Options for Europe – Part 54

The title is my current working title for a book I am finalising over the next few months on the Eurozone. If all goes well (and it should) it will be published in both Italian and English by very well-known publishers. The publication date for the Italian edition is tentatively late April to early May 2014.

You can access the entire sequence of blogs in this series through the – Euro book Category.

I cannot guarantee the sequence of daily additions will make sense overall because at times I will go back and fill in bits (that I needed library access or whatever for). But you should be able to pick up the thread over time although the full edited version will only be available in the final book (obviously).


Chapter X The EMU and Optimal Currency Areas (OCA)

Wyplosz (2006: 21) argued that the Commission’s publication ‘One Money, One Market’ “came to late” to influence the deliberations at Maastricht, but it did serve to “draw researchers into the issue” of monetary integration. As a result the economic researchers were left “with the task of assessing the treaty” (p. 211). There was a clear divide among the US-based studies which rejected the viability of the proposed design and thought it unlikely that it would proceed to fruition, on the one hand; and the European-based studies that were generally positive overall (Wyplosz, 2006).

While playing “no serious role in the drafting of the Maastricht Treaty” (Wyplosz, 2006: 211), the long-standing concept of an Optimal Currency Area (OCA), which emerged from the work of three economists, Canadians Robert Mundell (1961) and Ronald McKinnon (1963) and American Peter Kenen (1969), became an organising framework for the debate over the viability of the proposed EMU.

OCA theory purports to define the conditions under which several independent countries will be better off by forming a monetary union (sharing a currency) or, alternatively, fixing their exchange rates. Optimal is a term economists use with regularity and it often refers to some arcane mathematical exercise which is equivalent to counting the ‘number of angels on a pinhead’. In the case of monetary integration it refers to the collection of geographic units (in the case of the EMU, Member States) that would most effectively enter a monetary union. To few ‘geographical areas’ or too many will deliver a sub- or non-optimal arrangement.


In its original formulation, Robert Mundell defined three conditions, which if in existence, would justify the formation of a monetary union as an OCA:

  • The countries economic cycles move together and they face common consequences if hit by a negative shock (for example, a decline in private spending) – thus there should be no major asymmetric shocks which would affect one region/state significantly more than another. A consequence of this condition would be, for example, that unemployment rates should be similar across the countries in the union;
  • There should be a high degree of labor mobility and/or wage flexibility within the group of countries such that if unemployment rose in one country, workers could quickly move elsewhere to find jobs. Mobility also refers to a lack of cultural and institutional barriers (for example, a pension entitlement in one nation would be transferable to another without cost);
  • There is a common risk-sharing structure so that fiscal policy can transfer resources from better performing to poorly performing countries without constraints.

Crucially, for Mundell, “optimality relates to the state of the labor market” such that if “the currency regime within a given area causes unemployment somewhere in that area (or accepts some other portion of that same area to accept inflation as the antidote to unemployment), it is not optimal” (Kenen, 1994: 41). The area in question in our context is comprised of the nations forming the EMU. McKinnon (1963: 717) considered optimality to mean a “single currency area within which monetary-fiscal policy and flexible external exchange rates can be used to give give the best resolution of three … objectives: (1) the maintenance of full employment; (2) the maintenance of balanced international payments; (3) the maintenance of a stable internal price level …”

Consider the components – both monetary and fiscal policy are important and the goal of full employment is not subjugated to price stability ambitions. Policy has to achieve the ‘best resolution’ of all the goals and not pursue one (price stability) by deliberately undermining another (by creating unemployment). If an collection of nations cannot combine and use economic policy in this way then they do not belong together.

McKinnon (1963) added a qualifier to the labour mobility argument. He noted that if capital was mobile then if firms in declining areas might be able to ‘retool’ to produce products that are currently produced in growing areas and thus overcome labour mobility constraints. Kenen (1969) added that the disparities in labour skills across different regions would make these sort of transitions (either labour moving to growth areas or capital moving to declining areas) unlikely, suggesting the “sad certainty that the optimum currency area has to be small” (p. 44). He also considered that if all nations produced a range of goods (‘product diversity’), then spending fluctuations would not hit a particular region disproportionately.

McKinnon also considered the ‘degree of openness’ (how much a nation trades relative to its overall size) to be important. If nations trade extensively between each other then a fixed exchange rate (brought about by a common currency or an EMS-type agreement) will be beneficial as it eliminates risk that higher import prices will cause inflation.

In the early 1970s there was a new volley of papers on the concept of OCAs, which reflected on the early ideas. In 1973, Mundell added the additional insight that if capital is mobile between nations, then the exchange rate can easily be attacked and become a source of instability. In this case, monetary union that eliminates exchange rate fluctuations between nations in the union will be beneficial. However, Mundell was assuming that such an arrangement would not also eliminate the capacity of fiscal policy to reduce unemployment when there was a decline in private spending.

The fact is that proponents of the EMU in the late 1980s did not consider the requirements set out in the OCA literature to be significant for their plans.


