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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.
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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
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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. Also, the problems in the Euro zone could be partially but not fully because
the Euro zone is not an optimal currency area. Besides, several weaknesses and
limitations of the OCA have been discovered. The OCA has helped us to get this
far in forming a monetary union, but there are several other factors that have to
be taken account of before it can solve its problems, such as mobility of capital.
28
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