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Lecture 10
International Finance
ECON 243 – Summer I, 2005
Prof. Steve Cunningham
Optimum Currency Area (OCA)
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The economic theory examining the necessary and
desirable characteristics of countries economies for
membership in a monetary union is the theory of
the optimum currency area (OCA).
The theory was introduced and popularized by
Robert Mundell (1961), Ronald McKinnon (1963),
and Peter Kenen (1969).
Robert Mundell received the Nobel Price in
Economics in 2000, in part for his contribution to
OCA.
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Costs and Benefits
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Key question: Is the economy of the candidate country
characterized by relatively stable or rising prices and
wages?
The formation of a monetary union results in the loss of
monetary and exchange rate policies.
The loss of these policies is considered to be the most
important cost in joining a monetary union.
These are the most useful policies to a country
experiencing internal shocks. These policies are used to
fight recession or inflation.
Robert Mundell’s initial contribution on the OCA was
developed within the IS-LM-FE model which assumes
constant prices. Rising prices can neutralize some or all of
the positive effects of these two policies.
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Are the shocks symmetric?
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An exchange rate policy can be used by a non-member
country to fight its way out of recession caused by an
asymmetric shock.
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So it is important to study the nature and expected frequency of
asymmetric shocks for members of EU countries.
If most of the shocks are symmetric, then member countries
can use policy related to the common currency to jointly deal
with the shock.
Asymmetric shocks can arise from differing financial, legal,
and tax systems, and structural differences in labor markets
and institutions. Of course natural disasters within a limited
geographic region are another cause of such shocks.
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Integration and Shocks
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Increased intra-industry trade and further economic
integration should reduce country differences which
cause asymmetric shocks.
Empirical evidence suggests that business cycles in EU
countries became more synchronized after the 1980s.
Not all economists agree with this evidence.
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Paul Krugman (1993), drawing on U.S. evidence, argues
that economic integration leads to regional concentration
of industries. (e.g., automobile plants in Michigan)
Obviously, regional concentration of industries could lead
to asymmetric shocks.
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Seigniorage
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This is another potential cost to a monetary
union—the loss of the ability of the governments
involved to raise revenues through inflationary
finance.
Seigniorage is essentially an “undeclared tax” on
money balances held by people and businesses.
When gov’t print too much money and cause
inflation, the money already being held by the
public loses value (purchasing power).
This loss of value is almost equal to the value of
the newly printed money. This is seigniorage.
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Seigniorage (2)
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Generally speaking, most gov’ts relied heavily on seigniorage
prior to WWII. Since then, most industrialized countries have
developed elaborate tax systems to raise revenues. They have
not had to rely as heavily on seigniorage.
Southern EU countries consistently depended on seigniorage
for revenue, and have less well-developed tax systems, and
tend to inflate more readily.
This has caused some researchers to argue that Southern
European countries should remain outside the monetary
union.
Other researchers disagree strongly, saying that the monetary
discipline of the union would be a major benefit to these
countries.
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Overall Cost Considerations
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Expected costs of the formation of a monetary union
will be lower if labor markets are flexible and if free
labor mobility is high.
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Regional unemployment can be offset by labor moving to
another region, and would not require direct policy
intervention.
The expected costs of union would also be lower if
the budgetary process is centralized, and the
monetary union is vested with fiscal powers (i.e., a
budget).
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This would allow the union to direct loans or aid to
countries or regions suffering asymmetric shocks.
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Benefits
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The most frequently mention benefits arise from the
elimination of transactions costs.
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These occur when businesses and consumers must exchange currencies
to purchase goods and services.
They occur when businesses invest abroad.
They occur when financial investors purchase foreign securities.
Whether the reduction of such costs (risks) actually increases
the volume of trade is uncertain.
Ironically, while some firms may benefit the reduction of such
costs, it directly reduces the income of banks and other
financial institutions who sell services to deal with exchange
rate problems!
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Benefits (2)
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Price transparency
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Expressing all prices within the union in terms of
only one currency allows everyone to compare
prices more easily.
Consumers discriminate better on price, and firms
become more competitive. Both factors are antiinflationary.
Foreign Reserves
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Member countries do not have to hold reserves of
other member countries’ currencies.