Wyplosz (2006: 212) said that the European Commission “officials did not waste much time on the issue, which they saw as mainly political” The Maastricht Treaty was more about process towards the adoption of the single currency and the requisite institutional changes that would be required to accommodate this process. The question then arises as to why this existing economic framework (OCA) was ignored? Merely claiming that the policy makers constructed the EMU as a political issue is not sufficient. In fact, it goes much deeper than that.


In the 1990 One Money, One Market publication, the European Commission (1990: 46) concluded that the OCA literature provides a “rather limited framework whose adequacy for today’s analysis is questionable”. The reasons for their skepticism included that the “whole approach ignores policy credibility issues which have been stressed by recent macroeconomic theory” (p. 46), which was code for OCA being associated with the Keynesian view that fiscal policy provides an effective means of stabilising economies hit with private spending fluctuations. The ‘policy credibility issues’ relate to the unproven Monetarist assertions that fiscal policy is ineffective and causes inflation, which can only be controlled with tight monetary policy.


An application of the theory and its subsequent additions (in the 1970s and 1980s) was highly inconvenient to the proponents of the EMU. The only condition that could be reasonably satisfied was that relating to openness of trade between the nations. The planners deliberately negated the capacity for fiscal policy to redress regional unemployment arising from asymmetric spending fluctuations and there was no sense that labour is mobile. Eichengreen (1992: 22) pointed at that “migration rates within European countries are higher than migration between them … [but] … low” by US standards. He also suggested that while capital movements would be unimpeded in the EMU, a depressed region could hardly expect job saving capital inflow. He also noted that these type of adjustments are minor in mature federations. Regional disparities brought about by movements in the economic cycle are resolved more effectively by fiscal transfers rather than labour or capital movement.


Mongelli (2008: 215) noted that “This message was not pleasing to officials, and dutifully ignore for many years”. It was not pleasing because the existing OCA literature at the time of the Maastricht negotiations was associated with the Keynesian approach to macroeconomic policy and thus rejected out of hand by the Monetarists, who saw no major fiscal role for governments beyond maintaining tight fiscal positions to support the emphasis on price stability. De Grauwe (2006) reinforced the view that the EMU cheer squad was ideologically selective in their use of the prevailing knowledge. He noted that while the EMS crisis in 1992-93 demonstrated that “fixed exchange rates were unsustainable” without monetary union, there “was also the effect of an intellectual revolution that was started in the 1970s in the academic world and that reached the policy world during the 1980s. This was monetarism … [and] … In this monetarist vision … the costs of a monetary union are small”. OCA was Keynesian and to be rejected as a matter of course. The millions that have been unemployed since 2008 are testament to the fallacy of the Monetarist presumptions.

Whichever way you wish to interpret the OCA theory, it is very obvious that the group of nations that entered the EMU did not resemble the conditions required to ensure the adoption of a common currency would be beneficial overall. The result was that the only adjustments open to them once a major private spending collapse occurred would be very costly, a point ignored by the EMU proponents.

The decision to enter the EMU meant that each sovereign nation gave up their monetary policy independence. They further allowed the SGP to constrain their fiscal sovereignty, although once they surrendered their currency-issuing powers, their fiscal freedom became dependent on the preferences of the private bond traders.

The 2008 crisis has demonstrated what was already known when the OCA debate was going on in the early 1990s. The ability to absorb external spending shocks, such as the one that arose from the housing collapse in the US in 2007, is very different across the Eurozone countries. The stronger industrial countries like Germany, who also has the capacity to generate external surpluses as do the Netherlands, are in totally different situations to the capital importers such as Spain and Greece. The stronger nations can absorb spending shocks much better than the weaker nations of the union.

Further, some Eurozone nations are more closely tied together in trading relationships than others. Finland, for example retained close cultural and trading ties to Norway and its trade is not linked much with Spain, for example. Ireland maintained strong trading relationships with the UK and less with continental Europe. This also impacts on the capacity of the individual economies to adjust to a major decline in spending.

There is limited labour mobility within Europe because national identities are still strong and language barriers persist. One of the interesting side effects of the coincidence of the recession and the associated collapse in the housing market is that labour mobility in Europe is even lower than it was before the crisis. In bad times, those that can move tend to move to chase job opportunities elsewhere. However, when there is an accompanying major real estate collapse this mobility doesn’t occur as significantly because people cannot afford to move – especially those with negative equity in their residences.

Importantly, fiscal policy is unable to perform the functions that Mundell and others considered essential to maintain uniformity of outcomes within the nations that made up the monetary union. By construction, the neglect of a central fiscal institution and the imposition of the prohibitive clauses in the Stability and Growth Pact has neutered the capacity of sovereign governments within each individual country to respond to negative external shocks (like the current crisis). An OCA requires a single fiscal authority that can transfer net spending from one region to another to even out economic performance when there are disparate economic outcomes across the regions (Member States) of the union.

In this context, Financial Times chief economist Martin Wolf (2010) noted that:

The crisis in the eurozone’s periphery is not an accident: it is inherent in the system. The weaker members have to find an escape from the trap they are in. They will receive little help: the zone has no willing spender of last resort; and the euro itself is also very strong. But they must succeed. When the eurozone was created, a huge literature emerged on whether it was an optimal currency union. We know now it was not. We are about to find out whether this matters.

