Optimum Currency Areas : New Analytical and Policy Developments: New Analytical and Policy Developments

Leonardo Leiderman

• Publisher: INTERNATIONAL MONETARY FUND
• Year: 1997
• ISBN:
  9781557756527

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1 Introduction

Introduction

Mario I. Blejer Leonardo Leiderman and Assaf Razin

Dealing with intellectual history and, in particular, contemporary intellectual history, is indeed a dangerous undertaking. Any attempt to ascertain the origin of ideas and pin them down to a definite source always seems to raise a scholarly challenge and to invite claims that the idea under discussion has already been the subject of consideration and deliberation. Evidently, however, not everything has been said before. And certain ideas can be traced, without too much effort and without generating too much controversy, to their precise intellectual source.

That is, indeed, the case of the theory of optimum currency areas, pioneered by Robert A. Mundell in the 1960s. In his classical article, published in 1961 in the American Economic Review and reprinted in this book, Mundell defined the notion and posed, for the first time, the optimum currency area (OCA) problem. His paper generated an immediate chain reaction, with later contributions extending, improving, qualifying, and building upon the concept. The practical implications of the theory, however, did not appear to have particularly immediate consequences, except perhaps in the context of the fixed-versus-flexible-exchange-rate debate. Therefore, interest in the subject appears to have faded over time.

The dynamics of the current process of economic integration in Europe have clearly reversed that trend. Developments in Europe have been such that, by the second half of the 1980s, the issue of monetary unification and the creation of a single European currency became the centerpiece of the integration process. It could be claimed (Eichengreen, 1993) that the momentous enterprise of creating a single currency in Europe is neither the exclusive product of analytical thinking, nor a necessary corollary of the materialization of the single market in capital, labor, and goods—but rather the consequence of political economy considerations. Even if this is so, it is still true that the debate over monetary unification in Europe has prompted an intense search for an appropriate analytical framework to allow an adequate evaluation of the requirements and consequences of the process. Invariably, the point of departure of this search has been Mundell’s concept of an optimum currency area. This notion has, therefore, returned to center stage of economic policy debates, and as European economic and monetary union (EMU) draws nearer, it is important to focus again on the theoretical, analytical, and policy-oriented implications of Mundell’s seminal contribution.

As Corden (1993) recently pointed out, re-reading Mundell is a rewarding experience. Despite the rapid transformations of world economic conditions, the central part of Mundell’s analysis stands up well and continues to be highly relevant. The core of his thesis is that countries or regions constitute an optimum currency area when the real benefits for their economies of fixing irreversibly their exchange rates (or, in practice, adopting a single currency) exceed the real costs. This is, of course, the case when prices of goods and factors of production are perfectly flexible. But, as Mundell indicates, it is also the case when labor and capital are perfectly mobile among the countries or regions in question (Kenen, 1995). Although the essence of this insight remains unquestionable, the new wave of literature on monetary integration that flourished in the last decade has sought to adapt these original ideas to current world conditions (and, more specifically, to European conditions); it has also tried to provide new understandings of the factors that condition the existence of an optimum currency area, as well as the macroeconomic implications for an individual country of surrendering monetary and exchange rate policy instruments.

This new body of literature is too vast to be surveyed comprehensively. In this volume, we attempt to provide a brief primer on the subject. The book is divided into three sections. The first concentrates on Mundell’s contributions—including a reprint of his original article and an update on the issue from a 1996 perspective. Mundell provides current views on the factors affecting a country’s decision to join a currency union, and assesses the union’s chances of success and the scope of EMU. The second section consists of a discussion—in the form of a policy forum—centering on the issue of the exchange rate regime. It evaluates, in the context of current world circumstances, the new analytical and policy-oriented developments regarding the classic fixed-versus-floating-exchange-rate debate. The third section constitutes a sampling of the new thoughts that have emerged around the subject of optimum currency areas as discussed in the December 1996 Tel Aviv symposium honoring Robert Mundell. These ideas are compiled in the form of short nontechnical papers (which are summaries of formal papers to be published elsewhere). They offer insights on the most pertinent considerations regarding the relevance of Mundell’s contribution in the current context and demonstrate the continuing validity of his original concepts.

The papers reviewed in this book cover a variety of theoretical and empirical issues related to the theory of optimum currency areas and its current application to EMU. They can be grouped under four categories:

• a reassessment of the optimum currency area criteria and of the explicative power of the theory;
• a consideration of monetary policy issues within the EMU framework;
• fiscal and budgetary questions in the context of monetary unification; and
• the specific repercussions of the current drive toward EMU.

