The theory underpinning the euro

2011-02-08

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The optimal currency area (OCA) is the theory that establishes the framework within which a group of states can adopt a single currency without worrying about the occurrence of asymmetric shocks. There are a number of criteria that have been put forward by economists, such as Mundell, Kenen and McKinnon. In brief those are full labor mobility across countries, diversified production and similar structure of economies, intense mutual trade, willingness of countries to pay other countries for asymmetric shocks (also known as fiscal transfers), consensus in dealing with shocks, and a common vision. The EU satisfies all of these conditions, some to a lesser extend and some to a greater extend.

Nevertheless it should be pointed out that the policymakers who set the foundations of the EMU did not think of the OCA theory. The only thing they had in their minds was to set some strict economic criteria that would theoretically harmonize the economies of all member-states.

This should be underlined since it can show that the OCA theory has left some factors behind. It omits two important factors that are of cardinal importance in the real world: political willingness and human creativity in creating mechanisms, both of which play a dominant role in keeping the European dream alive. The most recent step forward was the entrance of Estonia in the eurozone, despite the unprecedented speculation against the euro and against all those who predict or wish the destruction of the single currency; the eurozone evolves, improves its internal mechanisms and expands to encompass more European states.

It would be useful to examine whether the euro satisfies the conditions set out by the OCA theory in order to shape an idea of the current situation regarding the fate of the euro. Is it thanks to the satisfaction of these conditions that the EMU is weathering the storms or is it something beyond the scope of the theory? We shall examine whether the EU satisfies the 6 conditions that form the prerequisites of a healthy single currency area according to the theory in order to find the answer to the above questions.

1. Labor mobility

Free movement of labor is one of the four freedoms of the single European market and is protected by EC Treaty laws, by ECJ (European Court of Justice) decisions and by the directive 2005/38/EC which contextualizes the European citizenship by bringing together the rich legal corpus concerning free movement of workers and of establishment.

It thus becomes crystal-clear that at least on paper the EU has take very seriously the issue of labor mobility and has acted accordingly to reinforce it with legal tools. It is true though that in practice labor mobility is fairly low between EU states. The economic barriers that were erected over time by member-states have been combated by the European commission. However the cultural, linguistic and practical barriers, plus the diversities in the welfare system prove to be stumbling blocks for higher mobility of workers.

Low skilled jobs such as waiters, cleaners, laborers are some of the fields where workers are quite fluid. Also academics are to some extend flexible and mobile. The most immovable workers within the EU are entrepreneurs who usually manage small firms such as family businesses. In that case they are almost always tied to their native state.

With respect to the OCA theory, the EU does not fully satisfy the criterion set out by Mundell who believed that labor mobility is the key to a successful single currency area. The rationale behind this criterion is that in the case of an asymmetric shock, workers can shift from the state that experiences the shock to that which enjoys the boom, since in the first country unemployment will rise whereas in the latter the economy will require more labor to sustain growth. Of course in the real world there are many other practical issues that do not allow these massive migrations.

2. Mutual trade

As was the case with the free movement of workers, free movement of goods, services and capital constitute three of the four freedoms of the single European market. Direct trade restrictions such as quotas and tariffs, and indirect restrictions such as safety certificates have all been abolished by the EU in an attempt to boost mutual trade. Goods, services and capital are much more mobile than workers within the EU, perhaps due to the fact that there aren’t any cultural or linguistic barriers. A Greek product for example can be found on the shelves of a supermarket in France, while a Belgian product can easily be enjoyed by Cypriot consumers. Judging by the prices of goods we can easily realize that prices are roughly the same. Italian pastas cost almost the same with Greek and Cypriot pastas.

This condition is met by the EU with ease. If this was the only condition then the eurozone would be the ideal optimal currency area.

3. Diversified production and similar structure of the economies

Most of the member-states have diversified production, there is of course some sort of specialization in all countries but this is not narrowed down to specific goods, or services. Instead the norm within the EU is to have a production that covers a wide spectrum of goods. The Mediterranean countries for instance have some sort of industrial sector, plus a fairly good agricultural sector. Shipping is also important for Europe’s south. The central European countries are quite good in heavy industry but are also competitive in shipping and agriculture. There is a plethora of examples that demonstrates the diversified production of the European economies.

he trick though lies in the structure of the economies. It is here where the EU stumbles. The structures of the economy in Europe can be divided into three families with differences applying even within them. Those families are the Nordic countries, the central European countries with Germany as their leader and the Mediterranean countries including France. The differing points are the welfare system, the fiscal policies and the competitiveness of the economy. A cynic would argue that it would be better to have three unions rather than one. However what binds these diverse groups of economic structures together is the common hope of gradual harmonization of the economies. For the time being this seems to be immaterial but in the long run anything can happen.

