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The Theory of Optimal Currency Areas. Pros and Cons of the Eurozone

Term Paper 2016 22 Pages

Economics - Finance

Excerpt

Table of contents

Abstract

Table of contents

List of Abbreviations

List of Figures

1. Introduction

2. Objectives

3. OCA theory: Insights and important criterions

4. The Euro Zone in the light of the OCA theory
4.1 High mobility of factor labor
4.2 Degree of openness
4.3 Diversification in production and consumption
4.4 Price and wage flexibility
4.5 Similarity of inflation rates
4.6 Fiscal transfers
4.7 Financial integration

5. Conclusion

6. List of references

List of Abbreviations

Abbildung in dieser Leseprobe nicht enthalten

List of Figures

Figure 1: Unemployment rate Eurozone 2009 / 2015

Figure 2: Annual cross-border mobility (EU, US, Canada)

Figure 3: Trade-Openness-Ratio (2000-2014)

Figure 4: EA12: Intra and Extra-EU trade by Member State 2015

Figure 5: Unemployment Rate in selected European Countries (2000-2015)

Figure 6: Change in Real Wages in selected European countries (2000-2014)

Figure 7: Unit Labor Costs (2000-2015)

Figure 8: Inflation rate Eurozone (2002-20015), HICP

Figure 9: Inflation rate Eurozone 'Core' countries (2010-2015). HICP

Figure 10: Inflation rate PIIGS (2010-2015), HICP

Figure 11: Price-based and quantity-based Financial Integration Composites

Abstract

On the 1st of January 1999, 11 European countries[1] adopted the Euro as their official currency. A new Economic and Monetary Union with more than 300 million citizens was born. Sharing a common currency offers several advantages for countries, firms and citizens like enhanced cross-border trade, a better price transparency or the disappearance of foreign exchange rate risks. However, a Monetary Union also comes with constraints like the loss of exchange rate regime of its members which is an important instrument to fight adverse shocks. In order to minimize economic risks for its members and to foster the economic stability of the future European EMU, the European Union member states agreed to meet the Euro Convergence Criteria[2] as a requirement to adopt the Euro. During the negotiations about the necessary criterions, the theory of Optimal Currency Areas – a theory which has its origin in the Bretton Woods era – was deliberately reincarnated by economists to verify whether or not the Eurozone can become a successful EMU. Until today the (traditional) OCA theory is often used by the literature and also by politicians to evince fundamental flaws of the Eurozone.

This assignment investigates the Eurozone in the light of the theory of Optimal Currency Areas.

In the first part of this assignment the main contributors to the theory of Optimal Currency Areas are enumerated and its most significant factors are explained.

The second part applies the listed factors to the Eurozone in order to determine whether or not a specific criterion is fulfilled by the European EMU.

A summary and conclusion complete this essay.

1. Introduction

Already decades before the launch of the European EMU on the 1st of January 1999, economists – in the light of the Bretton Woods currency system - started to discuss criteria that should indicate whether or not it makes sense for multiple countries to share a common currency. The findings of these discussions, the so called theory of Optimal Currency Areas, played an important role during the foundation process of the Euro.

The theory of Optimum Currency Areas (OCA) is a macroeconomic instrument which defines criterions under which it would create the greatest economic benefit for a geographic region to share a single currency. The concept of an OCA was first described by Robert Mundell (Mundell, 1961) in 1961 and extended by McKinnon (McKinnon, 1963), Kenen (Kenen, 1969) and other important contributions in the following years.

Initially, the theory of Optimum Currency Areas had a quite academic character (Broz, 2005, p. 54f). But while plans for an Economic and Monetary Union (EMU) were advancing, the practical relevance of this instrument became more and more obvious.

Although lots of scientific papers have been published[3] about weaknesses and limitations of the OCA theory, its criterions can still help to identify if the members of the Euro Zone benefit from a common currency or if monetary independence could be advantageous.

2. Objectives

This paper consists of three parts. The first section gives an insight into the literature of the OCA theory and points out its most important criterions. The second part applies the found criteria to the European EMU. The aim of this step is to find pros and cons to determine whether or not the Euro Zone can be considered an Optimum Currency Area. The last section consists of a summary and gives a conclusion.

3. OCA theory: Insights and important criterions

Generally speaking, the OCA theory determines the conditions that countries need to fulfill in order to ensure that the benefits of a monetary union exceeds its costs. The traditional OCA theory typically takes the advantages of a common currency (e.g. increased transparency and reduced transaction costs) as given and concentrates on formulating conditions under which the disadvantages of a monetary union – foremost the loss of a sovereign monetary policy - are minimized as much as possible. In the event of an asymmetric shock monetary and exchange rate policies are no available stabilizing tools for the individual member states of a monetary union. Therefore, the authors of the OCA theory often define factors as important for building an Optimum Currency Area that can be used as an instrument to fight asymmetric shocks in replacement of the lost monetary sovereignty.

