become an OCA in order to be sustainable. Most researches state that the Euro zone should become more of a political union to become an optimal currency area. In the first part of this paper the OCA criteria will be explained. In the second part a literature review will be done. The extent to which the OCA criteria are currently fulfilled will be investigated by examining the empirical findings from other researches. Furthermore, the relation between the OCA theory and the Eurozone crisis will be explained. Also, it will be investigated if the OCA can survive without being an OCA. Lastly, the paper will end with a conclusion. 2. Optimal Currency Area Theory 2.1 Costs and advantages of a currency area Having a currency area has myriad benefits. Firstly, the currency area would produce greater market integration. In an integrated market the price movements in various locations are proportionate to each other and the independent markets become one big market. A currency area would eliminate the costs of converting currencies for the trading countries in a currency area and also protects them of currency fluctuations it is easier for the countries with the same currency to engage in trade. Thus, by diminishing the currency risk the market will become more integrated. The EU countries that requested to join the EMU had to meet several requirements called the Maastricht Treaty. This way they would be assured of political stability. Adopting the Euro also showed the aspiration of cooperation of countries that were rivals in the past. The members of the EMU will this way have the same economic interest and thus it would create political stability. The costs of having a common currency are mainly because the countries are unable to have a national monetary policy instrument. The members of the EMU have either no national central bank or the bank does not have any real power. 5 The countries will not have the possibility to adjust its monetary policy to adjust for devaluations and revaluation anymore. Instead, there is a central bank that manages the monetary policy. For the EMU it is controlled by the ECB. This could be a problem when a country wants to adjust their monetary policy in order to fix unemployment for example. The countries will not have the possibility to adjust for devaluations and revaluations anymore. This is a problem in rigid labor and goods markets, because with a fixed exchange rate the real wage or level of employment cannot be adjusted. Whereas when labor and goods markets are flexible it is not necessarily a problem, because there the real wage or level of employment could still be adjusted to bring the market back to the equilibrium. According to Buiter, who did a research on why the UK should join EMU, small open economies with high capital mobility have a hard time to conduct an independent monetary policy though (Buiter, 2008). In a small open economy the interest rate is fixed on world markets. And the exchange rate is determined by monetary policy. When a country adopts a fixed exchange rate regime, it cannot use independent monetary policy anymore, only with a flexible exchange rate. Buiter states that for small open economies such as the UK, where much of the transmission of monetary policy is through the exchange rate, the timing unpredictability, the magnitude and occasionally even the directions of the effects of the monetary policy and other shocks on the exchange rate and other variables of interest are such that a dependent monetary policy is actually a good thing instead of bad (Buiter, 2008). This way the real economy is less exposed to the financial uncertainty caused by the foreign exchange market and the economy will become more improved. 6 2.2 OCA criteria 2.2.1 Similarities of national inflation rates and similarities of shocks and cycles Members of a currency area should have similar inflation rates. According to Fleming when members of a currency area have low and similar inflation rates over the years, terms of trade will stay reasonably stable too (Fleming, 1971). Different inflation rates cause variations in terms of trade, because when the inflation rate changes, this influences the flow of goods, because of the changes in the price of imports and exports. This causes the current account disequilibria to increase. The exchange rate variations would have to decrease in order to adjust for the disequilibria (Gandolfo, 1987). When there is no CA-equilibrium, for a country that has a deficit for example it will be compensated by another country with a similar number, but then a surplus instead. As mentioned as one of the costs of having a currency area theory it is a problem that the Euro countries cannot adjust the exchange rates to adjust for this equilibrium. Accordingly, this is a problem because if these countries are stuck in a position of for example unemployment or inflation they cannot adjust their monetary policy anymore to bring the position back to the equilibrium. Thus, one of the criteria for an optimal currency area is that the countries have similar national inflation rates to avoid a CA-disequilibrium. Furthermore, the shocks and cycles of a