Is Euro Zone an Optimal Currency Area and What Barriers Could Obstruct the Future Development?
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Is Euro Zone an Optimal Currency Area and What Barriers
Could Obstruct the Future Development?
Ing. Irena Vrňáková and Ing. Hana Bartušková
European currency integration has been a really ambitious project
since the very beginning and during last decade it succeeded in many
areas. The euro was launched without serious problems and the ECB
has managed to achieve low inflation rate in whole euro zone.
European Union and euro experienced the world economic crisis in
2008 and dealing with impacts of this crisis was a real challenge for
EU, for all the members, euro, euro zone and also for the whole
integration process. In our paper we will proceed from the optimal
currency area model (OCA, developed by Robert A. Mundell, Peter
Kenen and Ronald McKinnon) to a common conditions of euro zone
and European currency integration process. The paper will summarize
barriers to the OCA as imperfect mobility of labor market, unfinished
single market, insufficient coordination and cooperation in common
macroeconomic areas within the euro area, asymmetric shocks and
others. This paper will also discuss the perspectives of European
currency integration.
JEL: E42, N14
1.Introduction
Optimal Currency Area is a model of optimal currency integration characteristics. The
questions just stand: Is Eur ozone an Optimal Currency Area? And is euro the right path?
2. Literature Review
There are a lot of different approaches. (Mundell, 1961) examined if the floating exchange
rate between the currencies of individual countries leads to a compensatory process and
wondered if in some circumstances would it be better to create a common currency area
(or the area of fixed exchange rates). The argument for the use of floating rates must
therefore be based on the assumption of the existence of regional, not national currencies.
The optimum currency area is the region. (Mundell, 1968).
Ronald McKinnon continued with Mundell theory and examined the openness of the
economy as a share of tradable and nontradable goods produced in the economy in
context of sustainability of internal and external balance and full employment. McKinnon
also distinguished tradable goods as the exportable goods manufactured by home country
and partly exported, and importable goods which is partly produced at home and partly
imported. If the balance of trade is in equilibrium, the value of tradable goods produced
equals the value of tradable goods consumed. (McKinnon, 1988).
______________________________________
Ing. Irena Vrňáková, Irena Vrňáková, Department of World Economy, University of Economics, Prague,
E-mail: i.vrnakova@seznam.cz
Ing. Hana Bartušková ,Hana Bartušková, Department of World Economy, University of Economics, Prague,
E-mail:hana.bartuskova@gmail.com
1Peter Kenen (Kenen, 1969) extended the theory by the degree of diversification of
production in the economy. Kenen argues that the economy with sufficiently diversified
production will not lead to such changes in the exchange ratios, and therefore to changes
in demand for products. A diversified economy with a wide range of export products is able
to export a scale of export products and so in the case of asymmetric shocks and by this
economy can reduce negative consequences. A country may faces, on the one hand, a
decrease in demand for a product of a wide range of exported goods, on the other hand,
may increase demand for other goods. The greater the internal mobility of production
factors is the less the cost of a fixed exchange rate occurs. On the contrary, countries with
little diversified production should opt for a floating rate.
3. Methodology and model
We will use available data of economic variables to describe a current situation within the
euro currency area of 17 states (which differ in size, degrees of openness and structure of
economy) and compare it with the OCA model presumptions. In context of OCA model we
will follow casual connections and contrasts while focusing on macroeconomic
phenomenon of euro currency area. The analyze of supranational conditions and
coherency will lead to a comparison as our goal is to compare the optimal conditions of
OCA with the real imperfections of current euro area.
The basics of theory of optimum currency area involved by Canadian economist Robert A.
Mundell, who examined what criteria must be met in order to establish a common currency
and to ensure the effective functioning of monetary union. The basic assumption was the
high mobility of labor and capital, if prices and wages are fixed. A prerequisite for
sustainable currency area is also a synchronization of economic cycles so that in the case
of macroeconomic instability (demand or supply asymmetric shocks) in the area, the
countries would be able to respond in one effective way with a complex solution.
