Is the Euro Zone an Optimal Currency Area?

Is the Euro Zone an Optimal Currency Area? Marjan Petreski, MSc Ministry of Finance Macroeconomic Policy Department Macroeconomic Modeling and Projections Division Junior associate Euro College University Studies in Kumanovo Business Administration and Economics Department Lecturer in International finance, Monetary policy and banking March, 2007 Abstract The aim of this paper is to assess whether the Euro zone is an optimal currency area. The judgement is made on the basis of the existing literature and available data for several criteria as a part of the OCA Theory. The ultimate conclusion is that the Euro zone is not an optimal currency area, albeit significant advancements towards it were made past the introduction of the euro, in terms of inflation convergence, financial integration and intra-trade intensification. Yet, the criteria of labour mobility, wage flexibility, fiscal and political integration are far from being satisfied. Electronic copy available at: http://ssrn.com/abstract=986483

Contents INTRODUCTION...2 THE THEORY FOR THE OPTIMAL CURRENCY AREA...2 IS THE EURO ZONE AN OPTIMAL CURRENCY AREA: PREVIOUS STUDIES AND SOME RECENT EMPIRICAL FACTS...5 CONCLUSIONS...13 REFERENCES...14 Marjan Petreski 1 Electronic copy available at: http://ssrn.com/abstract=986483

Introduction After the launch of the European Monetary System in 1979, when the majority of the currencies of the then European Community fixed their exchange rates around the central parity known as a European Currency Unit (ECU) a debate arose as to the question whether Europe is an Optimal Currency Area. The debate gained on hotness especially behind the introduction of the Euro as of January, 1 st 1999, when the then Member States participating in the Exchange Rate Mechanism (ERM I) altered their national currencies into the common European currency. In other words, what has been frequently questioned in the preceding couple of years is whether the Euro zone countries are better off with a common currency as compared to the option of retaining the national currency. The latter simplified notion lies in the substance of the Theory for the Optimum Currency Areas. This paper is an attempt to link the theoretical backgrounds of the OCA Theory with the practice of the Euro zone. For that purpose, the remainder of the paper goes as follows. The next part briefly describes the Theory of OCA which emerged from the pioneering work of Robert Mundell in the 1960 s, laying down the criteria for becoming and OCA. The second part discovers some earlier works on the topic, along with an empirical assessment of whether the Euro zone is an optimal currency area. Finally, the last part concludes the paper. The Theory for the Optimal Currency Area The Theory of the Optimum Currency Area appeared in the early 1960 s as a result of the seminal work of Mundell (1961), along the subsequent work of McKinnon (1963) and Kenen (1969). To start with, Mongelli (2002) defines the currency area as an optimal geographic domain of a single currency, or of several currencies, whose exchange rates are irrevocably fixed and might be unified. Moreover, in the latter case, the common external value is determined on the foreign exchange market freed from an official monetary intervention (Grubel, 1970). The optimality in the context of the currency Marjan Petreski 2

areas refers to several properties of the currency areas which result in an improved welfare of the population resident within the area above the level enjoyed when each territory was a separate monetary entity (i.e. possessed its own monetary unit). To be precise, these OCA properties embrace the following: Mobility of labour and other factors of production; In a currency area satisfying this characteristic, it is likely that there will be less need for altering the real factor prices (Mundel, 1961). It is acknowledged that the factors mobility results in their most efficient allocation even within a free trade area or customs union, enhancing the welfare of the area. Moreover, in a currency area, the mobility of the capital is determined by the speed by which investment is being supplied by one country and absorbed by another. Whereas the labour mobility is usually higher in the medium to long run, in that manner easing the adjustment to the permanent shocks hitting the countries. Price and wage flexibility; This is essentially important for a currency area in a short run, when an adjustment process entails itself as a necessity, in order to absorb a shock in the economy. In that sense, if prices and wages in a currency union are flexible, the adjustment process will not end up with sustained unemployment in one country and inflation in the other. In turn, this will lessen the call for an exchange rate changes. Then again, if prices and wages are rather rigid, flexibility could be achieved through the mechanism of the exchange rate. Financial market integration; In a currency union, we usually speak about one unified financial market. Financially integrated countries in a currency union trim down the need for an exchange rate adjustment. In these countries only a small change in the interest rates will lead to capital movements across the countries until the equilibrium is again settled. Marjan Petreski 3