Reassessing OCA Criteria

While Mundell pointed out some of the theoretical considerations regarding the optimality of a single currency zone, some quantifiable parameters have been suggested as measures of the costs and benefits of joining a currency union. Two of the better-known among these parameters are the extent of trade and the correlation of shocks between countries contemplating monetary integration. In their paper, Jeffrey Frankel and Andrew Rose focus on an important observation: that trade patterns and income correlations are endogenous variables, in that they are not invariant to the degree of monetary integration among the countries considered. The econometric evidence they present is convincing: among most industrial countries, there is a positive relationship between the intensity of their bilateral trade and the nature of their business cycles. Thus, if monetary integration expands trade relations, it will also result in more correlated business cycles; countries are therefore more likely to satisfy the optimum currency area criteria ex post rather than ex ante.

Another of the well-known criteria postulated as determining the costs of monetary unification is economic openness. It has been widely claimed that the larger the degree of an economy’s openness, the lower the cost of abandoning the nominal exchange rate as a policy instrument. Daniel Gros and Alfred Steinherr challenge the view that openness, per se, is a determining element. They conclude that one should look at the product of the degree of openness and of some measure of the importance of external shocks. A very open economy with an export structure very different from that of the other potential partners in a monetary union would lose much more from surrendering its ability to use the exchange rate than a much more closed economy with a similar export structure.

In addition to broad discussions dealing with the optimum currency area criteria, the literature has also addressed the predictive power of the theory. Tamim Bayoumi and Barry Eichengreen claim that optimum currency area theory has, indeed, significant explanatory power, particularly regarding the behavior of exchange rates. They find that variables pointed to by the theory affect the behavior of bilateral exchange rates through both market conditions and official intervention. Asymmetric shocks—one of the factors determining the cost of joining a monetary union—result in exchange rate variability, while the intensity of trade links (a source of benefits of a common currency) affect the exchange rate through the incentive to intervene. Therefore, the balance between these two factors, which are essential elements of the optimum currency area theory, could well explain the observed variability of exchange rates across countries.

Monetary Policy Issues in the EMU Framework

Beyond the question of suitable criteria for joining a monetary bloc, the major issues that have attracted interest in the recent debate relate to the operation of financial policies in the context of a single currency. Of those, of course, the implementation of uniform monetary policy across the members of a union, in place of national monetary policies, has received the greatest attention. In their paper, Thomas Krueger, Douglas Laxton, and Assaf Razin look at the alternative macroeconomic effects of alternative policy rules that could be adopted by the prospective European central bank at the inception of stage 3 of EMU—that is, the period following the irrevocable locking of exchange rates among the first group of countries qualified to participate. In assessing these effects, Krueger, Laxton, and Razin distinguish between the impact on EMU participants; on the group of countries that, in preparation for joining EMU later, will tie their currencies to the euro, through an ERM-type of exchange rate arrangement; and on those countries that would continue to follow their own monetary policies (Tabellini and Persson, 1966).

Through a number of simulation exercises, Krueger, Laxton, and Razin illustrate that an initial lack of credibility of the European central bank (particularly regarding anti-inflation policies) may introduce, in the short run, a deflationary bias for the EMU area. The effects are broadly the same for the second group of countries, namely, those that have tied their exchange rates to the euro. The deflationary effects, however, appear to be smaller for those countries that preserve their monetary independence. The authors conclude that such a bias should be considered by the European monetary authority since an attempt to build credibility too fast may be counterproductive if the costs, particularly in terms of unemployment, become politically intolerable.

The issue of limited credibility of monetary policies is also taken up in Alex Cukierman’s paper, which focuses on the current Swedish situation. The paper examines the costs of weak credibility and assesses the relative advantages of different credibility-building institutions. Cukierman’s main conclusion is that Sweden, one of the countries not expected to join EMU in the first round, should reform its monetary and fiscal institutions with a view to heightening the government commitment to price stability (and to embrace the Maastricht convergence criteria) in order to enhance its policy credibility and leave open the option of joining the monetary union later on.

Fiscal and Budgetary Issues

The theory of optimum currency areas does not advocate the abolition of independent budgetary responsibilities. In fact, the original formulations of the model have not been explicit about the specific roles of fiscal policy in the context of monetary unification. And, in practice, the conceptual framework within which EMU has evolved is one in which fiscal policies are indeed constrained, before and after joining the union, but, to a large extent, national budgetary operations remain much in the realm of individual country sovereignty.