The theory of optimum currency area was further developed by two U.S. economists -
Ronald McKinnon in 1963 and Peter Kennen in 1969. McKinnon extended the theory to
the criterion of an open economy, which he defined as the ratio between tradable and non-
tradable goods in relations to domestic production and consumption and its impact on the
balance of external and internal economic process. Peter Kennen later introduced a factor
of production and concluded that countries with a high degree of diversification of
production are suitable for membership in the monetary union even at low labor mobility
between countries.
The emergence of macroeconomic imbalances can at least be partially eliminated by the
following assumptions, according to theoretical models of optimal currency area there are
different criterion:
Mundell (1961): high degree of mobility of production factors between the
economies
Friedman (1963): wages and price flexibility
McKinnon (1963): size and openness of the national economy
Kenen (1969): variety in production, consumption structure and export
diversification
Nominal and real convergence of national economies
Political integration and political will of member countries
Kennen (1969) and De Bandt&Mongelli (2000): fiscal integration and coordination
24.The Findings
Project of the European monetary union is an unique phenomenon in the world economy.
There have been several attempts to try a monetary integration in the past but never in
such a big scale. European monetary experiment is a first one regarding the number of
national currency integrated and characteristics of the member states. There is nothing like
this to compare to European monetary union in reality but there is an theoretical approach
that is trying to evaluated monetary integration according different criterion. This model is
called Optimal Currency Area (and its basis are explained in the previous chapter) model
and it is a goal of this paper to compare EMU with the theoretical conditions for successful
monetary integration.
The monetary union can only be effective if certain conditions are met (OCA), so that in
case of economic problems the states could respond as a whole bunch and don‘t
compromise their own national interests. The OCA model states various characteristics of
successful monetary integration area. EMU does not really meet fully any of these criterion
but have been working without any major problems since its creation in 1999 until recently.
Than in 2008 global economic crisis came and tested the readiness of EMU face to face to
external shocks. And as recent development showed EMU is failing.
In this paper we are going to evaluate the criteria of optimal currency area model and on a
data from euro zone members states we will try to conclude whether or whether not is
EMU an optimal currency area. As EMU is not a single isolated process we will also try to
put European currency integration to wider circumstances and evaluate the EMU as part of
European integration system.
4.1. Labor Mobility as a main factor stated by Mundell
Production factor mobility is one of the main criteria (Mundell, 1961). He sees the mobility
in production factors (labor and capital) as one of the main stabilizing mechanism in
common currency area. Under a normal conditions of national currency economic
imbalances would be maintained by flexible exchange rate. As this is not a case of
common currency area... factors mobility needs to step up.
Increasing mobility in capital is considered as a instant feature of the world economy
during the last globalization decades. There is not really exception within EU, capital is
highly mobile and European financial markets are strongly integrated, so this chapter is
going to focus on labor mobility as a main factor. Free movement of persons is one of the
four freedoms of EU and also a core part for European single market.
3Graph 1: EU citizens living in other EU countries in 2010 or (1) 2009
Data gain: Eurostat (2012)
4 000 000
3 000 000
2 000 000
1 000 000
0
Romania (1)
Luxembourg
Slovakia (1)
Lithuania
Slovenia
France
Finland
Ireland
Greece
Poland
Sweden
Estonia
Spain
Latvia
Austria
United Kingdom
Malta
Belgium
Portugal
Czech Republic
Germany
Netherlands
Denmark
Hungary
Cyprus
Italy
Unfortunately Europe is not as much mobile as the European Union would like it to be. We
can look on the latest statistics about migrating population of Europe. Following graph is
showing us total numbers of how many citizens of European Union are living in EU
member state other than their own by origin. You can see that there are almost 3,5 million
EU-foreigners living in Germany. Other countries with significant large portions are Spain,
France, Italy and UK.
In the second following graph we will look to the same data but this time as a percentage
rates of total number of EU citizens (domestic + other EU-member citizens). You can see a
high rate in case of Luxembourg or Ireland. So in fact there are a lot of EU-foreigners
working in Germany in absolute numbers but compared to a total number of German
inhabitants the value of 4,5% is merely just a little more than European average and in fact
not so significant to a labor power in Germany. The same goes for UK or Italy.