Economic openness; The higher the openness, the faster the international prices transmit on the domestic monetary scene. Thus, the exchange rate becomes less useful in the adjustment process. Diversification in production and consumption; The higher the diversification, the lower the need for changes in the terms of trade through the nominal exchange rates. In other words, diversification acts as an absorber of shocks. Similarity in inflation rates; It is expected that in a currency union, countries possess similar or close inflation rates. Fleming (1971, cited in Mongelli, 2002) argues that when inflation rates of the countries in a monetary union converge, terms of trade will also converge. In turn, this diminishes the need for exchange rate adjustment because of the equilibrated current account transactions. Fiscal integration; If the monetary integration is followed by an integration of the fiscal transfer system, than the latter will reduce the need for exchange rate adjustment behind a shock since the fiscal integration will lend a hand to the region or country hit by shock. Political integration; Finally, political will for adopting a single currency is the crucial one in the whole story. Haberler (1970) stresses that the political will encompasses commitment to joint economic policies, common fiscal policy and a strong institutional linkage. Tower and Willet (1976) add that a successful currency area needs a reasonable degree of compatibility in preferences toward growth, inflation and unemployment and significant ability by policy-makers in trading-off between objectives. (p.10). Currency area that satisfies these criteria becomes an optimal currency area. The optimality stemming from the fulfilment of these characteristics of the currency zones finished up with a process of welfare creation which means that the benefits form the monetary unification exceed the costs. Marjan Petreski 4

Is the Euro zone an Optimal Currency Area: Previous studies and some recent empirical facts Plenty of studies are devoted to the task to acknowledge whether a concrete monetary unification leaded to the accomplishment of the optimality clauses for a currency area. These studies usually refer to the case when a country fixes its exchange rate to that of its major trading partner, in that manner creating a currency area. In this case, the exploration of the optimality issue usually refers to the fixing country. However, a real research challenge emerges when the monetary unification is crowned by an introduction of a common currency, as was the latter case in the world, the introduction of the euro. As mentioned above, monetary unification in terms of the OCA Theory in Europe started in 1979 with the creation of the EMS, when the then member states of the then EC, irrevocably fixed the exchange rates of their currencies to the central parity represented through the imaginary European currency, the ECU. The notion behind this became known as the Exchange Rate Mechanism I. Yet, 20 years were needed these initial steps for monetary integration to be followed by a single currency adoption. Albeit some attempts to judge the EMS as an OCA were made, the real challenge was posed beyond 1999. Namely, the start of the EMU boosted the interest for the debate whether sharing a new single currency sets free forces that bring Euro area countries closer together (De Grauwe and Mongelli, 2005). Mongelli (2002), at an outset, vastly explores the OCA Theory, devoting significant share to the Euro zone. Although the study is conducted rather early, some important conclusions are drawn. For instance, he elucidates the inference that the labour mobility, as well price and wage flexibility across European countries are low. Supportive to this is the report of the EU Commission (2004), which finds this flexibility to be hampered by the slow completition of the Single market and by the slowness of dismantling some non-tariff barriers. Also real wages are quite rigid in the majority of countries; labour Marjan Petreski 5

mobility is low and usually motivated by other factors and not as a response to an economic shock (OECD, 1999). Supportive to these notions are the facts presented on the next graphs. The first one grasps the figures for the foreigners in the Euro area countries. Although a good part of the figures is missing, those presented for the period 1999-2005 show no changes, which indicates the slow labour mobility. On the second graph, an attempt to estimate the labour market responses to an asymmetric shock is made. It is visible that the labour market responds slowly to such shocks. The latter facts do not support the notion that the Euro zone is an OCA. Foreign population in Euro zone countries 8000000 7000000 6000000 5000000 4000000 3000000 2000000 1000000 0 Source: Eurostat Austria Belgium Finland France Germany Greece Ireland Italy Luxembourg Netherlands Portugal Slovenia Spain 1999 2000 2001 2002 2003 2004 2005 Marjan Petreski 6

