Optimum Currency Area Theory Grzegorz Tchorek Ph D

Optimum Currency Area Theory Grzegorz Tchorek Ph. D. Warsaw University

The outline of our course 1. Evolution of the OCA theory, which has a lot of weaknesses as an analytical framework, but is the only one relatively coherent economic approach to monetary integration. 2. Experiences of the euro area and causes of the crisis and we will try to juxtapose what we thought about the euro area functioning before the euro creation and before the crisis and what happened as a result of the crisis. 3. Reforms and prospects of the euro area and the UE

The euro zone: Is. Isthisreally the end? Economist November 26, 2011 „Super Mario” saved the euro ?

Theoretical aspects of monetary integration, - Evolution of the Optimum Currency Area (OCA)

Arguments in favour of the euro adoption • Direct effects - Elimination of the costs related to zloty/euro exchange rate transactions - Elimination of exchange rate risk - Decline in interest rates • Long-term benefits - Investment growth (FDI) - Trade expansion - Decrease in the country’s macroeconomic risk - Financial markets integration ( home bias) - Increased competition - More stable environment

Costs and threats of the euro adoption - arguments for slow monetary integration Monetary union membership involves major macroeconomic costs: • Giving up an independent interest rate policy and a floating exchange rate, • The risk of ECB monetary policy being inappropriate for the Polish economy • Potential short-term cost of meeting the inflation criterion …and also changeover costs

In order to recognize benefits, costs, opportunities, threats and challenges on the road to euro area we will turn to the economic theory and empirical studies The basis is still OCA theory … in its old (real convergence) and new (nominal convergence) view

Two opposite views on the monetary integration Real convergence Nominal convergence • Gives a lot of profits • How to avoid asymmetric shocks (elimination of exchange rate risk, after abandoning monetary policy more stable environment, more ? (susceptibility to shocks) trade and investment), • How to cope with these shocks ? (economic flexibility) • The credibility issue and the importance of a nominal anchor in monetary union, • Endogenous effects

• Nominal convergence approach induces fast joining, • Real convergence approach indicates rather gradual integration,

Nominal convergence • Nominal convergence criteria constituted a mechanism of supervision over the quality of economic policy • The endeavor to meet the criteria was a historical challenge, which helped to reduce fiscal imbalances and to increase the stability of economic policy • But many countries fulfilled the criteria because of a favorable economic environment and falling long-term interest rates which led to lower interest rate payment • Unfortunately it undermined incentives for further reforms

Nominal convergence • Moreover, in many cases reforms that were not based on reduction of expenditures and were still incomlpete and abandoned after the entry to the euro area • It was much easier to quickly achieve nominal convergence criteria in the countries aspiring to the EMU than to ensure sustainability of criteria fullfilment after adopting the single currency • The process of divergence started in the inflation rates as well as deficit and public debt levels

Real convergence • Real convergence criteria are evaluated on the basis of a country’s economic development measured, inter alia, by GDP per capita and by the synchronization of business cycles, which reduces the risk of assymetric shocks • Unexpectedly asymmetric shocks have not proved to be a problem. However, the source of concern are the differences in absorption of common shocks by individual countries • This was caused by significant differences in the structure of demand supply, as well as discrepancies in the sectoral composition and degree of flexibility of economies

. . . but Synchronization of business cycles in EMU seems to be a „cyclical” phenomenon,

Lessons from the euro area countries • The balance of costs and benefits of membership in the monetary union may depend upon how sustainable the achievement of nominal and real convergence criteria is • Because of weak structural convergence and flexibility of economies some benefits have not always materialized, whereas some costs and risks turned out to have been underestimated • A case-by-case approach based on country-specific conditions seems to be necessary due to the differences between the countries.

