Optimum currency area

In economics, an optimum currency area (OCA), also known as an optimal currency region (OCR), is a geographical region in which it would maximize economic efficiency to have the entire region share a single currency.

It describes the optimal characteristics for the merger of currencies or the creation of a new currency. The theory is used often to argue whether or not a certain region is ready to become a currency union, one of the final stages in economic integration.

An optimal currency area is often larger than a country. For instance, part of the rationale behind the creation of the euro is that the individual countries of Europe do not each form an optimal currency area, but that Europe as a whole does form an optimal currency area.^[1] The creation of the euro is often cited because it provides the most modern and largest-scale case study of the engineering of an optimum currency area, and provides a comparative before-and-after model by which to test the principles of the theory.

In theory, an optimal currency area could also be smaller than a country. Some economists have argued that the United States, for example, has some regions that do not fit into an optimal currency area with the rest of the country.^[2]

The theory of the optimal currency area was pioneered by economist Robert Mundell.^[3][4] Credit often goes to Mundell as the originator of the idea, but others point to earlier work done in the area by Abba Lerner.^[5]

Models

Mundell came up with two models.

OCA with stationary expectations

Published by Mundell in 1961, this is the most cited by economists. Here asymmetric shocks are considered to undermine the real economy, so if they are too important and cannot be controlled, a regime with floating exchange rates is considered better, because the global monetary policy (interest rates) will not be fine tuned for the particular situation of each constituent region.

The four often cited criteria for a successful currency union are:^[6]

• Labor mobility across the region. This includes physical ability to travel (visas, workers' rights, etc.), lack of cultural barriers to free movement (such as different languages) and institutional arrangements (such as the ability to have pensions transferred throughout the region) (Robert Mundell).
• Openness with capital mobility and price and wage flexibility across the region. This is so that the market forces of supply and demand automatically distribute money and goods to where they are needed. In practice this does not work perfectly as there is no true wage flexibility. (Ronald McKinnon). The Eurozone members trade heavily with each other (intra-European trade is greater than international trade), and most recent empirical analyses of the 'euro effect' suggest that the single currency has increased trade by 5 to 15 percent in the euro-zone when compared to trade between non-euro countries.^[7]
• A risk sharing system such as an automatic fiscal transfer mechanism to redistribute money to areas/sectors which have been adversely affected by the first two characteristics. This usually takes the form of taxation redistribution to less developed areas of a country/region. This policy, though theoretically accepted, is politically difficult to implement as the better-off regions rarely give up their revenue easily. Theoretically, Europe has a no-bailout clause in the Stability and Growth Pact, meaning that fiscal transfers are not allowed. During the 2010 Eurozone crisis (relating to government debt), the no-bailout clause was de facto abandoned in April 2010.^[8]
• Participant countries have similar business cycles. When one country experiences a boom or recession, other countries in the union are likely to follow. This allows the shared central bank to promote growth in downturns and to contain inflation in booms. Should countries in a currency union have idiosyncratic business cycles, then optimal monetary policy may diverge and union participants may be made worse off under a joint central bank.

Additional criteria suggested are:^[9]

• Production diversification (Peter Kenen)
• Homogeneous preferences
• Commonality of destiny ("Solidarity")

European Union

Europe exemplifies a situation unfavourable to a common currency. It is composed of separate nations, speaking different languages, with different customs, and having citizens feeling far greater loyalty and attachment to their own country than to a common market or to the idea of Europe.

—Milton Friedman, The Times, November 19, 1997"

The theory has been most frequently applied in recent years to discussions of the euro and the European Union. Many have argued that the EU did not actually meet the criteria for an OCA at the time the euro was adopted, and attribute the Euro Area's economic difficulties in part to continued failure to do so.^[10] While Europe scores well on some of the measures characterising an OCA, it has lower labour mobility than the United States (possibly due to language and cultural differences) and cannot rely on fiscal federalism to smooth out regional economic disturbances. The European crisis, however, may be pushing the EU towards more federal powers in fiscal policy. ^[11]

United States

Kouparitsas considered the United States as divided into the eight regions of the Bureau of Economic Analysis.^[12] He found that five of the eight regions of the country satisfied Mundell's criteria to form a single Optimal Currency Area.^[13] However, he found the fit of the Southeast and Southwest to be questionable. He also found that the Plains would not fit into an optimal currency area.

OCA with international risk sharing

Here Mundell tries to model how exchange rate uncertainty will interfere with the economy; this model is less often cited (publication in 1973).