In this line of thought, Mundell (Mundell, 1961) postulates a high mobility of the production factors labor[4] and capital as the key conditions to define a geographic region as an Optimum Currency Area. He argues that in the absence of flexible exchange rates high labor mobility can prevent unemployment and inflation pressures in a region in case of an asymmetric shock (Mundell, 1961, p. 664).

McKinnon (McKinnon, 1963) stresses the degree of openness of a region as an important factor for forming an OCA and he defines openness as the ratio of tradable to non-tradable goods (McKinnon, 1963, p. 717). He argues that the higher the degree of openness, the more changes in the international prices of tradables are likely to be transmitted to the domestic cost of living. This would reduce the potential for money or exchange rate illusion by wage earners.

Kenen (Kenen, 1969) proposes the degree of diversification in national production and consumption as one key economic criterion for forming a successful OCA. He argues that a well-diversified economy also has a diversified export sector. A negative shock of one industry could be compensated by a positive shock of another industry which then would result in a shock cancellation effect on the total export. Hence well-diversified economies could successfully share a common currency.

Kawai (Kawai, 1987) postulates that when prices and wages are flexible between and within regions that share the same currency, the transition towards adjustment following a shock is less likely to be associated with sustained unemployment in one country and / or inflation in another. This diminishes the need of nominal exchange rate adjustments (Friedman, 1953).

Flemming (Flemming, 1971, p. 476) stresses the importance of similarities in inflation rates when countries decide to form a monetary union. He notes that when inflation rates between countries are low and similar over time, terms of trade will also remain fairly stable.

Kenen (Kenen, 1969) also argues that the higher the level of fiscal integration between two areas the greater their ability to smooth out diverse shocks through fiscal transfers from a low- to a high -unemployment.

Ingram (Ingram, 1973) considers that the higher the degree of financial integration the lower the need for exchange rate changes among partner countries, because changes in interest rates would provoke compensating capital flows across national frontiers. Therefore, regions must achieve a high degree of financial integration in order to build an OCA.

4. The Euro Zone in the light of the OCA theory

Having roughly described the theoretical backgrounds of the traditional OCA theory in the first part of this assignment, the second part deals with applying the found properties to the Euro Zone in order to answer the question whether or not the European EMU is an Optimum Currency Area.

4.1 High mobility of factor labor

Figure 1 visualizes the unemployment rates in the Eurozone after the start of the Euro crisis in 2009 and in 2015.

Abbildung in dieser Leseprobe nicht enthalten

High unemployment rates can be seen in the outer parts of the Eurozone (e.g. Portugal, Spain, Ireland) after the start of the Euro crisis. Under the assumption of high labor mobility, we should notice significant migration flows of unemployed people from the periphery into the center of the Eurozone. The result should be a harmonization of unemployment rates across the Eurozone.

On the contrary, in 2015 the unemployment rates have even increased in the southern countries of the European EMU whereas the situation in Central Europe has improved.

The presumption of low labor mobility from the outer parts of the Eurozone to the center is supported by Figure 2 which compares the annual mobility rates within and between EU countries with labor flows inside the US.

Figure 2 : Annual cross-border mobility (EU, US, Canada); Source: (OECD, 2012, p. 64)

Abbildung in dieser Leseprobe nicht enthalten

It shows that the annual mobility rate between EU countries was in 2010 only around 0.2% of the total EU population, whereas the mobility rate of US citizens was more than 10 times higher (2.7 %).

The reasons for the low cross-country labor mobility within Europe are various, starting from language issues, family ties, culture to the housing market (Andor, 2014).

Nevertheless, with a rate 10 times lower than the rate of the US, the Eurozone suffers from a low labor mobility and does thus not fulfill the corresponding OCA criterion of high factor mobility.

4.2 Degree of openness

The degree of economic openness is one of the essential OCA criteria as price changes in international trade will have an impact on domestic prices, especially in the smaller countries, which would not be able to protect themselves against currency fluctuations.

The openness of a country is commonly measured with the trade-to-GDP-ratio which is also often called ‘trade openness ratio’. The trade openness ratio is defined as the sum of exports plus imports of a region divided by its GDP. The higher the score the more open a region is considered (Department of Business Innovation & Skills, 2014).