country should be assessed. There are two contradicting views on whether when the EMU countries are more integrated, the more or less similar shocks and cycles would be. They are based on different theories. On the one hand, it is stated that a more integrated economy would have less similar business cycles. Krugman states that integration increases industrial activities concentrated in a region due to specialized producers and this in turn causes more asymmetric shocks and it causes business cycles to diverge (Krugman, 1991). He deduced this from the comparative advantage theory. This 7 theory states that if a country specializes in production of a good in which they have a lower opportunity cost the economic welfare increases. Also, according to Kalemli-Ozcan, Sørensen and Yosha, when an economy is more integrated, there will be a more specialized production structure and the trade will also be boosted. They find that a more specialized production structure shows output fluctuations that are less correlated with those of other regions. This means that the market integration causes more asymmetric fluctuations. Accordingly, there will be less similar business cycles (Kalemli-Ozcan, Sørensen, & Yosha, 2001). For their research they used Gross state product data of fifty US states from the Bureau of Economic Analysis (BEA) and GDP data of OECD countries from the OECD National Accounts 1996, Volume 2 consisting of Belgium, Denmark, France, Netherlands, West Germany, Austria, Canada, Finland, New Zealand, Norway and the US. They used the GSP data of the US states from 1977-1994 to compute specialization indices by transforming the gross product magnitudes to per capita terms using population by state data also from BEA. They calculated the measure of asymmetry in GDP fluctuations for the pooled sample of the OECD countries and the US states and then regressed them on the specialization indices. The results show significantly positive coefficients for the specialization indices and thus the more specialized production structure is, the less synchronized business cycles are. On the other hand, it is agreed that a more integrated economy would lead to more similar business cycles. Frankel and Rose state for countries that have close international trade links it would be beneficial to join a monetary union. Also, countries with less asymmetric cycles are more likely to join a monetary union (Frankel & Rose, 1998). Furthermore, economic integration would lead to less asymmetric shocks and cycles because when trade barriers are removed, trade will be expanded and this causes the business cycles to become more correlated. This is because when trade increases, demand shocks will be more smoothly spread across national borders (Frankel & Rose, 1998). They used a panel of thirty years of bilateral trade and business cycle data for twenty industrialized countries. The findings show that bilateral trade and business cycles on bilateral trade intensity are significantly positively correlated. So a 8 higher level of integration has caused the cycles to be more synchronized in the past. Thus, more economic integration would lead to less asymmetric shocks and cycles. This is mainly because as mentioned as one of the cost for the currency area, countries can no longer use the interest rate and the exchange rate to adjust for unemployment and inflation when there are asymmetric shocks. When there are similar shocks, there is no longer the demand for an instrument to adjust for effect. In a small open economy countries cannot use the interest rate, because it is determined in world asset markets. However, whether they can respond depends on the exchange rate regime. If there is fixed exchange rate then the central bank or the government fixes the rate. Whereas, when there is a flexible exchange rate, the rate is determined by the demand of supply of the foreign exchange market. The EMU for example has a fixed exchange rate. 2.2.2 Labour mobility (by Mundell) Labour mobility is defined as the mobility between jobs, occupations and geographical regions. Labour mobility ensures a better balance between labour market supply and demand because it allows flows of mobility to adapt to the changing business cycles and needs. By removing the barriers for the labour mobility between the countries of the currency area, the labour market will improve and the trade and industry will become more competitive. When there is unemployment among low skilled workers because of institutional constraints such as union wages, more unskilled migrants are prepared to work when there is higher labour mobility and this way the industry is more competitive. Also, workers are enabled to move between the countries without restrictions. According to Mundell, the higher the degree of mobility of factors of production, mainly labour mobility, the better. He states that imbalances in the balance of payments are due to variations in unit factor costs (Mundell, 1961). When factors such as labour are able to move among countries without restrictions, there will be both external and internal balance. This means that the balance of payment is in balance and