European monetary integration relies on the theory of the optimal currency area (OCA). Successful currency unions generally meet four criteria:
- A high degree of economic integration exists within the region
- Prices (and wages) are sufficiently flexible
- Places within the region are exposed to symmetric shocks
- There exists a risk-sharing agreement (i.e., directed fiscal policy) for the region
A region fulfilling these four criteria makes a prime candidate because one monetary policy will be able to combat the root shock affecting the economy, with factor mobility and price flexibility reallocating resources to where they can be more fully utilized. The cost of joining is the sacrifice of an independent monetary policy. Instead of the Bank of Spain or the Bundesbank directing monetary policy for Spain or Germany, the European Central Bank does so for all included countries. As long as all included countries face the same shock, or provided that factor mobility is sufficiently high to easily reallocate resources, this unique monetary policy should be (according to the theory) adequate to combat any ensuing crisis.
While the effectiveness of monetary policy in mitigating adverse shocks is certainly not without its own controversy, for our purposes we will take the theory on its own merits and judge its outcomes accordingly. Importantly, the fourth criterion becomes a caveat on the others – only in circumstances of low factor mobility, price rigidity or asymmetric shocks will fiscal agreements and transfers payments be necessary to stave off recession. Hence, OCA theory states that targeting fiscal policy will only be necessary if these criteria are not met. In other words, if a country is not an optimal currency area.
The euro was originally sold as an economic enhancement to certain European countries. The costs of trade (through direct exchange costs and uncertainties) of having multiple currencies across the continent made at least some European countries candidates for currency union inclusion. While this cost reduction would be beneficial, inclusion in the currency union would only be net beneficial if the cost of joining a currency union was lower than the resultant benefits.
Against these criteria, how does the Eurozone fare?
Cross-border trade is quite high within Europe, so capital mobility is consequently high. The Treaty of Rome was passed in 1957 to liberate the mobility of goods, services, labour and financial capital across European borders. One would consequently believe that capital flows within the European continent are high, and by and large they are.
Labour mobility is a different issue. While freedom to movement is a key principle of European integration, there are inherent features of the labour market that make it quite rigid. Language differences are the most obvious difficulty to labour reallocations, but cultural differences also abound. An unemployed Spaniard does not just move to the Netherlands to find work (an unemployed Spaniard might not even move from his home province to another region of Spain to find work, but that is another question).
Is the Eurozone exposed to similar shocks? In a broad sense one can say that today’s crisis has homogeneous roots across the continent. Yet with the Dutch economy still performing well with the PIIGS in full depression, it is difficult to say that this is the case. One significant factor is the euro itself. One currency for the zone implies one currency value for the whole zone. The euro trades for the same price in Germany as it does in Greece. This would not be problem if prices were flexible. If Greek prices (and especially wages) were sufficiently downward flexible, an overvalued euro would see real prices equilibrated with the rest of the zone through nominal Greek price declines. This is not the case.
Southern European economies famously suffer from an overvalued euro, inhibiting their abilities to create export growth to escape the crisis. Germany, in contrast, is quite possibly exposed to an undervalued euro, resulting in a large net export position. While the euro may be more or less fairly valued for the whole region – net exports for the euro zone are about zero – for any specific component country this may not be the case.
Having a risk-sharing agreement for a currency area is effectively a caveat for when asymmetric shocks occur. In the Eurozone, fiscal agreements were only loosely defined at the euro’s inception. While transfer payments from high to low income European countries were fairly noncontroversial during the boom, as budgets are strained during this recession there is considerably more animosity towards the idea. Indeed, given the perverse incentives facing transfer payment recipients, it is not clear that increased risk-sharing is a desirable alternative. Indeed, Germany pushed for the Stability and Growth Pact to diminish reliance on fiscal transfers for this very reason.
Lacking flexible prices and labor or symmetric shocks, it is difficult to make the case that Europe is an optimal currency area. While this is becoming apparent in this recession, a proper reassessment of the “optimality” of the currency union is hard to come by. In other words, maybe we should be asking if the Eurozone was oversold to us.
In response, calls for fiscal consolidation are becoming increasingly common. If Europe’s woes cannot be solved by one blanket monetary policy, and some countries lack the resources to enact appropriate fiscal responses to stave off recession, other member states should chip in to save their less-fortunate neighbours.
This approach confuses what the criteria for a currency union are with whether it should exist in its present form or not.
If the criteria for the currency union were correctly met, such targeted fiscal policy would be unnecessary. Resources would be automatically reallocated as prices adjust to make this possible. Fiscal consolidation within Europe does nothing to promote such reallocations. Indeed, it could well inhibit it. German transfer payments to Greece in the current crisis remove the incentive Greeks have to reduce their prices downward to regain competitiveness. It also removes the incentives for Greeks to migrate to other Eurozone areas to find employment.
As this current recession progresses, instead of focusing attention on how to save the existing currency union, perhaps time would be better spent reviewing the initial arguments for its formation. The Eurozone was oversold at inception, the painful economic results of which are now all too obvious.
In the next article of this two-part series, we will look at the political arguments for currency integration, and see if they have fared any better than these economic arguments.