You can see from the table that there are not so many member states having a high
percentage of inhabitants that come from other EU member state. There are only 7 (out of
Graph 2: % of EU citizens living in other EU country to country citizens in 2010 or (1) 2009
Data gain: Eurostat (2012)
28,6%
35,00%
30,00%
25,00%
20,00%
10,2%
15,00%
7,4%
6,7%
6,1%
5,6%
5,6%
4,5%
3,9%
3,6%
3,2%
3,0%
10,00%
3,0%
2,9%
2,8%
2,8%
1,9%
1,9%
1,6%
1,6%
1,5%
1,2%
1,0%
0,6%
0,5%
0,3%
5,00%
0,00%
Ireland
France
Finland
Greece
Spain
Latvia
Poland
Sweden
Malta
Slovenia
Estonia
Austria
Lithuania
Romania (1)
Luxembourg
Slovakia (1)
Belgium
United Kingdom
Portugal
Italy
Cyprus
Hungary
Denmark
Germany
Netherlands
Czech Republic
427 EU members) states that have a higher percentage of foreign EU citizens than 5%. And
for example data for Belgium are not really relevant as majority of foreigners working in
Belgium is due to European institutions which tend to seat in Belgium. High rate for
Luxemburg is not a result of high workers mobility but mostly a historical progress.
Average rate for EU is less than 4%.
According to public opinion survey declared by EU most of the Europeans thinks that
seeking for a job in a different EU member state is good for the economies. But on the
other hand only one third of correspondents mean that it is also good for their families,
stated in Eurobarometer (Eurobarometer, 2010). 84% of European population have no
experience at all with living in other EU country than the original one as published in
Eurobarometer (2010) and the same level of EU population did not work or study in any
other European country that their own. Last but not least most of the Europeans do not
intend to move to other EU country any time soon or late in the future, in Eurobarometer
(2010).
Some other surveys of Eurobarometer (2010) and Eurobarometer (2006) also say that
almost half of the correspondents would consider moving to other country if they were
unemployed. As a long line of survey shows there is a strong tendency for not-moving-
anywhere mood in Europe and this unwillingness of European to move is a long-term
condition as a percentage of people living in other countries of Europe is steadily low –
less than 2% during last 30 years.
And what are the European reasons for such a low workers inter-states mobility?
Multilingual character of Europe, historical and cultural traditions of European states,
European bureaucracy, rigid labor markets, different types of education systems and
necessity of recognizing diplomas and other education certificates... and worldwide
economical crisis did not make it any easier.
Shortly... euro zone is not even close to a optimum currency area concept as the labor
mobility concerns. Of cause labor markets in Europe are really rigid due to national politics
of member states but there are also a lot of cultural, historical and languages reasons why
the European labor markets will not be any time soon highly mobile.
4.2.Wages and price flexibility – including the real exchange rate
Wages and prices in the EU are not very flexible. In most member countries of EMU wage
costs are rising every year. And it also negatively affects the unemployment rate as states
Arpaia (2007). The average hourly labor costs were estimated in 2011 to be €23,1 in the
EU27 and €27,6 in the euro area (EA17). However, there are significant differences
between Member States, with hourly labor costs ranging from €3.5 to €39.3. (Tab 1 below).
5Tab 1: Labor cost per hour in euros (costs for wages and salaries plus employer's social
contributions)
Source: Eurostat, 2012.
The inflation rate in Euro Area was recorded at 2.60 % at the beginning of 2012.