there is full employment. When factor mobility is high, factors can move from countries with high unemployment to countries with low unemployment and equalization of these factor costs will cause the inflation 9 rates to move to the equilibrium. This way there will be less need for an independent monetary policy (Mundell, 1961). Because the central bank determines the common monetary policy for the countries in a currency union, the countries cannot use the nominal exchange rate as an instrument of adjustment for when the country is not in it’s equilibrium. It is not possible for the countries to either revaluate or devaluate themselves in order to determine the quantity of the national money in circulation or for changes in the interest rate. Therefore, a high degree of mobility of factors of production, mainly labour, is necessary in order for problems such as unemployment to be automatically solved between members of a currency area. When there is unemployment the labour workers can move easily to another country from their currency area. De Grauwe explains this with the example of France and Germany that are in a monetary union together. If there would be an increase in unemployment in France and a decrease of unemployment in Germany, mobility of labour could automatically bring the countries back to equilibrium. French unemployed workers move to Germany where there is an excess demand for labour. Because of this the wages in Frances does not have to decrease and the wages would not have to increase in Germany anymore. This fixes both the French unemployment problem and the inflation problem in Germany. Thus, the problems are automatically solved between members of a currency area when factor mobility between countries is high (De Grauwe, 2011). 2.2.3 Financial market integration and product diversification (by Kenen) Product diversification is defined as a method to expand business opportunities by creating extra market potential for an already existing product. This could be done by joining extra markets and by pricing strategies. Usually the products are adjusted and there will be new marketing plans for those products. This criterion states that the more similar the production structures of countries are, the higher the financial market integration. According to Kenen, product diversification is an important criterion for the OCA theory. He defined product diversification as “diversity in a nation’s product mix, the number of single- 10 product regions contained in a single country (Kenen, 1969).” Kenen stated that a well-diversified national economy would not have to undergo changes in its terms of trade as often as a single product national economy (Kenen, 1969). When there is a high degree of diversification, there is a higher chance of having an export sector that has a high degree of diversification too. When a country has a high-diversified export, external shocks can be cancelled out without having to change the exchange rate to respond to the shocks. This is because less diversification leads to stronger terms of trade volatility. Therefore, when there is a high degree of diversification there will be less need for changes in the terms of trade via the exchange rates (Kenen, 1969). So, when there is enough product diversification, a country can handle the costs of abandoning the national exchange rates and benefit from a currency area. Kenen also argues that diversification is an even more important criteria than labour mobility (Kenen, 1969). This could be explained by the following example. Imagine a country in which there is low product diversification and that country also only produces one product that it also exports. When they are hit by a negative demand shock, the export would decrease and their revenue from exports would decrease. The effect of the decrease in revenue could be reduced when there is a flexible exchange rate, because the decrease in export would cause a decrease for demand of the domestic currency and therefore cause it to depreciate. The depreciation would then cause the export revenues to increase again. However, when there is a fixed exchange rate, this method cannot be used. In this case, adjustments can be made by reducing wages and prices or by increasing unemployment. In a currency area the countries have a fixed exchange rate. Thus, it is better to have higher product diversification and this way diminishing the need for adjusting the exchange rate. 11 2.2.4 The degree of economic openness and the size of the economy (by McKinnon) Openness is the share of economic activity devoted to international trade (Baldwin & Wyplosz, 2004). McKinnon states that a higher degree of trade openness will be necessary for a country join the currency area (McKinnon, 1963). The higher the openness of a country, the lower the cost of joining the currency area and losing the exchange rate as an instrument. This is because when countries have a high level of openness, the exchange rate loses its power as an instrument. As a result of high openness, the domestic currency has less utility as a value of deposit, because it loses stability in terms of purchasing power and