Optimum Currency Areas Past and Future
Abstract and Keywords
The literature on optimum currency areas differs from that on other topics in economic theory in a number of notable respects. Most obviously, the theory is framed in verbal rather than mathematical terms. Mundell’s seminal article coining the term and setting out the theory’s basic propositions relied entirely on words rather than equations. The same was true of subsequent contributions focusing on the sectoral composition of activity and the role of fiscal flows. A handful of more recent articles specified and analyzed formal mathematical models of optimum currency areas. But it is safe to say that none of these has “taken off” in the sense of becoming the workhorse framework on which subsequent scholarship builds. The theoretical literature remains heavily qualitative and narrative compared to other areas of economic theory. While Mundell, McKinnon, Kenen, and the other founding fathers of optimum-currency-area theory provided powerful intuition, attempts to further formalize that intuition evidently contributed less to advances in economic understanding than has been the case for other theoretical literatures.
Second, recent contributions to the literature on optimum currency areas are motivated to an unusual extent by a particular case, namely Europe’s monetary union. This was true already in the 1990s, when the EU’s unprecedented decision to proceed with the creation of the euro highlighted the question of whether Europe was an optimum currency area and, if not, how it might become one. That tendency was reinforced when Europe then descended into crisis starting in 2009. With only slight exaggeration it can be said that the literature on optimum currency areas became almost entirely a literature on Europe and on that continent’s failure to satisfy the relevant criteria.
Third, the literature on optimum currency areas remains the product of its age. When the founders wrote, in the 1960s, banks were more strictly regulated, and financial markets were less internationalized than subsequently. Consequently, the connections between monetary integration and financial integration—whether monetary union requires banking union, as the point is now put—were neglected in the earlier literature. The role of cross-border financial flows as a destabilizing mechanism within a currency area did not receive the attention it deserved. Because much of that earlier literature was framed in a North American context—the question was whether the United States or Canada was an optimum currency area—and because it was asked by a trio of scholars, two of whom hailed from Canada and one of whom hailed from the United States, the challenges of reconciling monetary integration with political nationalism and the question of whether monetary requires political union were similarly underplayed. Given the euro area’s descent into crisis, a number of analysts have asked why economists didn’t sound louder warnings in advance. The answer is that their outlooks were shaped by a literature that developed in an earlier era when the risks and context were different.
After an extended period of quiescence, the Maastricht Treaty occasioned a resurgence of interest in optimum currency areas. Given the real-world motivation, much of the contemporary literature was empirical and European in focus, although an important strand analyzed the operation of the U.S. economic and monetary union as a way of gauging Europe’s prospects. And that empirical literature focused tightly on the insights of the founding fathers, who had emphasized the symmetry of disturbances, the mobility of labor, and the role of fiscal stabilization.
Thus, Bayoumi and Eichengreen (1993) used a variant of a structural-vector-autoregression approach due to Blanchard and Quah (1989) to estimate aggregate supply and demand disturbances in different European countries; to document the correlation of those disturbances with that in the center or anchor country, taken to be Germany; and to draw comparisons with the United States. They found that the correlation of disturbances was lower between European countries than between U.S. census regions, suggesting that Europe would find it more difficult to live with a one-size-fits-all monetary policy. They found further that European countries seemed to be separated into a core, in which disturbances were highly correlated with Germany’s, and a periphery characterized by a very different pattern. The members of the periphery, as it happened, were Portugal, Italy, Ireland, Greece, and Spain (the countries that subsequent to the crisis came to be known as the PIIGS), along with the United Kingdom, which in its wisdom chose not to join the monetary union. This was a caution against moving ahead with a large monetary union that, in the event, was not heeded.
An obvious objection to drawing these inferences was that the pattern of shocks, based on historical correlations, might change with the advent of monetary union itself. An obvious possibility was that, with the move to a single currency and common central bank, demand shocks emanating from monetary policy would become less diverse (Minford, 1993). Changes in the structure of the constituent economies as a result of deeper integration might similarly alter the correlation of both demand and supply shocks across countries.