The “Pioneering Phase” - from the early 1960 s to the early 1970 s • The OCA theory emerged from the debate on the merits of fixed versus flexible exchange rate regimes • The pioneering phase initiated a debate on the benefits and costs of adopting a single currency. • “Problem of inconclusiveness” - as OCA properties may point out different directions, • Several properties were difficult to measure accurately and evaluate

The main issues of the OCA are: • How to avoid asymmetric shocks ? (susceptibility to shocks) • How to cope with these shocks ? (economic flexibility)

P - Price level, Q- Quantity of production, S – aggregate supply curve, D- aggregate demand curve

How can we restore balances in two countries?

The first option is Exchange rate policy • Germany can revalue its currency/ or if they have a floating exchange rate, it will probably appreciate automatically • Spain can devalue its currency/ or if they have a floating exchange rate, it will probably depreciate Spain currency The second option is Monetary policy • Spain can decrease its interest rates in order to help firms and households • Germany can increase its interest rates in order to avoid excessive surplus and inflation The third option is fiscal policy • Spain can decrease taxes • Greece can increase taxes In a fiscal union transfer between countries can be used as a shock absorber …The fourth option is structural policy – but in a long run. .

• Mundell and his successors stated that one country can give up its monetary and exchange rate policy when it fulfills some criteria which are called optimum currency area conditions. • They constitute a substitution mechanisms to the monetary policy

Factors which help countries to cope with shocks - Production factors mobility (including labour) – (Mundell 1961, Corden 1972) - Price and wage flexibility (labour and product market flexibility) – (Friedman 1953, Mundell 1961) - Financial market integration (Ingram 1962) - Fiscal integration (Kenen 1969)

Production factors mobility, mainly labour mobility – unemployed Spaniards should go to work to Germany • But labour mobility is constrained by a lot of factors like cultural and language differences, the lack of a common social benefit system, etc. • Finally, Mundell diminished the importance of this criterion because people cannot move in reaction to every shock (particular shocks repeat with every economic cycle, it can have different consequences in the phase of crisis even if countries are highly synchronized during a boom ). • On the other hand, nowadays, justification for labour mobility is lower because factories follow labour (FDI)

Labour market integration • Labour mobility could contribute to the adjustment in case of permanent shocks and downward real wage rigidity. • However, several studies have found that this mobility was two to three times higher in the US than in Europe, because of: - lack of employment flexibility and wage rigidity reinforce each other - there also some specific social, cultural and administrative determinants behind the low geographic mobility in Europe.

Labour market integration • There are significant barriers in the housing markets across the EU. • A panel of experts set up by the EU attributes low labour mobility to a combination of institutional and administrative factors including: – limited cross border portability of social protection and supplementary pension rights; – administrative difficulties and the high costs of gaining legal resident status; – lack of comparability and reciprocal recognition of professional qualifications; – and restrictions on public sector employment.

• • Wage and price flexibility According to theory, people in the country affected by a negative shock should be able to decrease their salaries, which could lead to lower prices and increasing international competitiveness The problem is that wages and prices are rigid, especially in the short term. High level of product and labour markets regulations causes greater rigidity. Nowadays in many sectors wages are not the main source of costs in companies For these reasons labour mobility can be an efficient adjustment mechanism in the medium and long term – People will not agree to change salaries if they are not sure that economic conditions have changed permanently

Price and wage flexibility as an alternative to the nominal exchange rate adjustment. . ? • Price and wage elasticity can be an efficient adjustment mechanism rather in the medium and long term – it is called the real exchange rate adjustment channel (instead of nominal) • The problem is that when nominal exchange rate change is needed, market forces lead to it - a country affected by a negative shock will usually experience currency depreciation. So this change is not subject to negotiation. When you have to change prices and wages (as well as hire people), it can be difficult and tough. This is the main reason why this process is slow and costly • Instead of wage adjustment, you can increase your productivity, but it is usually a long-term process

Institutional factors • Unemployment does eventually put some downward pressure on real wages in Europe, but a large share of the adjustment is borne by employment, • There are significant labour market asymmetries across EU countries. Several labour market institutions contribute to explain low wage flexibility including: wage bargaining arrangements, employment protection, unemployment insurance systems, and minimum wage provisions

Single Market is the most important challange…. • Several studies establish a significant link between product and wage markets: – countries with more stringent product market regulations tend to have more restrictive employment protection legislation • Therefore, product market reforms can be a catalyst for easing restrictive employment protection legislation. Such structural reforms would enhance competition, strengthening the links between wage and price flexibility allowing prices to adjust more rapidly in the wake of shocks. • Hence, the drive to continue implementing the Single Market Programme will enhance both price and wage flexibility.