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Benefits (3)
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If the monetary union is a large, successful, and
stable economic entity, then its currency is likely
to become an international medium of
exchange—a dominant currency.
This makes it easier and cheaper for the union to
sell its debt in foreign markets.
Foreign banks will hold its currency in reserve.
The union may also contribute to price stability
for its members, encouraging long-term
commitment of resources by the public, and
providing clearer economic signals to market
participants.
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Is the EU an OCA?
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An OCA, according to theory:
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Must consist of only economically integrated
countries. This ensures that shocks are
symmetric.
Economic integration leads to the formation of
a flexible common market for all factors of
production and products—another
requirement.
The central authority of the monetary union
must have significant fiscal powers to be able to
deal with remaining asymmetric shocks.
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Is the EU an OCA? (2)
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The Single European Act (SEA) which became
effective in 1993 contributed to the integration of
many aspects of the EU countries.
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The idea was to create a Single European Market
(SEM) without frontiers or barriers.
Differences still exist in:
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The legal, taxation, and financial systems.
The organization and flexibility of labor markets,
Economic growth rates, and
Unemployment rates.
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Is the EU an OCA? (3)
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(EU, EU15, EU25)
Biggest differences are between the Northern and
Central European countries and the Southern
Mediterranean countries.
The northern/central region includes the more
developed industrial countries, while the southern
region includes more agriculture-based employment.
This became an issue again with the May 2004
expansion to the EU to include 10 new member
countries.
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Is the EU an OCA? (4)
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Bayoumi and Eichengreen (1994) estimated and
compared permanent supply shocks among 8 U.S. regions
and among 11 EU countries.
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Permanent supply shocks were not correlated across the EU
countries, whereas the U.S. regional supply shocks were highly
correlated.
Supply shocks in the EU were also larger than those in the U.S.
regions.
They concluded that the 11 EU countries did not constitute an
OCA.
They argued that a smaller core of EU countries comprised of
Germany, France, Belgium, Netherlands, and Denmark form a
more homogeneous group, and therefore more qualify as an
OCA.
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Is the EU an OCA? (5)
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These authors recommended that this core group form a
monetary union, and that other countries be added as
they meet certain integration criteria.
A study by the EC Commission (1990) found that some
costs of forming a monetary union had been exaggerated,
shifting the cost-benefit ratio in favor more inclusive
membership.
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The loss of exchange rate policy was not as critical as some had
estimated previously.
Exchange rate policies against one another tends to allow one to
gain at the expense of the other. As a result, such policies tend to
be met with reprisals, thus reducing the benefits of such policy.
Also, such policies depend on prices being stable, so that real
exchange rates actually change.
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External Benefits of Integration
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The joint/total reduction of transactions costs
among member nations has been estimated at
about 1% of their joint GDP.
Each country joining the EMU also generates
external benefits.
As more countries join, the benefits of monetary
integration also increase.
One problem with applying this to the EMU is that
the EMU lacks substantial budget power.
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This makes it impossible for the the central authority to
compensate (through redistribution) member countries
for external benefits or individual costs.
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External Benefits of Integration (2)
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It has become clear that the countries that
benefited most from the EMU are those that
“imported price stability” by adopting the
common currency, avoiding local political
pressures to inflate their currencies.
These are primarily Greece, Spain, Portugal,
Italy, and Ireland.
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Labor Markets in the EU
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Labor markets in Europe are rigid.
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They have low mobility. Many European workers are
unwilling to relocate to seek employment within their
own country, let alone to other countries. This is
attributed to:
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Cultural barriers
Language
Climatic problems
They have high wage rigidity. EU labor markets have
strict labor laws and labor organizations which are
responsible for such wage rigidity.
Most economists are convinced that labor market
rigidity is one of the most important causes of high
unemployment rates in EU countries.
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Labor Markets in the EU (2)
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One problem is the heavy centralization of trade
unions and employers associations that often
negotiate labor agreements at the national or
regional levels.
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This allows for little variation of wages to account for
differences in labor productivity among companies.
Small companies often cannot afford to pay such wages
when their levels of automation and volumes do not
permit the high productivity rates needed to support
high wages.
Economic theory suggests that firms optimize when they
pay labor its marginal product.
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Labor Markets in the EU (3)
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Since the late 1990s, many policies were adopted in almost
every EU state to introduce more flexibility with labor
markets.