2009 2010 2011 2009 2010 2011
EU27 22,1 22,5 23,1 Lithuania 5,6 5,3 5,5
EU17 26,5 26,9 27,6 Luxembourg 32 32,7 33,7
Belgium 37 38,2 39,3 Hungary 7,3 7,3 7,6
Bulgaria 2,9 3,1 3,5 Malta 11,3 11,5 11,9
Czech Republic 9,3 9,9 10,5 Netherlands 29,8 30,5 31,1
Denmark 36,5 37,6 38,6 Austria 27,7 28 29,2
Germany 29 29,1 30,1 Poland 6,4 7 7,1
Estonia 7,9 7,7 8,1 Portugal 11,9 12 12,1
Ireland 28 27,9 27,4 Romania 4 4,2 n/a
Greece 17,6 17,5 n/a Slovenia 13,8 14,1 14,4
Spain 20 20,2 20,6 Slovakia 7,9 8 8,4
France 32,1 33,1 34,2 Finland 28,7 28,9 29,7
Italy 25,6 26,1 26,8 Sweden 31,7 36 39,1
Cyprus 15,9 16,2 16,5 UK 18,9 20 23,1
Latvia 5,9 5,7 5,9
Historically, from 1999 until 2012 euro area inflation rate averaged 2.3 % reaching an all
time high of 5.0 % and a record low of -0.7 % in 2009. Inflation rate records a general rise
in prices measured against a standard level of purchasing power. Bellow we can find a
chart with historical data of inflation rate of euro zone.
6Graph 3: Inflation in Europe
Source: Eurostat, 2012.
4.3.Sufficient size and openness of the national economy
The theory of optimum currency area as it developed McKinnon (1963) was based on
examination of the openness of the economy as a share of tradable and nontradable
goods. In a small open economy the domestic prices for goods are independent on the
exchange rate and monetary policy can not affect the competitiveness of the country. As
we can see, most countries of the European Union are open and are therefore good
candidates for monetary union.
Graph 3: Intra and extra EU-27 trade in 2011 (imports and exports, % share of total trade)
Source: Eurostat (2012)
Entry into the monetary union will increase the mutual trade relations with other member
countries. The countries that will become a member of the monetary union and can expect
to change their business cycles. This is a consequence of a common monetary policy but
also the aforementioned closer mutual trade with other members of the EMU. This view
confirms the endogeneity hypothesis of optimum currency areas and as this criterion of
optimal currency area concerns it shows us that Europe is a suitable candidate for a
common currency. European countries have a long history of between European states
trade and the inner-European trade is a core of integration process from very beginning.
Common trade policy, single market and single currency just developed a highly
concentrated area within Europe with intensive trade between the EU-members.
4.4.The existence of positive shock and correlation among countries
The monetary cooperation would work the better the more correlated the countries are. In
a open economies with flexible exchange rate and independent monetary policy, interest
7rates and exchange rate of national currency are two most powerful meanings for solving
economic discrepancies. In monetary union is the monetary policy maintained by central
bank for the whole area (European Central Bank for EMU). As much as the different
regions of monetary area correlate in various economic conditions so much could be the
common monetary policy effective.
Europe is diversified continent and European Union is heterogeneous unit with large
differences between member states. First, there is a large difference in development and
state wealth between original states (as we consider EU12 or even EU15) and the new
member of EU (12 member from central, south and east Europe). Second, there is also
few really strong economies as Germany or United Kingdom that represent kind of
economic core to the European integration with a main influence on the European
economy and high dependance of other smaller member state on these large members.
And third, there are big differences between economic growth in different countries, we
can find a large growth in some smaller countries from east (Baltic countries for example)
and some really low growth rates in original EHS states (for example France, Belgium or
Italy).
If we look simple on the data of economical growth in Europe we will not really see a lot of
similarities in progress. Yes all the European states was hit by the last world crisis but the
degree of growth decrease and also time needed for recovery differed.
Graph 4: Economic convergency in EMU area
Data source: Eurostat (2012)
15
EU (27 countries) Cyprus
10
Belgium Luxembourg
5 Germany Malta
0 Estonia Netherlands
Ireland Austria
-5 1997 1999 2001 2003 2005 2007 2009 2011 2013
1996 1998 2000 2002 2004 2006 2008 2010 2012 Greece Portugal
-10 Spain Slovenia
-15 France Slovakia
Italy Finland
-20
8Graph 5: Economic convergence in countries without euro
Data source: Eurostat (2012)
EU (27 countries)
15 Bulgaria
10 Czech Republic
Denmark
5
Latvia
0 Lithuania
-5 1997 1999 2001 2003 2005 2007 2009 2011 2013 Hungary
1996 1998 2000 2002 2004 2006 2008 2010 2012 Poland
-10
Romania
-15 Sw eden
-20 United Kingdom
We can see there are some differences between euro zone and non-euro-EU. Just a
simple comparison shows us that euro-area is more converging that the non-euro-area.