Four years later, we have certainly found out that the design of the monetary system matters and the structure chosen at Maastricht has forced millions of people to lose their jobs and suffer increased poverty rates. The logic of the EMU agreed to in the Maastricht Treaty has forced several nations to deliberately undermine the fortunes of their citizens through the imposition of fiscal austerity.

How then should we assess this part of the story? Despite its complexity and the various interpretations that have been made of OCA theory, a fundamental prediction that emerges from the theory is that, in the face of a serious slump in spending which is not uniformly spread across a group of nations, unemployment will rise significantly in some Member States if they have foregone their currency sovereignty and entered a monetary union. That is a simple prediction and easily assessed. The data tells us that this prediction has come to fruition.

In other words, the designers of the EMU would have been better advised to heed the general message from OCA before pushing on regardless. Ideology ruled and millions have suffered.

The malevolence goes further though. The Monetarists now use OCA theory as a means to justify attacking labour protections and wage security. They argue that while the requirements of OCA were irrelevant to the decision to create a monetary union, once the union has been created, there is a need to ensure that the requirements are in place. A paper by economists, Jeffrey Frankel and Andrew Rose (1998) twisted the OCA idea around to suggest that the requirements that Mundell and associates had indicated were essential before a group of nations should consider before entering a monetary union were in fact ‘endogenous’. This means that once the monetary union is formed, the nations will adopt characteristics consistent with the ‘requirements’, even if they were not in evidence at the time the union was formed. Their claim is that the formation of monetary union forces these economic changes to ensure that the conditions that make a monetary union work are created by the decision to form the union. Suddenly, all the pro-EMU economists started to recognise OCA theory because it was no convenient and supportive of their Monetarist intentions. They also discuss the need for ‘structural’ reforms, which is code for cutting worker entitlements and creating an environment of income and job insecurity.

While the growth period in the first few years of the operation of the EMU was used to justify the decision to force an EMU, the crisis period has shown, beyond doubt, that the conditions that are required for a successful monetary union have not ‘materialised’. They did not exist prior to the Maastricht decisions and they remain absent, by choice.

Chapter X The Stability and Growth Pact – neither growth nor stability

The Stability and Growth Pact (SGP) was formally adopted in 1997. It was motivated by a Memorandum circulated in November 1995 by the German Finance Minister Theo Waigel which outlined the structure of the ‘Stability Pact’. Growth was a feature of the initial version, nor its successor, despite the inclusion in the title.



Additional references

This list will be progressively compiled.

De Grauwe, P. (2006) ‘What Have we Learnt about Monetary Integration since the Maastricht Treaty?’, Journal of Common Market Studies, 44(4), 711-30.

Eichengreen, B. (1992) ‘Should the Maastricht Treaty be Saved?’, Princeton Studies in International Finance, 74, December.

European Commission (1990) ‘One Money, One Market’, European Economy, 44. http://ec.europa.eu/economy_finance/publications/publication7454_en.pdf

Frankel, J. and Rose, A. (1998) ‘The Endogeneity of the Optimum Currency Area Criteria’, Economic Journal, 108, 1009-25.

Kenen, P.B. (1969) ‘The Optimum Currency Area: An Eclectic View’, in Mundell, R.A. and Swoboda, A.K. (eds.) Monetary Problems of the International Economy, Chicago, University of Chicago Press, 41-60.

Kenen, P. (1994) ‘Exchange Rates and the Monetary System: Selected Essays of Peter B. Kenen’, Aldershot, Edward Elgar.

McKinnon, R.I. (1963) ‘Optimum Currency Areas’, American Economic Review, 53, 717-725.

Mitchell, W.F. and Muysken, J. (2008) Full employment abandoned: shifting sands and policy failures, Aldershot, Edward Elgar.

Mongelli, F.P. (2008) ‘European economic and monetary integration and the optimum currency area theory’, Economic Papers, 302, February.

Mundell, R.A. (1961) ‘A Theory of Optimum Currency Areas’, American Economic Review, 51, 657-665.

Mundell, R. (1973) ‘Uncommon Arguments for Common Currencies’, in Johnson, H.G. and Swoboda, A.K. (eds.) The Economics of Common Currencies, London, George Allen and Unwin, 114-32.

Wolf, M. (2010) ‘The eurozone’s next decade will be tough’, Financial Times, January 5, 2010. http://www.ft.com/cms/s/0/19da1d26-fa2f-11de-beed-00144feab49a.html

Wyplosz C. (2006) ‘European Monetary Union: The Dark Sides of a Major Success’, Economic Policy, 46, 207-247.

(c) Copyright 2014 Bill Mitchell. All Rights Reserved.

This Post Has 2 Comments

  1. “Growth was a feature of the initial version, nor its successor, despite the inclusion in the title.”



Leave a Reply

Your email address will not be published. Required fields are marked *

Back To Top