The theoretical literature did not provide strong guidance, however, about whether those shocks would become more correlated, as economic structures and policies continued to converge, or whether they would grow less correlated because the constituent economies, now more deeply integrated, came to specialize further along lines of comparative advantage (for a review of the debate, see Krugman, 1993). Here the approach of Frankel and Rose (1998) was influential. They asked whether business cycle movements tended to converge as trade increased, addressing the potential endogeneity of trade by using instruments like distance, drawn from the gravity-model literature. Their influential finding that fluctuations tended to converge across countries with integration lent an optimistic cast to the debate over monetary union.
Initially it was possible to argue that just such a process of convergence was underway, considering rapid growth in the number of members of the so-called European periphery (e.g., the Republic of Ireland) and the decline in interest rates in other countries to Germany’s lower levels. But there were also troubling signs of lack of convergence in certain other members of the periphery (e.g., Portugal) and in the behavior of other variables, notably the rate of productivity growth (Blanchard, 2007; Reis, 2013). It similarly turned out that the widely heralded convergence of interest rate spreads was not durable.
The question was why not. The European Central Bank (ECB, 2015) pointed to “weak institutions, structural rigidities, weak productivity growth and insufficient policies to address asset price booms”—to the kitchen sink, in other words. Bayoumi and Eichengreen (2017) added more specificity by updating their Blanchard and Quah-style analysis using data for the monetary union period. The found some modest evidence of convergence of demand shocks in Europe, consistent with the transition to a common monetary policy, although the correlation of shocks with those in the anchor region remained lower than in the United States, suggesting the existence of continued tensions.
Their second finding was more surprising. Although there was still evidence of a European core and a European periphery, in the more recent period the countries in the core, where disturbances were most highly correlated with Germany’s, turned out to be none other than Portugal, Italy, Ireland, Greece, and Spain—the euro crisis countries, in other words. One interpretation of this result is that macroeconomic fluctuations within the monetary union were driven not by labor and energy market shocks on the supply side or monetary policy shocks on the demand side but by the financial cycle, as described in Ozhan (2016) and Bayoumi (2017). The first decade of the euro area saw large-scale capital flows from northern to southern Europe, as investors relieved of exchange risk sought to arbitrage the initial interest rate spreads. Those financial inflows fueled consumption booms across southern Europe. With Germany booming due to the demand for its capital goods exports from China, there was a high correlation of shocks between what was formerly the periphery and the anchor country. After 2008, Germany then experienced a slowdown due to the global crisis, and capital flows from northern to southern Europe shifted into reverse. Thus, the increase in the correlation of shocks hitting Germany and the PIIGS should be viewed not as evidence that Europe had come to better satisfy the preconditions for an optimum currency area but rather that monetary union had an important and troubling financial aspect the importance of which had been neglected.
As noted, financial factors were not given their due in early work on optimum currency areas. Specifically, the effects of large cross-border capital flows within a monetary union were not adequately incorporated into early analyses, which focused instead on commodity flows, fiscal flows, and labor flows. Empirical studies of existing monetary unions had of course noted that cross-border capital movements could be substantial in the absence of exchange risk and regulatory impediments (see Davis, 1965; Ingram, 1962). What they had not anticipated was that such flows could be profoundly destabilizing.
Thus, Lane (2013) documented a striking rise in intra–euro-area capital flows following the transition of the euro, over and above the rise in capital flows experienced elsewhere—that is, in addition to any increase plausibly attributable to financial globalization. Kalemli-Ozcan, Manganelli, Papaioannou, and Peydró (2008) documented the positive impact of the euro on bank-intermediated flows in particular. Bank-intermediated flows disproportionately destined for southern Europe fueled massive consumption, public spending, and housing booms, depending on the destination country in question. They induced a reallocation of resources toward less productive nontraded goods-producing sectors that was not easily unwound. They then precipitated massive crises when those capital movements reversed abruptly.
Earlier contributions to the optimum-currency-area literature had argued that the cross-ownership of productive assets was a way of diversifying country risk in a monetary union, absent an independent national exchange rate policy, and had derived conditions under which such risk-sharing effects obtained (see, e.g., Melitz & Zumer, 1999). Subsequent analysis now considered why those benefits proved elusive and why cross-border flows concentrated risks, financed unproductive investments, and accentuated imbalances. One possibility is that financial market participants were simply confused: they confused the absence of exchange risk with the absence of credit risk and poured capital into less creditworthy southern European countries where interest rates were high. A second possibility is that the direction of capital flows in the monetary union was distorted by the collateral policies of the European Central Bank, which applied the same haircuts to the sovereign debt instruments of all euro-area central governments when these were offered as collateral for repurchase agreements (Buiter & Siebert, 2005). A third possibility is that French and German banks doing the lending were comfortable absorbing high-yielding southern European sovereign bonds because they expected an official sector bailout if things went wrong, and because southern European governments, enjoying the existence of this captive market for their debt securities, had every incentive to borrow (Cooper & Nikolov, 2013).
