Academic journal article The European Journal of Comparative Economics

An Optimum Currency Crisis

Academic journal article The European Journal of Comparative Economics

An Optimum Currency Crisis

Article excerpt

1. Introduction

The decision to establish a common currency in Europe had long been debated (Meade, 1957; Scitovsky, 1957; Mundell, 1961; McKinnon, 1963), before it was actually taken and implemented. At the summit of The Hague in December 1969 it was decided that the Community should evolve by stages into an Economic and Monetary Union (EMU). The objective of a full EMU was explicitly stated in the Maastricht Treaty in 1992. In 1999 the euro was introduced as the official currency of 11 Member States (MS) replacing national currencies2.

This new institutional setting represented a peculiar monetary union, more integrated than past agreements of fixed exchange rates, but still far from complete economic and political unions3. Monetary policies of the participating Member States (MS) became the responsibility of the European Central Bank (ECB). Fiscal policies remained responsibility of national authorities, even though subject to restrictive common rules on public finances known as the Stability and Growth Pact. This created an unprecedented divorce between the main monetary and fiscal authorities (Goodhart, 1998).

The reasons for such an ambitious experiment were mainly political, but several economic advantages were also expected: a reduction in transaction costs, promoting trade (Rose, 2000), and the elimination of the exchange rate risks, favouring financial integration. At the same time, participating countries lost a great deal of flexibility, renouncing to national monetary policies and to a mechanism for adjustment to shocks (Krugman, 2012).

The theory of Optimum Currency Areas (OCA), as developed by Mundell (1961), McKinnon (1963), Kenen (1969), Fleming (1971), proposes a set of necessary conditions for monetary unions and provides an analytical framework to assess risks and opportunities a region might be confronted with. This approach has been widely discussed in the literature (Robson, 1987; Bayoumi, 1994; Bayoumi and Eichengreen, 1997; Goodhart, 1998; Alesina et al, 2002; McKinnon, 2004; Tavlas, 2009; Krugman, 2012; O'Rourke and Taylor, 2013), and it has been used to assess ex-ante the feasibility of the EMU (Mundell, 1961; McKinnon, 1963; Kenen, 1969; Eichengreen, 1991; Eichengreen, 1993a; Tavlas, 1994; Obstfeld, 1997, Alesina et al, 2002).

The standard theory of OCA was later on defined "exogenous", in contrast to an "endogenous" approach (Frankel and Rose, 1998), which admitted the possibility that OCA properties, even if not fulfilled ex-ante, could be gradually satisfied during the existence of the monetary union.

Its applicability to the specific case of the EMU has been rather controversial. The report "One Market, One Money" (EC, 1990), for instance, discarded the theory, explaining that:

there is no ready-to-use theory for assessing the costs and benefits of EMU. Despite its early insights, the 'theory of optimum currency areas' provides a too narrow and somewhat outdated framework of analysis. Recent developments in both micro- and macroeconomics have not yet led to a unified theory of monetary unions (p.31).

Critics of the OCA theory highlighted that it lacks a formalized model allowing a measurement of the "OCA test" for potential currency unions (Robson, 1987), that it has little or no predictive capacity (Goodhart, 1998), and that analyses investigating OCA properties are by necessity backward-looking (Mongelli, 2008).

In this work, however, we apply the theory of OCA to study ex-post the developments of the EMU, following the main conditions for a suitable monetary union prescribed by the theory:

· factors mobility (capital and labour) across the area;

· price and wage flexibility;

· similarity of business cycles among participating countries;

· common fiscal capacity as a mechanism of shock absorption and risk-sharing.

The paper analyzes each one of these criteria, in order to assess to what extent they were satisfied before or during the EMU. …

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