Optimum Currency Area Theory

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

2. The outline of our course • Evolution of the OCAtheory, which has a lot of weaknesses as an analytical framework, but is the only one relatively coherent economic approach to monetary integration. • 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. • Reforms and prospects of the euro area and the UE

3. The euro zone: Is this really the end? EconomistNovember 26, 2011 THURSDAY, NOVEMBER 24, 2011 The euro zone: Is this really the end? EconomistNovember 26, 2011 „Super Mario” saved the euro ?

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

5. 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

6. 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

7. 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

8. Two opposite views on the monetary integration • Nominalconvergence • Gives a lot of profits(elimination of exchange raterisk, morestable environment, more trade and investment), • The credibilityissueand the importance of a nominalanchor in monetaryunion, • Endogenouseffects • Real convergence • How to avoidasymmetricshocksafterabandoningmonetary policy ? (susceptibilityto shocks) • How to cope with theseshocks ? (economicflexibility)

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

10. 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 fiscalimbalances 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

11. 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

13. 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 and supply, as well as discrepancies in the sectoral composition and degree of flexibility of economies

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

15. 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 convergenceand 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 dueto the differences between the countries.

16. The “Pioneering Phase” - from the early 1960s to the early 1970s • 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

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

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

19. How can we restore balances in two countries?

20. 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..

21. 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

22. 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)

23. 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)

24. 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 are also some specific social, cultural and administrative determinants behind the low geographic mobility in Europe.

25. 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 professionalqualifications; • and restrictions on public sector employment.

28. Wage and price flexibility • According to the 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

29. 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

30. 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

31. 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.

34. 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 financially integrated and hold claims on each other’s output

35. 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 contagion

36. 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 other than stabilization

38. 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

40. Increasing role of fiscal policy in montery union

41. 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 – McKinnon 1963) ? • Similarity of inflation rates (Fleming 1971, Ishiyama 1975)

42. 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

43. 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

44. 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.

45. Similarityof 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: • 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

47. 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

48. The “Reconciliation Phase” - the 1970s • 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

49. 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 (anti-inflationary) credibility (McKinnon)

50. 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.