It is now commonplace to be told that monetary union without banking union will not work, where the elements of banking union are a single supervisor, a single fully funded deposit insurance scheme, and a single-resolution mechanism (Noyer, 2014). The role of the single supervisor is to internalize cross-border externalities neglected by national supervisors—to prevent lax regulation of northern European banks from facilitating excessive lending to southern European governments and households, for example. The role of the single fully funded deposit insurance scheme is to prevent cutthroat competition over deposit insurance coverage from shifting confidence problems between countries, as happened in 2007–2008 (Engineer, Schure, & Gillis, 2013). And the role of a single-resolution mechanism is to reduce uncertainty and strengthen market discipline by alerting bank creditors to the prospect that they will be bailed in if there are solvency problems.
The early literature on optimum currency areas made essentially no mention of banking union. Recent work has begun to correct this deficiency, analyzing how the lower inspection costs of local supervisors should be balanced against the superior capacity of centralized supervision to internalize cross-border and interstate spillovers and how that balance shifts with the extent of financial integration and with the heterogeneity of tastes for or aversion to bailouts (Beck & Wagner, 2013; Carletti, Dell'Ariccia, & Marquez, 2016). There is also an extensive literature on the problems of implementing banking union in practice (see, e.g., Véron, 2015). But this clearly is an area where additional theoretical work is required.
Closely related is the idea that monetary union needs capital markets union in order to work smoothly (European Commission, 2015). The euro crisis provoked the realization that the continued segmentation of capital markets by national regulation resulted in the monetary union relying disproportionately on banks for cross-border capital transfers, aggravating too-big-to-fail and other problems associated with overbanking. Capital markets are a safer vehicle for cross-border capital transfers, the argument goes, because they are not subject to self-fulfilling depositor runs, nor are they too big to fail. It follows that the solution to financial fragility problems in a monetary union lies in the removal of regulatory and other obstacles to using capital markets as a vehicle for cross-border lending and borrowing.
Each of these propositions is arguable. Extending the theory of optimal currency areas to analyzing the conditions under which they obtain would clearly be desirable.
Kenen (1969) can be credited with integrating fiscal federalism into the theory of optimal currency areas and highlighting the role of fiscal policy in a monetary union. His intuition is straightforward: the stabilization role of an independent fiscal policy is especially important for a region or economy subject to asymmetric disturbances when an independent monetary policy is unavailable. But since discretionary fiscal policy is subject to inside and outside lags, enhancing the operation of automatic fiscal stabilizers is desirable. In a federal system, fiscal policy can also be thought of as playing a co-insurance role, with resources flowing automatically from booming to depressed regions, whose respective identities will change over time.
These ideas were developed empirically with reference to monetary unions like the United States, where fiscal resources flowed between the oil patch and the manufacturing belt depending on whether energy prices were high or low. But early empirical work using data for U.S. states and Canadian provinces did not reach a consensus on whether these fiscal flows were large or small. Different researchers reached different conclusions depending on whether they distinguished changes in the level and direction of transfers resulting from changes in economic conditions, on the one hand, or from ongoing transfers from high- to low-income regions, on the other (see Bayoumi & Masson, 1995; Sala-i-Martin & Sachs, 1992; von Hagen, 1992). More than 20 years later, it is still the case that this debate remains unresolved.
In addition, empirical studies, some again based on the experience of U.S. states, differ in their conclusions about whether market forces—increases in the cost of credit as levels of indebtedness rise—can be relied on to discipline sovereign borrowers—in other words, on whether market discipline can be relied on to prevent governments with fiscal discretion from abusing it. Bayoumi, Goldstein, and Woglom (1995) and Poterba and Rueben (1999) found that the premium on bond spreads rose with state government indebtedness and that credit markets tend to withhold access at very high levels of debt. Bernoth, von Hagen, and Schuknecht (2004) reached similar conclusions using data from the early years of Europe’s monetary union. Yet the strong spread compression affecting southern European bonds in the period before the 2009–2010 crisis rests uneasily with these conclusions (see, e.g., Inguanez, 2012). This experience suggests that market discipline is erratic. Empirical analyses of emerging market sovereign bond spreads (e.g., Eichengreen & Mody, 2000) point in the same direction.