Figure 3: Trade-Openness-Ratio (2000-2014); Data Source: World Bank

Abbildung in dieser Leseprobe nicht enthalten

Figure 3 indicates that starting from 2000 the Trade-Openness-Ratio of the European Union remained steadily much higher than the ratio of the US and other countries like Japan or Australia. In 2014 the European Union has achieved a quite high Trade-Openness-Ratio of 65 compared to the ratios of the United States (23), Japan (32) or Great Britain (40). Even Greece (as an example for the PIIGS states) scores with a ratio of 43 higher than the US, Japan or Australia.

Judging from the trade-to-GDP-ratio the Eurozone is a region with a high degree of openness (Jager & Hafner, 2013).

4.3 Diversification in production and consumption

Sector specific shocks don’t have a huge impact on regions with a high degree of diversification as shocks in one sector can be absorbed by potential booms in other sectors.

Figure 4 displays imports and exports of EA11[5] countries by sector in the year 2015. Export data hints at the degree of production diversification of a country, whereas the import data gives an insight into its consumption.

Figure 4: EA12: Intra and Extra-EU trade by Member State and by product group in 2015; Data Source: Eurostat

Abbildung in dieser Leseprobe nicht enthalten

Judging the exports, most of the EA12 countries could (at least temporally) compensate shocks in specific sectors as no sector contributes significantly more than 25 % to their export revenue. Then again Ireland (59 %[6] ), Greece (63 %[7] ), Luxembourg (60 %) and Finland (47 %) are highly dependent on specific sectors and could therefore hardly compensate corresponding shocks.

Similar but less pronounced is the situation regarding imports to EA12 countries. Most countries are not highly dependent on a specific sector. But also here, countries like Greece (42 %[8] ) and Luxembourg (53 %) show some imbalances and might be vulnerable to shocks in specific sectors.

In summary, not all regions of the Eurozone show a high degree of diversification.

4.4 Price and wage flexibility

Wage / price flexibility is also seen as an important criterion for an OCA as wage flexibility is a crucial adjustment channel to asymmetric shocks (Arpaia & Pichelmann, 2007, p. 3). Wage flexibility is defined as the speed with which real wages react to macroeconomic conditions and it is measured as the responsiveness of real wages to shocks, usually measured in unemployment variations (Clar, Dreger, & Ramos, 2007, p. 4).

Figure 5 shows constant unemployment rates in the first years of this century. Starting from 2008 we see a rise of unemployment in Spain and later in Greece, Ireland, Portugal and Italy when shocks struck parts of the EU. In comparison to 2008 we face drastic increases of 250 % (Greece 2013), 130 % (Ireland 2011, Spain 2013), 90 % (Italy 2014) and 85 % (Portugal 2013) in rates of unemployment between 2011- 2013.

Figure 5: Unemployment Rate in selected European Countries (2000-2015); Data Source: Eurostat

Abbildung in dieser Leseprobe nicht enthalten

Although these countries were hit by asymmetric shocks, Figure 6 shows increased real wages during 2008 and 2009. However, in 2010 we see decreased real wages in Greece (-7,5 %), Spain (-2,4 %) and Ireland (-1,3 %) with Italy (-1,5 %) and Portugal (-3,0 %) following in 2011.

Figure 6: Change in Real Wages in selected European countries (2000-2014); Data Source: OECDAbbildung in dieser Leseprobe nicht enthalten

The numbers above might suggest that wages in the Eurozone are flexible as they respond to increased unemployment. On the other hand, the downward adjustment of wages need to exceed a specific level in order to help regions regain competitiveness[9].

An indicator to price competiveness of a region are Unit Labor Costs (ULC[10] ) (European Commission, 2016, p. 1).

Figure 7: Unit Labor Costs (2000-2015); Data Source: Eurostat

Abbildung in dieser Leseprobe nicht enthalten

Figure 7 visualizes the development of ULC in selected countries from 2000-2014. It can be seen that the ULC of countries like Spain, Portugal and Greece – though decreased - are still above Germany’s. The ULC of Italy has even increased. Solely Ireland managed to decrease ULC and regained competitiveness.

Hence the flexibility of most of the regions is not high enough to work as shock absorbers.

4.5 Similarity of inflation rates

The similarity of inflation levels helps the ECB to implement effective monetary policies that functions in all Eurozone countries, thus eliminating the effects of asymmetric shocks in different countries. The ECB has defined an optimum inflation rate of below but close to 2% on a year-to-year basis (Constâncio, 2015).

As can be seen in Figure 8, starting from the introduction of the Euro hard cash in 2002 the inflation rates of the Eurozone countries were divergent. In 2002 the difference between the lowest (Germany, 1,38 %) and the highest (Ireland, 4,72 %) inflation rate was 3,34%, reaching a maximum of 6,28 % (Greece, 4,7 % & Ireland, -1,58 %) during the Euro crisis in 2010. In 2015 the difference between the highest (Austria, 0,82 %) and lowest (Greece, -1,1 %) inflation rate was reduced to 1,92 %[11].