future transactions (McKinnon, 1963). McKinnon also states that the small open economies are the most effected by changes in the exchange rate. If the exchange rate will appreciate, it will not significantly affect the international competitiveness (McKinnon, 1963). Therefore, small open economies would benefit from a currency area. The more open and the smaller the economy, the better it is for an OCA. 2.2.5 Fiscal and political integration When there is fiscal integration, there can be a financial transfer to another country of a currency union if the country that is hit by an asymmetric shock has a high unemployment. Funds will be transferred from rich to poor areas for more equality. According to Kenen, the higher the fiscal integration is, the easier it is to even out asymmetrical shocks through fiscal transfers from a low unemployment region to a high unemployment region (Kenen, 1969). Transfers between countries decreases the need for a nominal exchange rate adjustment, because it works as an alternative for it. Instead of having to adjust the exchange rate to respond to the shocks, the asymmetrical shocks can be solved when there is fiscal integration. However, fiscal integration mostly requires the countries to have political integration as well. 12 Political integration is often seen as one of the most crucial conditions for a currency union. Political integration implies joint commitments from the members of a currency area and it maintains cooperation. 3. Is the Euro zone an OCA? In this section a literature review will be done. Empirical findings from other researches will be used to assess whether the EMU fulfills all the OCA criteria mentioned in the previous section. 3.1 Similarities of national inflation rates and similarities of shocks and cycles Firstly, the more similar inflation rates are in a currency area, the more likely it is for the countries to form an OCA. Also, one of the criteria for joining the EMU was that the inflation rate of every country could not exceed 1,5% of the average inflation rate of the three best performing EU countries. The long-term interest rate had to stay below 2% of the average rate of the three lowest long-term interest rates of the EMU countries. Mongelli shows that inflation among the EMU members has been fairly stable at a remarkably low rate and at an inflation rate similar to the US (Mongelli, 2008). Figure 1 is a graph of the dispersion in inflation across the euro countries with an un-weighted standard deviation in percentage. It shows that the inflation rate was indeed fairly similar. The data is from Eurostat and the US Bureau of Labor Statistics. The Euro data is up to March 2007, and the US data up to January 2007. 13 Figure 1: Inflation among EMU countries fairly stable For most members of the EMU inflation remains constant and many countries that have a higher inflation rate than the average of the euro zone countries have that for quite a long period of time. This is the same for the countries that have a low inflation rate. Also, the inflation rate for most of the euro area countries has been lower since 1999 than the period before: 1991-1998. Only a few of these countries show increases in the inflation rate since 1999. Figure 2: More similar inflation rates in the period of 1997-2007 (after the Euro was implemented) than in the period of 1990-1998. Average inflation rate 1990-1998 1999-2007 Belgium 2.1 2.0 Germany 2.4 1.6 Ireland 2.4 3.4 Greece 12.0 3.2 Spain 4.4 3.1 France 2.1 1.8 Italy 4.4 2.3 Luxembourg 2.4 2.7 Netherlands 2.1 2.4 Austria 2.3 1.7 Portugal 6.2 2.9 Finland 2.5 1.6 14 Euro Area 3.0 2.0 Unweighted std. deviation 2.8 0.6 Memo item: US 3.1 2.7 Figure 2 shows the inflation rates across the Euro countries found in the Ameco database from the period 1990-1998 and from the period 1999-2007. For the period from 1999 onwards and thus after the Euro currency was implemented, the data shows more similar inflation rates compared to the period from 19901998, before the Euro was implemented (Mongelli, 2008). Dunska evaluated the advancements in the level of inflation in the EMU Member states by graphing it (Dunska, 2014). The data is from Eurostat and consists of the inflation rates of the EMU countries from the period 2002 to 2011. Figure 3: inflation rate of the EMU countries flat and somewhat steady from 20022011. This graph shows that the inflation rate was flat and somewhat steady in the period from 2002 to 2011. The differences among these countries were miniscule and not relevant. The similarities between the inflation rates enable the ECB to conduct an efficient monetary policy that works well in all EMU countries and therefore eliminating the effects the asymmetric shocks in the 15 different countries has. Dunska concluded that in overall the EMU countries meet this criterion (Dunska, 2014). Furthermore, the more similar shocks and cycles are in a currency area, the more likely it is for the countries to form an OCA because when there are similar shocks and cycles, there is no longer the demand for an instrument to adjust for effects. Rose conducted a meta-analysis to estimate the effects of EMU on monetary