Skeptics of market discipline suggest, as an alternative, binding rules constraining governments from running excessive deficits or accumulating excessive debts, along with procedures for eliminating excesses when they occur. This was the approach taken by the framers of the Maastricht Treaty, who specified a Stability Pact (eventually renamed Stability and Growth Pact), an Excessive Deficit Procedure, and a raft of related rules. Academics (e.g., Buiter, Corsetti, & Roubini, 1993; Eichengreen & Wyplosz, 1998) questioned their workability, asking whether arbitrary rules were credible and if governments would sanction violators when they themselves could be subject next. Again, empiricists seeking to test these propositions drew evidence from U.S. states that have constitutional and legislative limits on debts and deficits of varying degrees of intensity. Such studies (e.g., Poterba, 1994, 1995; von Hagen, 1994) generally concluded that fiscal rules have a discernible effect on fiscal performance and borrowing costs, although the magnitude of the effect is disputed, as is the extent to which results for the United States carry over to other monetary unions. Specifically, evaluations of operation of the Stability and Growth Pact were not entirely favorable (Wyplosz, 2006), something that is not surprising given how the pact was prominently violated by both France and Germany after the turn of the century. Revelations in 2009–2010 that Greek budget deficits were a multiple of the levels previously acknowledged did not enhance confidence in the willingness of governments to abide by the rules or in the capacity of the Commission to enforce them.
The official response has been to reinforce the rules with ancillary measures like the Fiscal Compact, the Six-Pack, and the Two-Pack (European Commission, 2010). One is reminded of the definition of insanity attributed to Einstein: doing the same thing over and over again and expecting different results.
A second response has been to attempt to make the rules more flexible, enhancing compliance by eliminating perverse side effects. An example is keying the Stability and Growth Pact to cyclically adjusted deficits rather than headline deficits. The problem here is lack of agreement on how to do the cyclical adjustment—equivalently the difficulty of estimating full employment (Tereanu, Tuladhar, & Simone, 2014).
Yet a third approach has been to attempt to strengthen both rules and market discipline by enhancing budgetary transparency (Burda & Gerlach, 2010). The compatibility of this with the second approach is uncertain, however.
A fourth and final approach has been to seek to reduce the likelihood that governments will violate fiscal norms by strengthening fiscal procedures. Examples include requiring the formulation of multi-year fiscal plans and outsourcing monitoring and decision-making to an independent fiscal council (Wyplosz, 2005).
These various approaches are not necessarily incompatible. Thus, the requirement for strengthened national fiscal frameworks, including the creation of fiscal councils, was part of the Six-Pack in 2011 and the Two-Pack adopted in 2013. But neither is there a theoretical or empirical consensus on what works.
The alternative to more complex rules and institutions at the level of the currency area is to return control of fiscal policy to the constituent political jurisdictions (Eichengreen & Wyplosz, 2016), relying not just on market discipline, which may be erratic, but also on the possibility of restructuring the debt if things go wrong. Even if market discipline is erratic and sovereigns have scope to incur excessive deficits, there may be no better alternative to entrusting governments with this responsibility and requiring them to pay the price—in other words, expecting them to restructure their debts when they are unsustainable. Repatriation of national fiscal policies is consistent with the principle of subsidiary that governs the allocation of policy functions in a currency union (Barton, 2014). It is consistent with the theory of clubs that suggests that functions should be centralized only when cross-jurisdiction spillovers are large and tastes are homogeneous (Buchanan, 1965; Sandler, 1997), since tastes over fiscal policy are anything but homogeneous in practice, and evidence of large spillovers is tenuous (Oudiz & Sachs, 1985).