The implications and potential conflicts associated with this setting are addressed in three papers in this book. The first paper, by Charles Goodhart, is strongly based on monetary doctrine. It claims that much of the debate on the boundaries for a single currency, and therefore, most of the discussions on the theory of optimum currency areas, has been based on the view that a currency’s value depends primarily on the intrinsic value of that currency’s backing. Goodhart advances the opposing view that a currency’s value is based essentially on the power of the issuing authority, and therefore the extent of its use depends on considerations of political sovereignty. The key relationship arising from this alternative view is the strong link between political sovereignty and fiscal power, on the one hand, and money creation on the other. In this light, the EMU process appears unique: it is postulated upon divorcing the main monetary and fiscal authorities, which has not been seen before. Within this context, Goodhart claims, the market position of the domestic debt of the participating countries’ could weaken markedly. This, in his view, could lead to a shift in the focus of potential credibility crises and runs from the foreign exchange market toward sovereign bond markets.

Covering similar ground, but in a more policy-oriented framework, Roel Beetsma and Lans Bovenberg set up a formal model to analyze the consequences of monetary union with decentralized fiscal authorities. In contrast to the results suggested in the existing literature—which imply that such a setting produces pro-inflationary biases and excessive public spending—Beetsma and Bovenberg argue that monetary unification without coordination among autonomous fiscal powers may actually reduce the inflation bias and dampen any inclination toward increased public spending. They reason that a union containing noncooperative fiscal players strengthens the strategic position of the common central bank, which is always assumed to prefer lower inflation than the individual fiscal players. They claim further that the spending bias, and its inflationary consequences, falls as the number of countries within the union rises. Therefore, adding new participants to a monetary union raises the common welfare throughout the union. The argument of Beetsma and Bovenberg is also symmetrical: fiscal coordination among the members of a union strengthens the strategic position of the fiscal authorities against the common central bank and therefore leads to stronger inflationary propensities. The authors’ argument supports, indeed, the subsidiarity principle regarding fiscal policy making.

Tamim Bayoumi and Paul Masson articulate an opposite view. Their reasoning focuses on the role and size of fiscal stabilizers, and they argue for conferring on a central union authority a significant role in fiscal stabilization. The argument of Bayoumi and Masson is based on Ricardian equivalence considerations. Indeed, if the private sector discounts the future tax liabilities arising from increased public debt and modifies its saving behavior accordingly, federal stabilizers will be more effective than local ones since local actions are more likely to be offset by the private sector. The same logic is used to claim that stabilization by national governments is likely to result in more offsetting behavior than an equivalent all-union policy. Based on their empirical results for Canada, the authors interpret their evidence as providing an argument for Europe to consider expanding fiscal policy at the union level.

Repercussions of the Move Toward EMU

As EMU draws nearer, some of its practical implications for both its members and the rest of the world are attracting greater attention. One of these issues, related to some extent to the previous discussion about the role of fiscal policies in a monetary union, is connected with the available mechanisms for achieving income insurance and consumption smoothing after the inception of EMU. Bent Sørensen and Oved Yosha study risk-sharing patterns among European Union members and OECD countries and compare them to their results for the United States.

The central finding of Sørenson and Yosha is that about 40 percent of the shocks to income are smoothed within a year, with roughly one-half the smoothing achieved through national government budget deficits. Their results also indicate that, unlike among individual states in the United States, factor income flows do not smooth income across countries in Europe, which suggests that European capital markets are less integrated than those in the United States. The main implication of these results is, in the authors’ view, that the restrictions on budget deficits and public debt embodied in the Maastricht convergence criteria may threaten the stability of EMU in the absence of alternative risk-sharing mechanisms.

The last paper, by Fabio Ghironi and Francesco Giavazzi, deals with the size of EMU and the exchange rate regime that would emerge between the euro and the currencies of other EU countries. The authors suggest that the decision, in 1998, about the initial size of EMU will create substantial strain among the various players, with the outcome decided largely on the basis of the relative bargaining powers of the various policy makers. Once the initial size is decided, however, the propensity will be toward enlargement to cover the entire European Union, but the process could prove slower and more contentious than expected. Therefore, the question of the exchange rate regime between ins and outs is still highly relevant. Ghironi and Giavazzi claim that a linking of exchange parities (in the form of an EMS-style regime) is preferable to a flexible exchange rate regime. Moreover, as most of the previous authors whose papers are reviewed here, Ghironi and Giavazzi assert that the ability to use fiscal policies to react to supply-side shocks makes all parties better off; therefore, they argue against the rigid application of strict fiscal rules.

The papers summarized in this book testify to the immense interest that the EMU’s imminence has generated in the profession. But they also prove the vitality of Mundell’s seminal paper. Although Mundell...

Table of contents

• Cover Page
• Optimum Currency Areas: New Analytical and Policy Developments
• Copyright Page
• Contents
• Preface
• Acknowledgments
• 1. Introduction
• 2. Contributions of Robert A. Mundell
• 3. Policy Forum: Fixed Versus Floating Exchange Rates: What’s New in the Debate?
• 4. New Developments
• Participants
• Footnotes