union, international trade and business cycle synchronization (Rose, 2008). A meta-analysis is a statistical technique used to summarize the findings of a number of studies into one estimate. He estimated the effects of EMU while assessing all existing literature he found on this topic. In total he found twentysix papers. Twenty of which that provide estimates of the effect of trade on the similarity of business cycles. The effect of trade on business cycle synchronization was measured by the following formula: 𝐵𝐶𝑆ijt = 𝛼 + 𝛽 ∗ ln(𝑡𝑟𝑎𝑑𝑒ijt) + 𝑐𝑜𝑛𝑡𝑟𝑜𝑙𝑠 + ℇijt Their coefficient of interest was β because it measures the effect of trade on BCS. The effect of trade can test for similarity of business cycles because shocks in one economy will change the demand for foreign intermediate products. (Intermediate goods are 75% of worldwide trade). When there is for instance a positive shock in a country it will generate a higher output and income and this will cause the demand for foreign intermediate goods to increase. Because the demand increases, the output of the other country increases and the business cycles of the two countries synchronize. Therefore, for countries that have a higher degree of trade with each other, the higher the synchronization of the business cycles are. With the data from the twenty papers on the effect of trade on the similarity of business cycles Rose estimated β that shows the effect of trade on BCS. He aggregated the estimations of the different studies. The data consists of pre- and post-EMU data, because the post-EMU period was too short. The null hypothesis of no effect of β on the trade on BCS is rejected. Rose’s estimations of β show that 16 the EMU has increased trade and the synchronization of the business cycles. He concludes that the EMU is on its way to becoming an optimum currency area (Rose, 2008). Moreover, Papageorgiou, Michaelides and Milios did a quantitative analysis on the business cycle synchronization in Europe. They used data from AMECO from the period 1960-2009. They divided their data into three periods in order to investigate the influence of the EMU on the business cycle synchronization. Period 1: 1960-1992 (before the Maastricht treaty), Period 2: 1992-1999 (from Maastricht treaty till the single currency EMU formation) and Period 3: 20002009 (from the implementation of the EMU). Firstly, they tested for the correlations among the various business cycles of the countries by calculating the Pearson correlation coefficient. Then they used a rolling window approach to find the correlation coefficient over time. With this approach the correlation coefficient is calculated for every point in time. Next, they investigated the frequencies of business cycles and find an indication of the length of the cycle. Last but not least, they did a cluster analysis and split the observations into a number of clusters in a way that observations are similar in a group, but in different groups they are not. There is no general way of calculating the number of clusters. The formation and number of clusters vary over time. The findings of the various methods show that the business cycle synchronization increased from 1992-1999, but decreased from 2000-2009, the period in which the Euro was implemented (Papageorgiou, Michaelides, & Milios, 2010). Also, Eichengreen assessed similarity of shocks in Europe by comparing it to Canada and the US. According to Eichengreen the real exchange rates are more variable in Europe than in the US, which implies that region-specific shocks are more common there and nominal exchange rate changes coordinates. Furthermore, he compared their regional stock price differentials, because the price of equities should reflect the present value of current and expected future profits. He states that when shocks are asymmetrical, the profit in one region 17 would rise relatively more than in the other region. Thus, the more closely real share prices move across regions, the more symmetrical the disturbances and the more rapid the reallocation of factors of production from regions experiencing negative shocks to regions experiencing positive ones. Therefore, he compared the differentials between averages of the prices of securities traded on two regional Canadian stock exchanges with differentials between Paris and Dusseldorf. The results show that the share prices in Toronto and Montreal move much more closely together than the share prices in Dusseldorf and Paris. And it can be concluded that there was convergence between Paris and Dusseldorf over time and thus the criterion of similar shocks is met (Eichengreen, 1991). 