Debt restructuring was not considered by early contributors to the theory of optimum currency areas. It was not an issue addressed in background papers to the Maastricht Treaty (Emerson, 1992) or the Treaty itself. It was stridently opposed by European officials like ECB president Jean-Claude Trichet when the Greek crisis erupted in 2010 (Blustein, 2016). Their opposition was evidently grounded in two reservations. First, the cross-border spillovers of debt restructuring can be large even when it is undertaken by a small country like Greece, given the special circumstances of monetary union. Specifically, a Greek restructuring might have destabilized banks in neighboring countries (read Germany and France), given the large exposures accumulated by these banks to Greek sovereign bonds (this being a corollary of the spread compression highlighted above). This suggests that a precondition for making debt restructuring feasible and, therefore, for repatriating fiscal policy to the national level is breaking the “diabolic loop” connecting sovereign debt and banking-system stability (Pozzolo, Calzolari, & Navaretti, 2016). This might be accomplished by eliminating the incentive for banks to load up on the debt of risky sovereigns (by inter alia changing ECB collateral policies) and tightening bank regulation and risk-weighting generally.
The second reservation was that restructuring may be prohibitively costly to the country contemplating it. Domestic banks holding government bonds may be devastated by the crisis. Again, this is a problem that can be addressed by regulatory reform (changing the European risk-weighting scheme that treats domestic sovereign bonds as risk free). A related fear is that a deadlock in negotiations with creditors may interrupt the country’s financial market access for an extended period. Following the outbreak of the Greek crisis, European officials addressed this by mandating the inclusion of collective action clauses, under which only a supermajority of creditors is required for agreement on restructuring terms, in all future sovereign bond issues. To supplement this contractual approach, there have been a number of proposals (e.g., Weder di Mauro & Zettelmeyer, 2010) for creating a statutory mechanism to facilitate debt restructuring in the currency union, although the need for new statutes continues to be disputed. Still others (e.g., Andritzky, Feld, Schmidt, Schnabel, & Wieland, 2016) have sought to square the circle by suggesting mechanisms incorporating both the contractual and statutory approaches.
Labor mobility is the final adjustment mechanism in the theory of optimum currency areas. Mundell himself emphasized migration in adjusting to asymmetric shocks, while other authors considered wage flexibility as a mechanism for pricing labor back into employment. Blanchard and Katz (1992) showed that migration between U.S. states was of first-order importance in adjusting to shocks in the U.S. economic and monetary union. Mobility within European countries in the pre-euro period was significantly less (see, e.g., Eichengreen, 1993), and there was reason to think that mobility between European countries would be even more limited. Decressin and Fatas (1995) replicated Blanchard and Katz’s analysis for European countries and found evidence consistent with these conclusions.
In addition, Europe was characterized by lower levels of real wage flexibility (Arpaia & Pichelmann, 2007; Knell, 2010). Bayoumi and Eichengreen (1993) found that the speed of adjustment to shocks was less in European countries than in U.S. regions, consistent with these observations about labor market inertia. All this fed skepticism that Europe was an optimum currency area and about whether it approached that ideal to the same extent as the United States.
The same point about the endogeneity of the optimum currency area criteria made by Frankel and Rose (1998) for asymmetric shocks could also apply, however, to labor market adjustment. Dao, Furceti, and Loungani (2014) therefore re-estimated these relationships for both the United States and Europe following the transition to the euro. They found some evidence of convergence over time, with labor mobility falling in the United States (as documented also by Molloy, Smith, Trezzi, & Wozniak, 2016) and rising in Europe. Beyer and Smets (2015) replicated their finding of convergence in adjustment patterns on the two continents.
But their findings also indicated that differences between the two monetary unions remain substantial. Dao et al. (2014) find that in the year following a negative 1% regional employment shock in Europe, 10% of the adjustment comes in the form of an increase in unemployment, 60% in reduced labor force participation, and 30% in outmigration. In the United States the analogous proportions are 20%, 20%, and 60%. From this it appears that migration is still twice as responsive in the United States. Beyer and Smets (2015) find that labor mobility ultimately accounts for about 50% of long-run adjustment in both economies in response to demand shocks but that it accounts for much less in Europe in the short run. Europe consequently takes twice as long to get to the steady state (consistent with the impulse responses in Bayoumi & Eichengreen, 1993).