Financial market integration criterion Countries sharing a single currency can mitigate the effects of asymmetric shocks among them through the diversification of their income sources, by adjusting their wealth portfolio, • through capital market - savings channel – diversification of assets before the shock (ex ante insurance) • through credit market - credit channel – shock absorption through access to a liquid financial market (ex post insurance) The result of the discussion was the conclusion that similarity of shocks is not a strict prerequisite for sharing a single currency if all members of the currency area are

• This channel can work when agents in both countries are able and willing to diversify their assets • In our case households in Spain buy Spanish and German car companies’ shares (the same in Germany) • In case of an asymmetric shock, Spaniards lose on Spanish shares but they compensate it through profits from German companies • Germans earn on German shares but lose money on Spanish ones. • In this way, financial market integration serves as an insurance system • Taking into account crisis experiences, we know that the ability of financial markets to smooth economic cycle differences between countries appeared weak. Moreover, financial market integration was the main cause of

Fiscal and political integration • In our case (Germany vs Spain) increased tax revenue in Germany should be transferred to the common budget and furthered to Spain • Such a situation demands some form of political union and ability of central institutions to impose taxes in individual countries • Due to the lack of social and political integration the UE budget is very small and dedicated to functions

• Nowadays we are discussing the future shape of fiscal policy and fiscal union but it is difficult to establish them when you are in crisis • As George Soros said, Europe was to be cooperation of equal countries but because of the crisis now it has become a confederation of debtors and creditors. • In such circumstances it is difficult to establish a level playing field. Insurance mechanisms should be established ex ante • Economic integration should be accompanied by political

Increasing role of fiscal policy in montery union

Factors which make countries less susceptible to shocks Meta property as a result of reconciliation phase “Symmetry” of shocks - Correlation of the business cycles (one monetary policy fits all) - Production diversification as well as similarity of economic structure (sectoral, supply, and demand distribution of the GDP, - Trade integration (The degree of economic openness – Mc. Kinnon 1963) ? - Similarity of inflation rates (Fleming 1971, Ishiyama 1975)

Trade openness • Openness of the economy is a special OCA property/measured by trade to GDP • First, in good times it is a channel through which the economy is tied to the rest of the monetary union and benefits from prosperity • Second, in bad times it is also a channel connecting one economy with the monetary union but in a negative way • Shock transmission depends on the degree of openness - Poland as an axample…. and the most open countries as Ireland, Belgium

Trade openness Costs of abandoning monetary policy Trade/GDP -the more open the economy is, the more benefits can be achieved from the elimination of transaction costs (lower cost of monetary abandoning) -usefulness of exchange rate adjustment decreases with increased degree of openness. Why is it so? The more open the economy, the greater share of import input. It means that when you depreciate/devalue your currency, it affects import prices and costs of external debt service (they increase) and with some lags leads to the general price increase

Diversification of production • In Mundell`s model we assumed two countries and one good which is traded across borders • In the reallity world this is more complex. A stable economy should not be dependent on one dominant activity. • If you have more diversified structure of your production and export, the probability of a severe shock is lower • A good example of monocultural production is Slovakia (about 50 % of its export production is concentrated on machinery equipment) as well as Spain and Ireland in the past when almost 20 % of their GDP was concentrated in the construction sector.

