Is the EMU a Viable Common Currency Area? A VAR Analysis of Regional Business Cycles

By Kouparitsas, Michael A. | Economic Perspectives, Winter 1999 | Go to article overview

Is the EMU a Viable Common Currency Area? A VAR Analysis of Regional Business Cycles


Kouparitsas, Michael A., Economic Perspectives


Introduction and summary

In January 1999, 11 European countries bravely launched into a common currency area known as the European Monetary Union (EMU). By joining the common currency area, member countries have agreed to keep the value of their national currency fixed in terms of the currencies of the other EMU countries for an indefinite period. Consumers and businesses in these countries will, however, find that very little has changed. The most noticeable change will not occur until 2002 when national currencies are replaced by a common currency known as the euro. In the intervening period, prices will be denominated in terms of existing national currencies and euros. Consumers using cash will pay the national currency price, while consumers using credit cards (including U.S. visitors to the euro zone) will notice that their transactions are carried out in euros.

Although they might disagree about the exact size of the gains, most economists would agree that the EMU will yield significant microeconomic benefits through lower transactions and hedging costs. According to the European Commission, the gains from carrying out transactions in a single currency could be as high as 0.5 percent of European Union gross domestic product (GDP) per year. However, many economists are skeptical about the long-run viability of the EMU. Euro-zone members have given up the right to set their own interest rates and the option of moving their exchange rates against each other. The widespread view is that this loss of flexibility may involve significant costs (in the form of persistent high unemployment and low output growth) if their economies do not behave as one or cannot easily adjust in other ways. The ultimate concern is that for some countries, these macroeconomic costs will eventually outweigh the microeconomic benefits and lead them to abandon the EMU.

How well the EMU performs along the macro dimension will depend on how closely it fits the notion of an "optimal currency area" (OCA). Beginning with Mundell (1961), economists have long agreed that the following four criteria must be met for a region to be an optimal currency area: 1) countries should be exposed to similar sources of disturbances (common shocks); 2) the relative importance of these common shocks should be similar (symmetric shocks); 3) countries should have similar responses to common shocks (symmetric responses); and 4) if countries are affected by country-specific sources of disturbance (idiosyncratic shocks), they need to be able to adjust quickly. The basic idea is that countries satisfying these criteria would have similar business cycles, so a common monetary policy response would be optimal.

How far the euro zone is from an OCA is an open question for research, as is the more important question of whether the apparent deviation from an OCA is sufficient to question the long-run viability of the EMU. On the surface, the data seem to support the skeptics' view that the EMU is not an OCA. First, euro-zone countries have experienced frequent and often large idiosyncratic shocks over recent years. A well-known example is German reunification, which many argue led to the breakdown of the precursor to the EMU known as the European Monetary System (EMS) in 1992. [1] Second, persistently high unemployment rates throughout Europe suggest that EMU economies (especially their labor markets) are slow to adjust to all economic disturbances.

The purpose of this article is to formally assess the long-run viability of the EMU. I do this by comparing the sources and responses to economic shocks to the EMU with those from a well-functioning currency union, the U.S. My working hypothesis is that if the EMU is as close to an OCA as the U.S. is, based on the criteria outlined above, it may well be a viable currency union in the long run. If, on the other hand, the EMU is less like an OCA than the U.S. is, one might question the long-run viability of this monetary union. …

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