Recent experience suggests that labor mobility may also have other effects influencing adjustment to regional shocks not considered in early contributions to the theory of optimum currency areas. Skilled, educated, prime-age workers are relatively mobile; it follows that they are most likely to emigrate in response to a local shock. If so, labor mobility will be a source of brain drain. Falling average levels of human capital and labor productivity will then be an unintended consequence of relying on labor mobility for adjustment (Eichengreen, 2014).
Emigration may also fail to facilitate adjustment if emigrants have relatively high propensities to consume. Emigration will reduce the supply of labor, but it will also reduce spending, aggregate demand, and hence the demand for labor. Dmitriev and Hoddenbagh (2012) and Farhi and Werning (2014) show that while outmigration unambiguously benefits those who migrate—Why else would they move, after all?—it may leave the stayers worse off. It reduces competition for demand but it also reduces spending by residents, and there are circumstances where the second effect dominates.
Labor mobility may also limit fiscal autonomy: regional authorities may have limited ability to raise taxes in order to offset spending shocks when the tax base is mobile, permitting footloose factors of production to flee to lower-tax jurisdictions. Baglioni, Boitani, and Bordignon (2013) show how high labor mobility may prevent the fiscal authorities from responding in stabilizing ways. This was a problem for Greece after 2010, when tax increases and reductions in social services led to the exodus of skilled workers, forcing the authorities to raise taxes and cut social services still further. The problem was reinforced by the mobility of capital. One newspaper account reported that as many as 2,000 Greek companies had moved to Bulgaria, where the corporate profits tax was 10%, in 2015, little more than a third of Greece’s 29% level.
One can see how this problem may feed on itself. Tax increases intended to restore debt sustainability and confidence can lead footloose factors of production to flee, requiring further tax increases and leading further emigration and capital flight until the region is emptied out: Can you say Puerto Rico (a part of the U.S. currency union that lost some 9% of its population in the last decade)?
In all, labor mobility thus may not be the panacea that the early theory of optimum currency areas made it out to be.
The theory of optimum currency areas dates from the 1960s, when questions began to be asked about the durability of the Bretton Woods System and about whether countries should forsake exchange rate flexibility and monetary autonomy in order to hold their currencies stable. These early contributions were heavily abstract, informal, and informed by the experience of functioning currency unions like the 50 U.S. states and 10 Canadian provinces.
That theory has not stood still. It experienced a rebirth in the 1990s with negotiation of the Maastricht Treaty and Europe’s decision to create the euro. With this impetus, but prior to the advent of Europe’s single currency, much of this new wave of research continued in the tradition of drawing inferences about the effects of the euro from the experience of Canada and the United States. But starting in 1999, when the euro became a fact, it was also possible to test the implications of the theory using data for the euro area itself. It became possible to make direct comparisons of shocks, responses, and adjustment mechanisms between Europe and North America rather than simply attempting to infer behavior in Europe from prior behavior in America. It became possible to test for the endogeneity of the optimum currency area criteria by comparing pre- and post-euro experience. By scrutinizing euro-area experience, it became possible to identify aspects of the operation of currency areas—the financial effects of monetary union and the unanticipated consequences of labor mobility, for example—not adequately acknowledged by the founding fathers of optimum currency area theory. And that in turn began to lead, finally, to useful new theoretical analyses in this issue area.
I am grateful to Fabio Ghironi for helpful comments.
Readers can find guidance to further reading on the subject of optimum currency areas by following up on the references cited in the text. Seminal contributions to the theory of optimum currency areas are Mundell (1961), McKinnon (1963), and Kenen (1969). An early contribution that considers fiscal and labor-market aspects is Jame Ingram, Regional Payments Mechanisms: The Case of Puerto Rico (Durham: University of North Carolina Press, 1962)Google PreviewWorldCat. Two early applications to the euro are Barry Eichengreen, “One Money for Europe? Lessons from the U.S. Currency Union,” Economic Policy, 10, 118–187Google PreviewWorldCat, and Peter Kenen, EMU After Maastricht (New York: Group of Thirty, 1992).Google PreviewWorldCat The European Commission’s own evaluation of the operation of the monetary union, along with a range of independent assessments, is Marco Buti, Servaas Deroose, Vitor Gaspar, and Joao Noguerira Martins, The Euro: The First Decade (Cambridge, UK: Cambridge University Press, 2010).Google PreviewWorldCat
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