Figure 8: Inflation rate Eurozone (2002-20015), HICP; Data Source: Eurostat

Abbildung in dieser Leseprobe nicht enthalten

Having a closer look at the “core” countries (Figure 9) one can see that the difference in inflation rates floated between 0,69 % (2015) and 1,59 % in the years 2010 – 2015.

Figure 9: Inflation rate Eurozone 'Core' countries (2010-2015). HICP: Data Source: Eurostat

Abbildung in dieser Leseprobe nicht enthalten

In contrast, Figure 10 shows significant higher inflation rate differences between the PIIGS countries (1,61 % (2015), 6,28 % (2010).

Figure 10: Inflation rate PIIGS (2010-2015), HICP; Data Source: Eurostat

Abbildung in dieser Leseprobe nicht enthalten

Although the inflation rates of the ‘core’ countries seem to converge since 2010, a synopsis of the last decade with high inflation rate differences between the member regions suggest that the Eurozone as a whole doesn’t fulfill the OCA criteria of similar inflation rates.

4.6 Fiscal transfers

An automatic fiscal transfer system from prosperous to distressed regions can help smoothen adverse shocks (e.g. in the form of joint unemployment expenditure). Such a system needs a budget that is centrally administered by the OCA (Marco, 2014, p. 18). In fact, the countries of the European EMU agreed on debt and annual deficits limitations with the Stability and Growth Pact and recently with the “Sixpack”. However, a fiscal union (and a fiscal transfer system as part of the union) has not been established until today which is already indicated by the relatively small[12] annual budget of the European Union (2016: € 155B[13] ).

But ever since the start of the Euro Crisis economists start to wonder if the Eurozone can be successful in the future without a fiscal union[14].

4.7 Financial integration

Financial integration can be defined from an institutional and legal point of view (de jure) or on a factual basis (de facto).

Since the creation of the monetary union, the Euro area has - from a legal point of view - transformed into a closely integrated financial market, with a level of integration comparable to the United States or Japan (Perea & Van Nieuwenhuyze, 2014, p. 101).

The degree of ‘de facto’ financial integration in Europe can be measured using price-based[15] and quantity-based[16] financial integration composites which range from 0 (full fragmentation) to 1 (full integration).

[...]


[1] Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, Netherlands, Portugal and Spain.

[2] Also known as the Maastricht Criteria.

[3] See the summary of Mongelli (Mongelli, 2008, p. 4ff) for details.

[4] Krugman ( (Krugman, Revenge of the Optimum Currency Area, 2012, p. 445) argues that labor mobility isn’t important for OCAs. He even states (Krugman, New York Times - Opinion pages, 2015) that in absence of an effective fiscal integration labor mobility can make a currency union worse.

[5] As a representative for the Eurozone.

[6] Ireland is highly reliant on the export of pharmaceuticals (28%) and organic chemicals (21%) (see http://www.tradingeconomics.com/ireland/exports).

[7] Mineral fuels contribute 37% to Greece ‘s export revenue (see http://www.tradingeconomics.com/greece/exports).

[8] 34% of Greece’s imports are mineral fuels (see http://www.tradingeconomics.com/greece/imports).

[9] (In absence of an adjustable currency.)

[10] Downward adjustments of wages help to reduce ULC as they are calculated as the ratio of total labor costs to real output.

[11] The inflation rates of Cyprus (-1,54%) and Malta (1,18%) were not taken into consideration due to special situations in these countries.

[12] Compared to e.g. the budget of the US (2015) of € 2,758B (see https://www.gpo.gov/fdsys/pkg/BUDGET-2015-BUD/pdf/BUDGET-2015-BUD.pdf#page=174)

[13] See http://ec.europa.eu/budget/annual/index_en.cfm?year=2016

[14] See amongst others (Wren-Lewis, 2013)

[15] The price-based FINTEC is constructed from a selection of price-based indicators that cover the four main market segments: money, bond, equity and banking markets (European Central Bank, 2016, p. 142)

[16] The quantity-based FINTEC is constructed using intra-euro area cross-border holdings which are expressed as a percentage of euro area total holdings (European Central Bank, 2016, p. 145).

Details

Pages
22
Year
2016
ISBN (eBook)
9783668551343
ISBN (Book)
9783668551350
File size
1 MB
Language
English
Catalog Number
v377616
Institution / College
University of applied sciences, Cologne
Grade
1,7
Tags
European Union OCA Eurozone Euro Monetary Union EMU Currency Euro Convergence Criteria

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Title: The Theory of Optimal Currency Areas. Pros and Cons of the Eurozone