These two graphs illustrate development in economic growth during last two decades in
Europe. We can see that the correlation between different state are not really coordinated.
There is some similarities within growth or depression tendencies but there are always big
differences between states in a mind of how deep the recession is or how big the
economic growth is.
If we consider economic convergences as one of the criterion of optimal currency area
than we have to admit that euro zone is not really a converging area but on the other hand
we can notice some improvements in this area.
4.5.Political reasons for currency integration
As we can see from previous chapters Europe is not an economical homogeneous area
or any kind of suitable area for monetary integration. The mobility in labor factor is really
low and European economies absorbs any kind of shock not really in perfect symmetry.
And in fact introduction of euro was mainly a political steps in a long walk of European
economic cooperation rather than economical decision.
In the time of euro beginning (during preparing of Maastricht treaty in early nineties)
Europe was a successful and highly integrated region. Single market was introduces in
1986 and Single European Act should have been a core of a future economic development
in Europe. Free movement in goods, services, persons and capital should have
represented the main substantial ingredients of growing European markets and euro just
compromised a highly convenient instrument for better single market.
As we look at the economical standards for optimal currency area we can see that this
view can be also seen little different. Europe wanted to implement euro not because it was
economical reasonable and because of an optimal European currency area. Euro was
more seen as an ingredient maintaining better free movements of goods, persons or
capital and also served as a new impulse for integrating European single market. For
many reasons introducing the euro currency also seemed as a logical step to further
economical and maybe (in a distant future) also political integration. Euro represented
mostly a step of a big wish to have a real single European market. Single market – single
currency – single Europe. In this lights single euro just made much more sense than
evaluating optimal currency area conditions.
4.6. Economical vs. political standards of optimal currency area
Fathers of European common currency tried to incorporate some prerequisites for optimal
currency area into the currency cooperation. Convergence criterion had been set up and
supposed to be followed. Participation in Exchange Rate Mechanism (ERM II) was some
9kind of a main test for every single member state how they can handle fixed exchange rate
and if it is possible for them to meet the convergence criterion even under this condition.
Convergence of member states economics was expected by meeting the Maastricht
criterion: fiscal stability, stable price level and strictly maintained monetary policy was
about to support a real convergence of euro zone member states. It should also ensure
the endogeneity of European currency area: as long as European states participate on the
currency integration so more is the European currency area (euro zone) closer to the
concept of optimal currency area. There are some studies, Optimum Currency Areas
structural changes and the endogeneity of the OCA criteria (2009) supporting this
argument and determining that euro area is really developing some kind of convergence
between member states but there are also studies that stated opposite opinion, Ten Years
EMU – Reality Test for the OCA Endogeneity Hypothesis (2009) consisting on facts that
economical variables are stable and different across the whole euro zone and not even a
little closer to converging process.
It is quite evident from some studies that small and open economies from new EU member
states are converging to euro zone. These countries usually have national currencies
bonded to euro anyway and their economical growth is largely depending on a progress in
bigger European countries (mainly Germany). In a theoretical sphere (and not speaking
about political opinions and actions) question whether to adopt an euro currency is mostly
a question of when rather than if so, as offered in Šaroch (Šaroch, 2003). These states are
anyway so much dependent on the change in euro zone that they can get more profit if
they are part of the European currency.
Resent development in Europe also shows us that the common currency has brought
some big problems for various of the European states like Greece or other highly indebted
countries. Not only European common currency area is not converging to an optimal
currency area but also the common currency and common monetary policy with low
interest rate and common exchange rate were steadily increasing the differences between
member states. With a not optimal use of fiscal policies and lack of controlling process for
fiscal stability within the area euro zone have to face now days such a big problems with
indebtedness and instability situation as in Ten Years EMU – Reality Test for the OCA
Endogeneity Hypothesis (2009).