Source: OECD, 1999 Contrary to the voice of the above discussion, several studies found strengthening of the relevance of the foreign direct investment flows in the Euro area, which is a support for the OCA. For instance, OECD (1999) shows that both inward and outward FDI s from the Euro area countries raised in almost all countries behind the introduction of the Euro. Yet, broadly speaking for the overall financial integration in the Euro zone, it is rather lower as compared to that in the US (Krugman and Obstfeld, 2003). Still, Issing (2000, cited in De Grauwe and Mongelli, 2005) observes an increasing degree of financial markets integration in terms of fewer opportunities for arbitrage and smaller interest rates differentials. Moreover, the money market is being integrated first right after the introduction of the Euro, while the yield differentials among the euro area government bonds markedly converged. Mongelli (2002) further stresses the high economic openness of all European countries as well the high diversification in production. Not only the trade intensified beyond the intro of the Euro, but also countries that will join the Euro area in future will satisfy the properties no matter whether they built OCA with the Euro zone before (Frankel and Rose, 1997). In addition, inflation differentials narrowed down in the Euro area countries (EMI, 1998). On the fiscal plan, he explains that all Euro area countries matched the fiscal Maastricht criteria and now comply with the Stability and Growth Pact. However, federal transfers and changes in federal tax payments provide a much bigger cushion for regionspecific shocks in the U.S. than do EU revenues and expenditures (Krugman and Obstfeld, 2003). Marjan Petreski 7

Moreover, there are no such fiscal transfers within the EU, at all. The EU budget is very small, only 2% of the GDP of EU. In the context of the economic openness, several studies tested the effect of the monetary unification in Europe on the intra-european trade. Two of them are worth mentioning, i.e. that of Rose and Van Wincoop (2001) who predicted an increase of the intra-euro-area trade of more than 50%. Similar results stem from Bun and Klaassen (2002) who use a dynamic panel model and estimate a long run effect of about 40%. On the next graph, I present the share of intra-euro-zone-trade (exports-plus-imports) from the GDP of the Euro zone countries. It can be inferred that there is an effect of the monetary unification on trade, although it is not ample. Namely the intra trade before the introduction of the Euro in 1998 accounted to 41,1% of GDP of the Euro zone countries, whereas this percentage is 54,6% in 2006, which corresponds to an increase of 13,5 percentage points or 33%. Albeit the previously mentioned studies expected higher increase, still this figure provides support for the Euro zone as an optimal currency area. Total intra trade (% of Euro area GDP) 60,0 50,0 40,0 30,0 20,0 10,0 0,0 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 Source: European Economy, 2006 Marjan Petreski 8

In the study of De Grauwe and Mongelli (2005) an attempt for overall assessment of whether the Euro zone is an optimal currency area is pursued. They conclude that in the first two years, HICP inflation significantly converged, although the convergence started even before the introduction of the euro. Domestically the adoption of the euro has been associated with an extended period of price stability: the low level of inflation and inflationary expectations testify to the credibility of the common monetary policy (European Economy, 2006). Additionally, Beck and Weber (2001) found considerable turndown in the cross border volatility of the relative prices among Euro countries. Source: Eurostat Marjan Petreski 9

On the preceding graph, I present the inflation indices for the EMU countries (which as of 1 January 2007 are 13, after Slovenia has joined). It can be inferred that the huge inflation discrepancies during the 1990 s converged right behind the introduction of the Euro in 1999. The convergence is even reinvigorated in the last period, i.e. the period from 2004 onwards. Finally, De Grauwe and Mongelli (2005) agree that financial integration was spurred, especially in the money market segment, which has been integrated almost immediately; deposit market has been also integrated, while significant advancement has been made on the bond market. I will try to assess again these notions of De Grauwe and Mongelli (2005), by looking at some indicators of the financial integration in the Euro zone. On the next graph, I look at two indicators for the money and bond market. It is inferable that standard deviations for both overnight lending rates and government bond yield spreads sharply decreased immediately behind the introduction of the euro. This points to a strong support for the notion that the Euro zone is financially integrated and, therefore, a support for OCA Theory in respect to the Euro zone. Money and bond market indicators Indexes 200,00 180,00 160,00 140,00 120,00 100,00 80,00 60,00 40,00 20,00 0,00 Cross-country standard deviation of the average overnight lending rates Standard deviation of government bond yield spreads for 2- year maturity 1997-01 1997-10 1998-07 1999-04 2000-01 2000-10 2001-07 2002-04 2003-01 2003-10 2004-07 2005-04 2006-01 Source: Eurostat Marjan Petreski 10