Similarity of inflation rates between countries In the monetary union the issue of real exchange rate channel (measured by the level of prices and costs) becomes more important. This is the feature which relates to two important factors: 1. Similar rates of inflation prevent excessive shifts in price competitiveness among countries – lose of export market share 2. This condition is rooted in Maastricht Treaty in price convergence criterion in order to avoid differences in real interest rates

• After creating the monetary union the euro area has one nominal interest rate but in case of different inflation at national level real interest rates are diversified • Real interest rate = nominal interest rate – inflation • Due to higher inflation rates, peripheral countries experienced lending and consumption booms

The “Reconciliation Phase” - the 1970 s • Assess balance of costs and benefits of monetary integration • Slowing down of integration processes in Europe due to oil crisis and break up of Bretton Woods System • The criteria have become more evident • The importance of the OCA properties have changed to some extent

Some observations on the “reconciliation phase” • Reconciliation strengthened the interpretation of some properties and led to diverse new insights such as the role of similarity of shocks – called “symmetry” meta property, because of its importance • Ishiyama points out that differences in inflation rates and wage flexibility are of the utmost importance • The usefulness of a common currency depends on the openness of the country, • Countries prone to shocks should cast an anchor in a more stable environment and import its monetary (antiinflationary) credibility (Mc. Kinnon)

Some observations on the “reconciliation phase” • A new “meta-property” was advanced: i. e. , the similarity of shocks -openness and similarity of shocks are also very important, • Mundell (1973) argues that if members of a currency area are financially integrated, a high similarity of shocks among them, although desirable, is no longer a strict prerequisite. • Mobility of factors of production and labour is highly desirable but also entails some costs and cannot effectively cope with disturbances in the very short-term. • For Ishiyama, similarity in price and wage inflation ranks the highest.

The “Reassessment Phase” the 1980 s and early 1990 s • When interest in European monetary integration reemerged in the mid 1980 s, economists looked back at the OCA theory, but could not find clear answers to the question whether Europe should proceed towards complete monetary integration. • At the end of this reassessment phase a “new” OCA theory starts emerging in relation to the “old” OCA theory (Tavlas (1993)).

The OCA changed owing to the reassesment: – of the Phillips Curve - neutrality of money in the longer term – the credibility issue (import credibility) – the importance of a nominal anchor, – The (in) effectiveness of exchange rate changes. • There are somewhat fewer costs in terms of the loss of autonomy of domestic macroeconomic policies • There also more benefits, due to credibility gains, for countries with a track record of higher inflation (prior to adopting common currency)

The “Reassessment Phase”: the 1980 s and Early 1990 s • One of the main perceived costs of monetary integration is that member countries lose direct control over their national monetary policy. • This prevents them from undertaking business-cycle stabilisation: the cost that is represented by wider cyclical fluctuations is more severe when shocks are asymmetric However, monetarist critique of the short-term constant Phillips curve showed neutrality of money in the longer term, • It means that a change in the interest rates affects only nominal variables in the economy such as prices, wages and exchange rates, having no effect on real variables like GDP, employment and consumption • Hence, from this standpoint, the costs of losing direct control over national monetary policy are low.

The Credibility Issue (increases the role of stable and predictable macroeconomic policy) • The ability of a country to achieve and maintain low inflation is important while evaluating the costs of monetary integration. • Some governments could have an incentive to abandon a low inflation commitment that has been accepted at face value by the public in order to reduce unemployment along some short-run Phillips curve (Kydland Prescott (1977) and Barro and Gordon (1983)). • Similarly, devaluations can also cause strong and longlasting inflationary expectations

The Credibility Issue • For a country with a track record of relatively higher inflation and a reputation for breaking low inflation promises, a way to immediately gain a low-inflation credibility is to ‘tie its hands’ by forsaking national monetary sovereignty and establishing a complete monetary union with a low inflation country (Giavazzi and Giovannini (1989)) • Similarities of inflation rates could be a feasible outcome from participating in a monetary union but is not a necessary precondition (Gandolfo (1992) • This turns around one of the main OCA properties provided that the nominal anchor country can maintain the hegemony of the institutional setting that have preserved the low

Negative consequences of excessive debt of public sector • The greater public sector, the smaller role of private sector. We can justify it as follows: Market forces are the only way to stimulate labour productivity which is the fundamental growth factor in the long term. Crisis episodes usually confirm that absolutely free market should be subdued to regulations, but market forces give better incentives to growth than administrative decisions) • Huge share of public sector can lead to high social expectations – One of the roots of the European crisis is its relatively high level of social protection, which sometimes is not accurately addressed.