3.2 Labour Mobility Since the ECB controls the monetary policy for the EMU countries, they cannot use the nominal exchange rate as an instrument of adjustment. Therefore, the higher factor mobility between the EMU countries, the more likely it is for these countries to form an OCA. Silva did an empirical research on the labor market (Silvia, 2004). The labor market adjustments provide indication for trade expansion and price convergence. A new equilibrium will be found that reflects the loss of transaction costs and barriers and labour costs will converge because of price competition. He uses labor cost data from ten of the twelve Euro countries from 1995 till 2002, because Greece and Luxembourg did not have any data at that time. The data is still considered ample, because they have rather small economies. The unit labor cost data represents the tradeoff of producing in a country versus the other country and is thus a good way to measure how labor, one of the most important factors of production is affected by the growth and production. Labor costs are a good measure, because labor mobility is costly. For example, the costs of finding a new job and the costs of quitting the job they have currently. He conducted t-tests on the standard deviations of OECD’s data on unit labour costs from 1991 to 2000. Portugal was an outlier so it was also removed from the data. 18 Findings of the statistical research show that the standard deviations of nominal hourly labor costs in the periods before and after the introduction of the euro are not significantly different. Therefore, it can be concluded that the labor costs did not converge significantly in the euro zone and thus there are no or little improvements in labor mobility or integration. He states that the European labor mobility is pretty low and thus impedes the EMU from operating well (Silvia, 2004). He argues that the euro zone still falls short as OCA in most respects. Moreover, Baldwin and Wyplosz compared labour mobility with several countries all over the world. Labour mobility indicates how easy it is for the workers are able and willing to move between different jobs, occupations and geographical areas. The labour mobility could be measured by assessing the number of migrants because the labour flow depends on the demand for migrants. An increase of the number of migrants could indicate an increase in labour mobility. However, if economic growth and social development continues to improve, the increase in labour migration will diminish, as there will be less demand for migrants. Baldwin and Wyplosz graphed the foreign born population in percentage of the total population with data from 1998. Figure 4: High foreign-born population in percentage of the total population for most of the EMU countries. 19 Next Baldwin and Wyplosz graphed the international migration across regions, also in percentage of the total population with data from 1995. It shows that the labour mobility is low across countries and even within countries in Europe (Baldwin & Wyplosz, 2004). Figure 5: labor mobility is low across countries in and outside Europe Also, Eichengreen assessed labor mobility and similarity of shocks in Europe by comparing it to Canada and the US (Eichengreen, 1991). For his analysis he used data from 1965 to 1983 of the 9 EU countries excluding Greece, Portugal and Spain. He estimated time-series models of regional unemployment differentials for both Europe and the US. He investigated how quickly the unemployment in various European countries adjusted to their long-run equilibrium when they were not in equilibrium and he compared that to how quickly the regional unemployment rates in the US arrived back to their national average. The results show that unemployment rates adjust 20% more quickly in the US than the unemployment in European countries. He concluded that the labor mobility is lower in Europe than in the US and that a higher degree of labor mobility leads to faster adjustments to shocks. Also, real exchange rates remain considerably 20 more variable in Europe than within the US. Therefore, Europe is further away from an OCA than the US (Eichengreen, 1991). 3.3 Financial market integration and product diversification The financial market integration has clearly increased since the EMU has been founded. Mongelli did a literature review and he states that there is an increase in financial integration due to the decrease in opportunities for arbitrage and smaller differences in market interest rate (Mongelli, 2008). Also there is an increase in financial integration because of the law of one price, which states that goods should sell for the same prices in every location. Christev and Melitz conducted a statistical research and examined the impact of the EMU on market integration. They used an econometric model with which they calculated consumption volatility, international capital market integration, trade openness, domestic credit development and currency union. For their research they used data of the World Bank World Development Indicators (WDI) from 1980 to 2006 consisting of 180 countries. Their results show that there is an increase in financial market integration in most countries and it is larger for the countries inside the EMU than the countries outside the EMU (Christev & Melitz, 2013). Thus, there is a positive influence of EMU on the market integration of the EMU countries. Ferreira, Dionisio and Pires did a quantitative analysis for the evaluation of the financial integration achieved by the EMU (Ferreira, Dionisio, & Pires, 2010). They used an econometric technique that is similar to the OLS methodology, but it also enables the parameters of a regression model to be