Incentives were offered to firms to increase hiring and to
unemployed workers to seek jobs more aggressively.
Employment levels have improved, but many of the gains
have been through temporary, contract, and part-time
employment.
From 1996 to 2001, employment in the Euro Area
increased by 1.6% per year. (U.S. employment increased by
1.3% per year, even though its economy grew more
quickly.)
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A Success Story
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Ireland was a slow-growth, low income
country not so long ago.
By 2001, Ireland had the 2nd highest per
capita income in the EU ($28,500).
Ireland also has the lowest corporate tax
rate in the EU at 12.5%.
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The Lisbon Agenda
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During the March 2000 EU Summit in Lisbon,
Portugal, the members agreed to transform the EU
by 2010 into the most dynamic, knowledge-based,
competitive economy in the world.
The countries agreed to pursue economic, social, and
environmental policies that would lead to sustained
development, high economic growth, and social
cohesion.
They will pursue structural reforms by investing in
R&D and innovation, and by completing the SEM.
The idea is to make the EU more of a OCA.
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The Lisbon Agenda (2)
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Among the changes introduced in the individual countries,
have been the reforms called for by firms:
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To reduce long-term unemployment benefits,
To Reduce pension payments,
To have more freedom in laying off workers, and
To have more freedom in increasing working hours per week.
Not surprisingly, many EU workers and trade unions saw
these proposals as challenges to workers’ rights and benefits,
and an adoption of U.S. practices.
Many governments accepted in principle the Lisbon Agenda
as a necessary program to help the EU economist recover
from slow growth and unemployment.
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Example: France
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Nicholas Sarkozy, a French politician, asked Michel
Camdessus, a former head of the IMF for an
explanation of the causes of the French economic
slowdown, and asked for recommendation to
reinvigorate the French economy.
Camdessus with a 20-member team published a
140-page report in 2004.
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He argued that the problem was a failure to respond to
challenges related to:
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The diffusion of new technologies and training
An aging population
Globalization
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Example: France (2)
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Recommendations:
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Liberalize the labor market,
Reduce public debt, and
Get the universities and companies to work together to
promote the necessary knowledge base among the
workforce.
He argued that similar reforms were working in:
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Sweden (which restructured its labor markets and state
pensions)
Finland (which attained a high-level knowledge
economy)
Denmark (which reformed its welfare state)
UK (which liberalized its labor market)
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Example: France (3)
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Camdessus found that for many years GDP growth
for the U.S. exceeded that of France and other EU
countries, and the U.S. unemployment rates were
lower.
At the same time, labor productivity in the U.S is
about the same time as in France.
The direct implication is that the problem if France
and the EU in catching up to the U.S. is not
competitiveness of its industries.
European workers, by choice, work 20% fewer
hours than U.S. workers.
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Example: Sweden
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Introduced substantial labor market flexibility that
has increased manufacturing sector labor
productivity.
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Unfortunately, Sweden did not increase labor productivity
in the services sector as in the U.S.
Wages are no longer set at the national level.
Sectoral labor contracts are flexible.
The pension system was reformed:
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Pension income is determined according to real wages,
longevity of the retiree, and the growth of the economy.
This ensures the integrity of the system.
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The Future of the Lisbon Agenda
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According to a 2004 EC Commission report, the following
areas are key to achieving the goals of the Lisbon Agenda:
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Investment in networks and knowledge.
Strengthening competitiveness in industry and services through the
completion of the internal market.
Increased labor participation of older people by encouraging older
workers to delay retirement.
After reviewing the Commission report, in March, 2004, the
EU leaders pledged to accelerate the pace of the reforms.
The Dutch prime minister, Wim Kok, was chosen to head a
group to study the progress. The Kok Report of November
2004 focused on the lack of political commitment of the EU
member states to the objectives.
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Comparative Statistics, 1999-2003
Euro Area
US
Japan
Real GDP Growth (%)
1.78
2.72
1.22
Unemployment Rate (%)
8.76
4.96
5.02
Inflation Rate (%)
Area (thous. sq. km.)
1.94
2,509
2.46
9,631
-0.58
377
Population (millions)
308.7
291.1
127.6
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Euro Timeline
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1957: The Treaty of Rome was signed,
establishing the EEC and EUROTOM.