• Growing government spending leads to budget deficits and public debt – which probably will be repaid by the next generation rather than people who made the commitment (borrowed money). • There is a risk of crowding – out effect - it means that growing borrowing needs of governments can cause interest rate rise and lead to the situation where private investment projects cannot be implemented because of high cost of financing • High interest rates can cause capital inflow and currency appreciation - In turn, growing price of national currency can undermine international price ccompetitiveness

• non - keynesian effect. According to Keynes assumptions, when you have unused production factors, you should spend money in order to employ them. Higher production will generate new revenues and spending, so GDP should increase. • But when you have a huge level of public debt, further borrowing can have counterproductive effects. Because when Agents in the economy observe public indebtedness instead of higher spending, they can increase savings (because they expect future tax increases) • So in case of huge indebtedness a better solution may be to decrease taxes and administrative burdens to lower budget deficit. It can have more fruitful effects than continuing to borrow.

Are Exchange Rate Adjustments Effective in Each Case? • Are changes in nominal exchange rate actually effective? If not, the cost of losing direct control over the nominal exchange rate instrument would be small • Canzoneri, Vallés and Viñals (1996) show that the cost of having no nominal exchange rate for countries joining EMU is likely to be low because movements in exchange rates are dominated by monetary and financial shocks preventing the exchange rate from performing the macroeconomic stabilisation function (Poland PLN exchange rate during crisis) • Exchange rate changes operate instead with considerable lags due to the slowness of the portfolio-balance channel (Branson (1986)).

New interpretation of the OCA as the justification for nominal convergence criteria. . .

• The “new view” of the OCA corresponds to nominal convergence criteria defined in Maastricht Treaty. • Money neutrality in the long run (it means that you cannot use your own monetary policy for your own purposes –it was an argument for giving up incredible monetary policy in peripheral countries) • The necessity of keeping stable and credible economic policy – after experiences in fiscal policy in the 70 s and 80 s it seemed justified to take care of credibility of fiscal policy, because high public debt could run out of control • Insufficient exchange rate adjustment channel (increasing capital flows and growing importance of financial markets make financial assets prices unstable and dependent on short-term investment horizons

The Maastricht Treaty specifies that EU member countries must satisfy several convergence criteria: • Price stability – Maximum inflation rate 1. 5% above the average of the three EU member states with lowest inflation – Long-term interest rates should not exceed by more than 2 p. p. the interest rates of three best performing EU countries in terms of price stability • Exchange rate stability – Stable exchange rate within the ERM without devaluing on the country’s own initiative • Budget discipline – Maximum public-sector deficit 3% of the country’s GDP, Maximum public debt 60% of the country’s GDP

Some observations on the “reassessment phase” • The revisions to the analytical framework behind the “old” OCA theory lead to a “new” OCA • An important legacy of this phase is that there are somewhat fewer costs in terms of the loss of autonomy of domestic macroeconomic policies. • There also more benefits, due to credibility gains, for countries with a track record of higher and more variable inflation (the similarity of inflation property can then be satisfied ex-post). • Monetary union is likely to be more beneficial than what can be presumed on the basis of the application of the OCA properties alone.

The “endogeneity of OCA” issue • It postulates a positive link between income correlation and trade integration (this will in turn promote reciprocal trade, economic and financial integration and business cycle synchronisation among the countries sharing a single currency) • Rose and Frankel, based on the empirical research, formulated thesis of endogeneity of OCA properties. • They claim that one country does not have to fulfil the traditional OCA criteria before joining the monetary union. Instead, this country should join the monetary union ex ante, and as a consequence of home bias elimination, the fulfilment of condition would be easier.