Supposing that the currency is managed properly, the larger the area, the better. In contrast with the previous model, asymmetric shocks are not considered to undermine the common currency because of the existence of the common currency. This spreads the shocks in the area because all regions share claims on each other in the same currency and can use them for dampening the shock, while in a flexible exchange rate regime, the cost will be concentrated on the individual regions, since the devaluation will reduce its buying power. So despite a less fine tuned monetary policy the real economy should do better.

A harvest failure, strikes, or war, in one of the countries causes a loss of real income, but the use of a common currency (or foreign exchange reserves) allows the country to run down its currency holdings and cushion the impact of the loss, drawing on the resources of the other country until the cost of the adjustment has been efficiently spread over the future. If, on the other hand, the two countries use separate monies with flexible exchange rates, the whole loss has to be borne alone; the common currency cannot serve as a shock absorber for the nation as a whole except insofar as the dumping of inconvertible currencies on foreign markets attracts a speculative capital inflow in favor of the depreciating currency.

—Mundell, 1973, Uncommon Arguments for Common Currencies p. 115

Mundell's work can be cited on both sides of the debate about the euro. Most economists cite preferentially the first (stationary expectations) model, and conclude against the optimality of the euro. However, in 1973 Mundell himself constructed an argument on the basis of the second model that was more favorable to the concept of a (then-hypothetical) shared European currency.

Rather than moving toward more flexibility in exchange rates within Europe the economic arguments suggest less flexibility and a closer integration of capital markets. These economic arguments are supported by social arguments as well. On every occasion when a social disturbance leads to the threat of a strike, and the strike to an increase in wages unjustified by increases in productivity and thence to devaluation, the national currency becomes threatened. Long-run costs for the nation as a whole are bartered away by governments for what they presume to be short-run political benefits. If instead, the European currencies were bound together disturbances in the country would be cushioned, with the shock weakened by capital movements.

—Robert Mundell, 1973, A Plan for a European Currency pp. 147 and 150

Criticism

Keynesian

The notion of a currency that does not accord with a state, specifically one larger than a state – formally, of an international monetary authority without a corresponding fiscal authority – has been criticized by Keynesian and Post-Keynesian economists, who emphasize the role of deficit spending by a government (formally, fiscal authority) in the running of an economy, and consider using an international currency without fiscal authority to be a loss of "monetary sovereignty".

Specifically, Keynesian economists argue that fiscal stimulus in the form of deficit spending is the most powerful method of fighting unemployment during a liquidity trap. Such stimulus may not be possible if states in a monetary union are not allowed to run sufficient deficits. The Post-Keynesian theory of Neo-Chartalism holds that government deficit spending creates money, that ability to print money is fundamental to a state's ability to command resources, and that "money and monetary policy are intricately linked to political sovereignty and fiscal authority".^[14] Both of these critiques consider the transactional benefits of a shared currency to be minor compared to these drawbacks, and more generally place less emphasis on the transactional function of money (a medium of exchange) and greater emphasis on its use as a unit of account.

Austrian

Offering a contrary criticism, Austrian economists have supported the disassociation of currencies from political entities entirely.^[15] Whereas Keynesians see flaws in supranational currencies, Austrians see flaws in any centrally planned currency not determined by a free market process.^[16] This alternative approach seeks to limit deficit spending, as well as to increase the accountability of currency makers to their users in the same way that markets for other goods maximize the accountability of businesses to their customers. Founding Austrian economist Friedrich Hayek advocated denationalization of money reasoning that private enterprises which issued distinct currencies would have an incentive to maintain their currency’s purchasing power and that customers could choose from among competing offerings.^[17] Thus, the Austrian critique of optimal currency areas does not prejudice any particular arrangement so long as it is arrived at by a fair and competitive market process. From "The Failure of OCA Analysis" (The Quarterly Journal of Austrian Economics):

Monetary unification enhances the welfare of individuals only if it springs naturally from the voluntary actions of the money users...In a free market, entrepreneurs will try to respond properly to the demands of their customers, providing goods—including money—of the type, quantity, and quality desired. Therefore, only in a free monetary market would it be possible to discover what is the “optimum” circulation of a certain currency...OCA theory fails to acknowledge this, precisely because it conflates the proper nature of money, focusing exclusively on a single type of money, namely fiat government-produced money.

—^[18]

See also

• Economic and monetary union
• Mundell–Fleming model

References