In the same line of reasoning, the share of MFI cross-border holdings of debt securities issued by euro area and EU non-mfis, also increased after the threshold. Finally, looking at the dispersion of the number of bank branches and subsidiaries and their total assets across Euro area countries, again the conclusion is in favour of the spurred financial integration of the Euro zone. Share of MFI cross-border holdings of debt securities issued by euro area and EU non-mfis (% ) 0,45 0,4 0,35 0,3 0,25 0,2 0,15 0,1 0,05 0 1998-01 1998-03 1999-01 1999-03 2000-01 2000-03 2001-01 2001-03 2002-01 2002-03 2003-01 2003-03 2004-01 2004-03 2005-01 2005-03 2006-01 Dispersion accroess Euro area countries 7 6 5 4 3 2 1 Number of euro area bank branches (% ) Number of euro area bank subsidiaries (% ) Total assets of euro area bank branches (% ) Total assets of euro area bank subsidiaries (% ) 0 2001 2002 2003 2004 2005 Source: Eurostat All in all, significant changes seen through the prism of the OCA properties have been made in Europe right after the introduction of the Euro. However, early studies conclude that the Euro zone is Marjan Petreski 11

not an optimal currency area. A significant question is weather the Euro zone is heading towards an optimal currency area. The presentation of the recent empirical facts, however, points out to some indicators which provide affirmative support for this question. The next table tries to summarise the topic explored above: Criterion Labor mobility Price and wage flexibility Financial market integration Trade openness Diversification in production Similarity in inflation rates Fiscal integration Political integration Satisfied? no no yes yes yes yes no no According to the table, half of the criteria are fulfilled. However, those that are not, are those which are more significant, among which, the political integration and the common fiscal policy. The former is in the basis of the EU Constitution Draft, which for the time being is dead, whereas the latter is probably a distant future. All in all, although significant changes in terms of the optimality issue for the Euro zone as a currency area have been made, the Euro zone could not be considered as an optimal currency area. Yet, since the introduction of the euro, significant advancement followed in the area of financial integration, inflation convergence and the trade openness. On the contrary, labour mobility and wage flexibility remained low, while the fiscal integration is downed to respecting the SGP rules and not to a common fiscal policy which will enable the fiscal transfers to act as an absorber of external shocks. Marjan Petreski 12

Conclusions The question that has been addressed in this paper was whether the Euro zone is an optimal currency area, i.e. whether the welfare of the countries participating in the EMU increased after their monetary unification under a common currency, that is the euro. In that sense, several factors are under consideration when measuring the optimality of the currency area: labour mobility and wage flexibility, financial integration, inflation convergence, trade intensification, fiscal and political integration. The exploration of the topic ranged from citing what previous studies found to empirical assessment of recent economic data for the Euro zone. The conclusion sheds light on the notion that significant advancement has been made on the inflation convergence, which has been strengthened especially in the last years, financial integration, mainly measured through the money market and bond market indications, and in an extent, the trade intensification among Euro area countries, which intensified by about one third. At the same time the production is well diversified. On the other hand, labour mobility is low, wages are rigid, whereas on the field of fiscal integration is done almost nothing. The fiscal policy is still a national policy and not a common one. Political integration is still questioned as the CT is stuck in the approval process. By all accounts, the Euro zone is not an optimal currency area. Efforts are needed on many fronts in order optimality to be achieved for every OCA criterion and in that sense the Euro zone to become an optimal currency area. Marjan Petreski 13

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