• That elimination of exchange rate risk and transaction costs will provide huge trade increase between countries • In the literature it is called “elimination of home bias” – it means that agents in the economy are less attached to local products and assets and they become more intra – euro area oriented (in terms of trade in goods, services, capital etc. ).

• Frankel (1999) singles out two of the OCA properties as crucial in assessing the net benefits of the currency union: – their degree of openness, i. e. , the extent of reciprocal trade among a group of partner countries, – and their correlation of incomes Countries sharing a high level of either openness or income correlation , but preferably both properties, will find it beneficial to share a single currency Frankel notes that the optimum currency area properties evolve over time. Most authors agree that reciprocal trade and openness increase among countries sharing a single currency

• But… there is disagreement though concerning the extent to which income correlation rises or falls following monetary integration and the effective increase in reciprocal trade. • Two opposite paradigms with different implications have been put forward: - specialisation - endogeneity

• An increase in integration would move a country away from the OCA line, e. g. , from point 1 to point 2 (more openness and less correlation). Frankel notes an apparent paradox of the argument that higher integration leads to increasing specialisation that lowers diversification, and in turn makes countries worse currency area partners.

• The second paradigm is the “endogeneity of OCA” hypothesis that postulates a positive link between income correlation and trade integration. • A common currency among partner countries is seen as “a much more serious and durable commitment” (Mc. Callum (1995)). • It precludes future competitive devaluation, facilitates foreign direct investment and the building of long-term relationships, and might over time encourage forms of political integration. • This will in turn promote reciprocal trade, economic and financial integration and business cycle synchronisation among the countries sharing a single currency.

• Frankel and Rose present the following example. They start with postulating that there is a group of countries which is initially at point 1 in Figure. These countries are initially on the left of the OCA line • If these countries join together and form a “union, ” such as the European Union (EU), both trade integration and income correlation within the group will rise: i. e. , they will gradually move to point 2. • A country’s suitability for entry into a currency union may have to be reconsidered if satisfaction of OCA properties is endogenous or “countries which join EMU, no matter what their motivation may be, may satisfy OCA properties ex-post even if they do not exante!” (Frankel and Rose 1997). • Hence, one of the criteria for judging the suitability of countries for EMU is turned around.

Nominal convergence • Masstrich requirements provided a strong nominal anchor • However, many countries fulfilled the criteria because of a favorable economic environment and falling long-term interest rates which led to lower interest rate payment • Deterioration of economic conditions starting in 2001 revealed that fiscal reforms undertaken had in many cases been based upon a budget income increase and one-off events, such as privatization.

Nominal convergence • Moreover, in many cases reforms that were based on reduction of expenditures were still incomlpete and abandoned after the entry to the euro area. • It was much easier to quickly achieve nominal convergence criteria in the countries aspiring to the EMU than to ensure its sustainability after adopting the single currency.

Nominal convergence • The process of divergence started in the inflation rates as well as deficit and public debt levels • Consequently, increasing differences in the inflation rates, accompanied by a common monetary policy brought about different effects, depending on local conditions determining the real price of money • The price of money equal for all monetary members. irrespective of the quality of individual countries’ economy (“interest free ride”)

Real convergence in the euro area countries • Fulfillment of real convergence criteria is evaluated on the basis of a country’s economic development measured, inter alia, by GDP per capita and by the synchronization of business cycles. • So far asymmetric shocks have not proved to be a problem. However, the source of concern are the differences in absorption of common shocks by individual countries

Conclusions • The balance of costs and benefits of membership in the monetary union may depend upon how sustainable the achievement of nominal and real convergence criteria is. • The overall effects of the euro that member states have experienced so far are generally positive, though they have varied among individual countries. • Because of structural convergence and flexibility of economies some benefits have not always materialized, whereas some costs and risks turned out to have been underestimated.

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