1958: The Monetary Committee was formed
as an advisory body to the ECOFIN.
1964: The Committee of Central Bank
Governors was formed.
1970: The Final report of the Werner plan is
completed. (Feasibility of a European
Monetary System)
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Euro Timeline (2)
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1979: The EMS became effective. The EMS consisted
of three components:
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Exchange Rate Mechanism (ERM)
European Currency Unit (ECU)
European Monetary Cooperation Fund (EMCF)
1989: The Delors Report is published. (Recommends
three stages for deployment of a full monetary union
for the EC)
1991: The Maastricht Treaty was approved by the
heads of the EC states in 1991, signed in Maastricht in
1992, and comes into force in 1993.
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Euro Timeline (3)
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1999: The EMU is launched in 11 EU countries.
2002: Euro notes and coins are distributed in
12 European countries. On March 1, 2002, the
euro is the sole legal tender in 12 Euro Area
countries.
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The Eurosystem
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Monetary policy in the Euro Area is entrusted to the
Eurosystem. This consists of:
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The European Central Bank (ECB)
12 National Central Banks (NCBs)
The organization is remarkably similar to the U.S. Federal
Reserve System, although the number of NCBs is only
coincidentially the same as the district banks in the U.S.
system.
There will be an NCB for each country that joins.
Along with the General Council, an advisory body to the ECB,
and the NCBs of non-euro countries, this constitutes the
European System of Central Banks (ESCB).
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European System of Central Banks
EUROSYSTEM
GOVERNING COUNCIL
(Decision-making Body)
Executive Board
President
Vice President
Members
Formulates
monetary policy
1
1
4
6
Governors of NCBs
12
Total
18
National Central Banks implement
monetary policy in the Euro Area
NCB1
1
1
Total
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NCB2
…
NCB12
National Central Banks that
have not adopted the euro
GENERAL COUNCIL
(Advisory Body)
President
Vice President
Governors of NCBs
of all countries
EUROPEAN CENTRAL BANK (ECB)
Frankfort, Germany
NCB13
…
NCB24
NCB25
25
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Eurosytem
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Note that the distinction between the
Eurosystem and the ECSB will continue until
all EU member countries join the EMU and
adopt the euro.
At that time, the system will simply be the
ECSB.
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The Governing Council
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The Governing Council formulates the monetary
policy of the Euro Area.
The Maastricht Treaty requires the Governing
Council to convene at least 10 times per year, but it
usually meets twice a month in the Eurotower in
Frankfurt, Germany.
It has three (3) major functions:
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Provide price stability,
Provide liquidity to the entire Euro Area banking and
financial system, and
Establish and maintain an efficient payments
mechanism throughout the EU.
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The Governing Council (2)
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To do this, the Governing Council controls bank
reserves, sets certain key interest rates, and
ultimately attempts to control the money supply
in the Euro area.
The first president was Willem Duisenberg,
previous the governor of the Dutch Central Bank.
The second president is Jean-Claude Trichet,
previously president of the French Central Bank.
Both presidents are known for their strong stance
on price stability in their countries.
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The Executive Board
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Executive Board members serve 8-year,
nonrenewable, staggered appointments. It is hoped
that this will provide continuity of experiences
members on the Board.
The Executive Board is responsible for implementing
monetary policy on a daily basis. The Executive
Board instructs the NCBs to conduct certain policies.
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The idea is that the NCBs are closer to their local money
and financial markets, and therefore are better able to
implement policy. Geographic distance was one reason
given. (Like US FRBs?)
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The General Council
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To coordinate actions between euro and noneuro EU countries, the General Council was
created.
The General Council inherited the
responsibilities of the previous European
Monetary Institute (EMI) which was dissolved
with the creation of the ECB.
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Objectives
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The primary objective of the ECB is the pursuit of price
stability for the entire Euro Area, as stated in Article 105 of
the Treaty which established the EC.
In order to do this, the ECB was granted political
independence from other EU institutions and national
governments. As of today, the ECB is considered the most
independent central bank in the world. (It was modeled
after the Bundesbank of Germany.
It is prohibited from financing government deficits.
It is institutionally and financially independent from EU
institutions by having its own budget. (It is financed by the
NCBs and not the EU budget.
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