Optimal Currency Area Theory

There is an economic reason for a currency union and there is a political reason.  The economic reason is to boost trade and commerce.  Regions that share a currency have much greater trade than regions that don’t share a single currency.  Some empirical analyses suggest that the European single currency has increased trade by 5 to 15 percent in the euro-zone when compared to trade between non-euro countries.

The political reason is to force greater political unity because it creates greater interchange of all sorts between two regions and it gives more power over the region to whoever controls the monetary policy.  The European elites who pushed towards a currency union were probably more interested in increasing the political unity of Europe because there aren’t very good economic reasons for the single currency.

Krugman: Europe/euro:

Back when the single currency [the Euro] was being contemplated, the fundamental concern of many economists on this side of the Atlantic was, how will Europe adjust …[when] some members of the euro zone are hit much harder by a downturn than others, so that they have much higher-than-average unemployment… In the United States, such shocks are cushioned by the existence of a federal government: the Social Security and Medicare checks keep being sent to Florida, even after the bubble bursts. And we adjust to a large degree with labor mobility: workers move in large numbers from depressed states to those that are doing better.

Europe lacks both the centralized fiscal system and the high labor mobility. (Yes, some workers move, but not nearly on the US scale). To be sure, America has at least minor-league versions of the same problems: we are having fiscal crises in the states, and the housing slump has depressed mobility in the recession. But we’re still better able to cope with asymmetric shocks than the eurozone.  Was the euro a mistake? There were benefits — but the costs are proving much higher than the optimists claimed. On balance, I still consider it the wrong move, but in a way that’s irrelevant: it happened, it’s not reversible, so Europe now has to find a way to make it work.

Krugman: How Many Currencies?:

Some commenters on my Europe/euro post [above] offer a reductio ad absurdum: if Spain should have its own currency, why not every state/town/family in America?

Strange to say, economists have thought about that — a lot. It’s called optimal currency area theory. …The basic idea is that there’s a tradeoff. Having your own currency makes it easier to make necessary adjustments in prices and wages [using monetary policy], an argument that goes back to none other than Milton Friedman. As opposed to this, having multiple currencies raises the costs of doing business across national borders.

What determines which side of this tradeoff you should take? Clearly, countries that do a lot of trade with each other have more incentive to adopt a common currency: the euro makes more sense than a currency union between, say, Malaysia and Ecuador. Beyond that, the literature suggests several other things that might matter. High labor mobility makes it easier to adjust to asymmetric shocks; so does fiscal integration [having taxes and government spending flow across all regions in the currency zone].

When [the Euro] began as a project, there were a number of studies comparing the EU with the United States. What all of them suggested was that Europe was less suitable as a currency area, basically because of lower labor mobility and lack of fiscal union. That didn’t settle the question of whether the euro was a good idea, but it did suggest that appealing to the success of the United States with a single currency didn’t tell you much.

The big problem with sharing a currency is that it eliminates monetary policy as a tool for fine-tuning the economy across the business cycle. One region often needs different monetary policy than another.  For example, US monetary policy was too loose (interest rates too low) for Nevada during the housing bubble (2002-2007) and it was far too tight during the 2008 recession because Nevada had one of the highest unemployment rates.  There are three ways that countries ameliorate the problems of having the same monetary policy everywhere in the nation:

  1. fiscal union (gov’t spending mobility),
  2. labor market union (mobility of workers),
  3. goods market union (mobility of goods & services).

Krugman argues that we have learned from the experience in Europe that one of the above criteria turns out to be much more important than the others.

The theory of optimum currency areas [OCA] is one of those old-fashioned pieces of macroeconomics…. Still, we do learn some new things. And what we’ve learned lately, I’d argue, is that labor mobility — which was supposed to be good, and a prerequisite for currency union — is actually much more problematic than we knew.

In my somewhat stylized intellectual history, we owe OCA theory to three main players: Robert Mundell, Ron McKinnon, and Peter Kenen. All three assumed, realistically, that wages and prices are sticky, so that fixing your exchange rate or adopting a shared currency imposes costs in the form of making it harder to adjust to “asymmetric shocks” that depress your economy relative to trading partners. These costs must be set against the benefits of making business across borders easier and more certain. The question then becomes how the characteristics of an economy affect that tradeoff.

In Mundell’s original version the key question was labor mobility: if workers moved freely and rapidly from slumping to booming regions, asymmetric shocks became a much smaller problem. One of the arguments American euroskeptics used to make was that Europe was less suited to a single currency because it lacked America’s extremely high interstate mobility of labor.

McKinnon offered a different criterion — the share of tradables in output; basically that required relative price adjustments would be smaller in very open economies, and also that having more transactions would increase the benefits of a common currency.

Finally, Kenen argued that fiscal integration or the lack thereof was crucial, that it mattered a great deal whether depressed regions would be cushioned by paying less in taxes and receiving more in benefits from the core.

So what have we learned? I’d say that we’ve learned that Kenen trumps Mundell — that in the absence of effective fiscal integration, labor mobility makes a currency union worse, not better.

I’ve said this before, but it seems worth emphasizing again in the light of this FT report on Portugal’s “perfect demographic storm.” The debt crisis in Portugal, it turns out, looks alarmingly like the trigger for an economic death spiral: a depressed economy is leading to large-scale emigration of working age Portuguese (also lower fertility, although this will take longer to matter), undermining the tax base, making an exit from crisis even harder. It’s not easy to see how this ends before you’re left with a rump nation of old people with no resources to care for them.

Regional economies in the US are less vulnerable to this sort of thing, although our imperfect fiscal integration means that it can still happen to some degree: Puerto Rico is also in a sort of death spiral of emigration and fiscal stress, but the degree of hardship is much less thanks to the national safety net.

But the point is that the Single European Act, which was among other things supposed to prepare the ground for a shared currency, may actually have interacted with the failure to integrate fiscal matters in such a way as to create a whole new kind of catastrophe.

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