4.7. Fiscal integration and coordination
If the monetary area is not optimal insufficient mobility of production factors can be
compensated by fiscal transfers. When the recession in one region does not fix this flexible
movement of labor, social problems can be dealt with fiscal transfers. This means that a
common currency can work in areas that can not be described as an optimal currency
area if there is the political will to implement fiscal transfers.
For the coordination of fiscal discipline and to avoid excessive government deficits and
public budgets the EMU countries establish in 1997 „Stability and Growth Pact“. This pact
is an agreement between members of the euro zone, which concerns the coordination of
budgetary policies to not endanger the stability of the euro and to not increase inflation in
the euro area. This Agreement shall also apply to some countries outside the European
Monetary Union. Extra large countries such as Germany and France violated the pact and
especially at the Initiative the EU Council in March 2005 agreed on new rules. Increased
number of options which can exceed three per cent deficit in public finances and the
period before the EU accedes to sanctions has been extended.
The general government deficit in order to the Agreement shall not exceed 3% of GDP and
public debt must be less than 60% of GDP, or must at least diminish. If either country does
not fulfill these conditions, the European Commission's made warning and even a money
penalty can be imposed (0.2 to 0.7% of GDP depending on the violation). These penalties
10do not apply in case of emergencies such as natural disasters or in the case of a
prolonged economic crisis.
The following graph shows the debt of individual EU Member States (whether member
states or non-EMU) as a percentage of GDP. It is also one of the Maastricht criteria,
allowable value is 60% of GDP.
Graph 6: General government debt, 2010 and 2011
Source: Eurostat (2012)
The border of three percent of budget deficit over the years failed to comply by several
states, including Germany and France. In the long term, however, have difficulties in
fulfilling this criteria, Italy, Portugal, Spain and Greece. The fall in the deficit immediately
after the crisis erupted in Europe, we can see in the following chart.
Grapf 7: Government deficits in percentage of GDP, 2009 and 2010
Source: Eurostat (2012).
11In 2011 the largest government deficits in percentage of GDP were registered in Ireland (-
13.1%), Greece (-9.1%), Spain (-8.5%), the United Kingdom (-8.3%), Slovenia (-6.4%),
Cyprus (-6.3%), Lithuania (-5.5%), France and Romania (both -5.2%) and Poland (-5.1%).
The lowest deficits were in Finland (-0.5%), Luxembourg (-0.6%) and Germany (-1.0%).
Hungary (+4.3%), Estonia (+1.0%) and Sweden (+0.3%). However, 24 Member States
recorded an improvement in their government balance relative to GDP in 2011 compared
with 2010, two a worsening and one remained stable. (Eurostat, 2012).
5.Summary and Conclusion
So is the European currency zone an optimal currency area? As we can see from the
previous chapter... not even close. There are a lot of obstacles and some of them (as a
high mobility of labor) is not easy to remove. As discussed in previous chapters many
problems and insufficient conditions of European economy for optimal currency area can
be resolved by fiscal cooperation and fiscal union. Right now is EU on a careful and
gradual way to a fiscal union. A new fiscal pact for coordination in budget area has been
introduced this year. But this pact is maintaining only national budget problems with deficit
and it put some restraining limits for national fiscal policies.
Possibility of fiscal transfers... is not a question for European states right now. The
common budget of EU is used strictly for common policies and should not serve as a
European common fiscal policy instrument. Willingness of members states is not really
ready for such a transfer of national competencies and not big enough to sacrifice
independent nation fiscal policies.
There are few possible future for euro and monetary integration in Europe. First: European
markets will soon or later converge and the endogeneity of currency area will serve as a
starting point for European optimal currency area. Second: fiscal union as much as no
possible it seems today will happen as the member states will be forced by the
circumstances of European integration process. Third: right now European states are
getting ready for possibility of Greece leaving euro, this will set the precedence and other
states will gradually leave euro and return to their national currencies. It mainly depend on
the member state and political will in Europe as we stated in previous chapter... euro is a
economical phenomenon but with a strong political moment. And maybe the theoretical
point of view can see that euro zone is not a right thing to fight for but the European
politicians still do.
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