It seems once again that the EU does not pass with ease a condition. Actually it passes it only by half. Had the economies been of similar structure then this condition would be fully satisfied. There aren’t any signs though that this will change in the short run.

4. Collective action in dealing with emergencies

Before the actions that were taken in the cases of the Greek and the Irish crises, the European Union did not possess any sort of safety mechanism, since the drafters of the treaties never envisaged ways of collective action with respect to economic emergencies. Over the last months things had to change dramatically for the euro to continue its existence. A safety mechanism was developed last April to help Greece to escape from bankruptcy, while recently the same technique was applied in Ireland. It was announced by European leaders that this mechanism will remain in place on a permanent basis. With today’s conditions we can say that the EU passes this criterion, though at first it would fail.

5. Consensus in dealing with shocks

With one way or another consensus is always reached in dealing with shocks. Nevertheless these often require a considerable amount of time. Often enough time is a luxury when having to deal with shocks, because timing is of crucial importance. In the case of the Greek crisis, if Germany had the willingness to act earlier Greece would never reach the threshold of collapse. The problem lies in the way decisions are taken in the higher levels of the EU. Those are either taken by qualified majority voting or by unanimous voting; hence a group of states or even a single state can block a decision from materializing. From the perspective of efficiency these decision making processes are really ineffective. Nevertheless the EU is not a single state but a group of states; hence there cannot be any other way in making crucial decisions. Economically and practically it would be ideal but politically it wouldn’t work. Therefore the EU passes this criterion with great difficulty.

6. Euroskeptics vs Euroenthusiasts

The trends in politics Europe-wide show that the popularity of euroskeptic parties is rising. This should ring a bell since the very foundations of the European Union lie in the common vision of a unified Europe. Should the Euroskeptics gain the upper hand then the integration process could freeze and on the extreme case the EU could be dismantled. Fortunately for the European dream, those who lead in the member-states and at the community level are pro Europeans.

As long as there is a common vision of a unified Europe anything else can be achieved. Perhaps this is the most important of the six optimal currency area conditions. For the time being the EU fulfills this condition.

Conclusion

Based on the aforementioned, the EU satisfies at least to some degree all of the six conditions to be qualified as an optimal currency area. Some might say that in order to satisfy the conditions the union must fully satisfy all criteria. The leaders of Europe would disagree though, and they would be well justified since despite the fact that Europe does not constitute an ideal currency area, it still has the euro. The ongoing existence of the single currency should at least be seen as a sign that even the theory of OCA cannot explain how the real world functions. As stated in the introduction, this theory omits political willingness and the craftsmanship of European leaders and policymakers.

I myself, though I appreciate the principles of the OCA theory, am not a supporter of it since this theory can even be applied to states that have their own currency and reach the conclusion that they do not satisfy the criteria to have a single currency. If the OCA was applied to Greece when it had the drachma it would call for at least three currencies within the country. Athens and its periphery would have its own currency; Crete would have another currency while the rest of Greece would have a third currency. Something similar would apply to North and South Italy, to East and West Germany, to North and South UK, to Basque and Castilian Spain, to French and Flemish Belgium and so on.

I personally believe in what really is rather than what ought to be. What exists today is a single currency which is shared by 17 of the 27 EU member-states. For the time being we should focus on this reality. But the future is unpredictable. Maybe tomorrow Germany will find out that it is not worth paying the debts of other countries. Or maybe other countries will be in need of the safety mechanism, countries such as Spain, Portugal and Italy. In such cases the euro can potentially meet its end. But will that be due to the insufficient grounds to establish an Optimal Currency Area, or will it be the end result of other pressures deriving from the ongoing speculative war? We shall find out when that moment comes. Now all we have is the euro. Let us focus on how to improve it rather that making ontological conversations about it.