estimated without any constraints on the probability distribution of errors and it also works well with ill-posed problems. For this evaluation the EU countries were separated in a group that adopted the euro and a group that did not adopt the euro. To investigate the financial integration of the EU countries that did adopt the euro for the period before they adopted a common currency, they use spot and exchange rates for the countries relatively to the German one. To study financial integration of the non-euro EU countries they recovered exchange rate with 21 respect to euro. They conclude that the degree of financial market integrated for countries that did not adopt the Euro is even lower than the degree of financial integration for the countries that adopted the euro had before adopting the euro (Ferreira, Dionisio, & Pires, 2010). Furthermore, a country with higher product diversification is more likely to handle fixed exchange rates. Baldwin and Wyplosz found the percentage of diversification of several countries with the data from European Economy from 2001. Figure 6: High percentage of diversification for most EU countries Country Percentage of diversification Austria 53.5 Belgium 91.7 Denmark 43.1 Finland 39.9 France 31.5 Germany 38.4 Greece 29.9 Ireland 85.4 Italy 29.9 Netherlands 65.3 Portugal 38.3 Baldwin and Wyplosz state that most of the EU countries have high degrees of diversification, which means the intra-industry trade is dominant (Baldwin & Wyplosz, 2004). 22 3.4 The degree of economic openness and the size of the economy The higher the degree of economic openness and the smaller the size of the economy, the better it will form an optimal currency area. Dunska stated that when assessing the criterion of size of the economy, one could conclude that the euro zone countries are different from each other. This is clear from differences in absolute indicators and from differences in the GDP per capita, which show the diverse standards of living (Dunska, 2014). Rose used the quantitive technique of meta-analysis. A meta-analysis is a statistical technique used to summarize the findings of a number of studies into one estimate. Rose took 26 relevant studies that research the effect of a monetary union on trade into account. His findings show that the EMU has increased the trade inside the Eurozone with more than 8%. He concludes that the EMU is on its way to becoming an optimum currency area (Rose, 2008). Baldwin and Wyplosza state that most of the EMU countries are really open. Openness is indicated by the average ratios of the exports plus imports divided by GDP in percentage. The higher the trade-to-GDP ratio, the higher the openness of a country. The following table shows the average of ratios of exports and imports to GDP in percentage. The numbers show that this ratio is pretty high for most of the member states of the EMU (Baldwin & Wyplosz, 2004). Figure 7: High average ratio of exports and imports to GDP (in %) for most EMU member states Country Ratio of exports and imports to GDP (in %) Austria 53.5 Belgium 91.7 Denmark 43.1 Finland 39.9 France 31.5 Germany 38.4 23 Greece 29.9 Ireland 85.4 Italy 29.9 Netherlands 65.3 Portugal 38.3 Spain 33.6 Sweden 48.8 UK 30.7 3.5 Fiscal and political integration When there is fiscal integration, resources can be transferred to another country of a currency union if that country that has high unemployment for example is hit by an asymmetric shock. This also decreases the need for a nominal exchange rate adjustment. However, for this political integration is necessary. Mongelli states that the fiscal policies were pro-cyclical in quite a few European countries for most of the 1970s and 1980s. However, the results for the period after the introduction of the euro are ambiguous. There is also no consensus on this (Mongelli, 2008). Also, Matthes’ findings agree with Mongelli. He states that the fiscal policies have been pro-cyclical. This increases divergence because countries would not decrease their deficits when there was high growth and therefore had to compensate for this when there was little growth (Matthes, 2009). There is little evidence on the political integration criteria. Baldwin and Wyplosza state that from governmental opinion surveys show that there is no clear resistance to European Union institutions (Baldwin & Wyplosz, 2004). In the surveys the inhabitants of the EU countries were asked whether they trusted their national government more or the EU more. The findings can be found in the figure 8. Most countries trust more in the EU than their own national 24 government. This could be an indication that there is somewhat political integration. Figure 8: Most countries have more trust in the EU than in their own national government. 4. Can OCA theory explain the Eurozone crisis? And can the Eurozone survive if it is not an OCA? Firstly, the OCA is not an explanation for the Eurozone crisis. The Euro zone not being an OCA does not cause the ongoing crisis. Historical events show that when there is high capital mobility, unexpected capital inflow breaks may occur, typically causing financial crises. Deeper analysis of the dynamics underlying the current Eurozone crisis shows that financial deregulation and liberalization was a major cause of the crisis in periphery countries in the Eurozone (Svrtinov, Temjanovski, & Trajkovska, 2014). According to Harari, the Eurozone crisis is caused by other factors and not due to the Eurozone not being an OCA (Harari, 2014). Harari states that the crisis is caused by monetary policy that is controlled by the ECB. The ECB controls the interest rate for all countries in the Eurozone. This was not efficient, because countries with weak growth needed a low interest rate, while on the other hand countries with high growth need a higher interest rate. Also, because the countries could not take certain controls (because of the fixed exchange rate for 25 example) to adjust for the crisis like they were able to before the adoption of the Euro, it was harder to get out of the crisis. Furthermore, for a stable currency area the role of financial instability and banks is important. According to Buiter and Rahbari the Eurozone can survive if the EMU is not an OCA as long as it fulfills three conditions (Buiter & Rahbari, 2012). Firstly, sovereigns such as banks need a lender of last resort (LoLR) because they can help them solve problems with liquidity, solvency and maturity mismatch among assets and liabilities. Buiter and Rahbari argue that for the euro zone the ECB is acting as a lender of last resort (Buiter & Rahbari, 2012). However, the ECB does not admit to be a LoLR even though the ECB has also even prevented sovereigns having to default and has also created opportunities for sovereign debt restructuring and bank recapitalization. Secondly, the Euro zone should be able to sustain if they have a banking union. For a banking union there should be a common supervisor and common rescue plans for banks and other relevant financial institutions for the whole currency area. There should also be a bank recapitalization facility and a facility for guaranteeing new unsecured term borrowing by banks. In addition, there should be a deposit insurance system and insurance fund. Thirdly, there should be sovereign debt restructurings mechanism for insolvable governments. Without this there could be serious consequences before and after a crisis occurs. As long as these criteria are met the Eurozone should be able to survive even though the EMU is not OCA. 26 5. Conclusion To investigate whether or not the EMU is OCA, the five main criteria of the OCA theory was evaluated. When the Euro was implemented back in 1999, the Euro was already not an optimal currency area and it is clear that it still is not one. However, they are making improvements, but still not close to becoming an OCA. Firstly, the criterion of similarity of inflation rates and similarity of shocks and cycles was examined. Members of a currency area should have similar inflation rates. From our findings it is clear that inflation was indeed fairly similar in the EMU countries and the degree of similar inflation rates has increased. And also the similarity of shocks and cycles has increased. Secondly, the criterion of labour mobility is assessed. Here, the higher the labour mobility between the countries, the better the countries will form an OCA. This criterion was not fulfilled. Labour mobility was low between the EMU countries and there were barely any improvements in labor mobility from since the Euro was implemented. What is more, the Euro is further away from an OCA than the US. The next criterion was the financial market integration and product diversification. The financial market integration has increased significantly since the EMU was founded. Also, most of the EMU countries have high degrees of diversification. So this criterion is satisfied too. Moreover, the following criterion is the economic openness and size of the economy. The more open a country is and the smaller its economy is, the better it fulfills this criterion. Most of the EMU countries are really open and the trade in the Eurozone has increased significantly. For the size of the economy it differs per country though as can be seen from the differences in GDP per capita. Last but not least, there is the criterion of fiscal and political integration. There is the least research done on this criterion, as it is hard to measure political 27 integration. Also, fiscal policies were pro-cyclical, but there is no consensus on this criterion. In summary, two of the five criteria are still not satisfied. The criterion for labour mobility and the criterion for fiscal and political integration. Therefore, it can be concluded that the EMU is definitely not an optimal currency area. However, in overall, there has been some degree of integration since the implementation of the Euro and the benefits outweigh the costs. Therefore, the EMU has had an overall positive effect on the EMU countries. All in all, the Euro should be sustainable even though it is not an optimal currency area since the benefits outweigh the costs. According to several studies, there have been improvements in meeting the criteria for the optimal currency area. 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