Optimum Currency Areas in Europe*
The enthusiasm which accompanied the introduction of the common currency in Europe in the 1990s was largely owing to an economic concept which now influences the debate on euro failure or survival: The theory of Optimum Currency Areas (OCAs).
* Thanks to Tim Coldwell for generous friendship and help.
The basic idea is that countries whose economies are linked by trade and other economic relations could eliminate the related risk of exchange-rate fluctuations by adopting a common currency. The theory has three assumptions: For a country joining a common currency it makes sense if
– economic integration is high;
– capital is mobile and prices and wages are flexible enough to adjust to changing circumstances (unforeseen “shocks”);
– and the shocks that economies in the area are exposed to are symmetric by nature, so that no conflict of interest about which policy to adopt to fight a disturbance will arise.
In searching for an answer to why the euro experiment failed the first criterion, which at first view seems maybe the least suspicious, requires closer inspection.
Although there are other motives, the integration criterion is THE rationale for adopting a common currency. In policy debates, integration is usually understood as integration of markets for goods and services: Cross-border trade and direct investment is exposed to currency risk. Hedging is costly, not always possible and fraught with uncertainties with respect to positions and maturities (see here for various hedging concepts. Remember also in another context the debate about hedging under the Volcker rule). A common currency rules out exchange rate volatility, speculative pressures and competitive devaluations thereby, for example, making the price of an imported or exported good a calculable and foreseeable number.
The current crisis in the eurozone demonstrates that for a currency union to function not only goods markets but also (and perhaps more importantly) financial markets must be integrated. As I explained elsewhere it is with the advent of Credit Default Swaps (CDSs) which allow hedging and betting against sovereign default that, for the first time under the common currency, differences in the riskiness of supposedly equal and risk free government debt in the eurozone became visible rendering the system unsustainable. Further, with sovereign CDS spreads already at record highs it comes as no surprise that market interest is increasingly shifting to private sector businesses and banks in crisis countries. The fathers of the euro did not take into account that in principle each non-integrated financial market segment is an invitation for markets to test policy commitment to the common cause.
These days, markets for goods and services are dwarfed by financial market size: In April 2010 the estimated daily foreign exchange turnover worldwide was $3,981bn. Market capitalization of world exchanges around that time was $57,107bn, total issue of international debt securities amounted to $26,751bn and foreign consolidated bank claims worldwide were $34,906bn. By contrast, world annual exports in 2010 were $14,950bn.
There are all sorts of financial markets: Capital and credit markets are supplemented by a large variety of exchange-traded and OTC derivatives markets and markets for synthetic instruments. Maturities range from fractions of a second up to thirty years and even longer. Money markets allow policy a direct grip via central banks at the short end although recent examples of Japan, the US, and increasingly the eurozone, demonstrate that their influence is limited. The same holds for financial regulation: As a rule, banning or restricting activities in one market only risks triggering shifts to other markets or even the creation of new products to circumvent rules – with often unforeseen and highly undesirable consequences.
Limits to policy influence
The theory of Optimum Currency Areas knows only one capital good: money. In the case of countries with different currencies money is exported and imported depending on its price or interest rate and, at the same time, serves as one of two policy instruments (the other is government spending or fiscal policy). By assumption, domestic and foreign money are perfect substitutes which only differ by their respective price.
The limited arsenal of policy instruments leads to a phenomenon known as The Impossible Trinity. It states that it is not possible for a country to have a fixed exchange rate, monetary policy autonomy and open capital markets at the same time. Assume monetary policy is directed at achieving price stability. In this framework, fixing the exchange rate would require domestic and foreign interest rates to be equal. Any attempt of monetary policy to influence domestic prices would result in a change of the domestic interest rate which immediately would trigger arbitrage movements:
Under perfect capital mobility, money is borrowed at the lower interest rate and flows to the area with the higher rate to be invested there. A rising demand for money in the country under consideration raises the lower interest rate (an additional supply of money lowers a higher rate) until the domestic rate has adjusted to the foreign so that both are equal again and the policy effect is annihilated. Under a common currency there is one central monetary policy for all member countries which aggravates the Impossible-Trinity problem in case several countries have a need for individual policy responses (for example, this is the rationale behind the assumption of shock symmetry).
There are several implicit or explicit assumptions behind this concept. One is the small-country assumption: Compared to the rest of the region the country is too small to exert an influence on foreign economic conditions and the foreign interest rate. In money markets it is a price taker. Without this assumption the effect of a monetary expansion or contraction would be felt in the foreign country or the region as well, the policy problem would become a strategic one taking into account interactions of both sides and the outcome would become negotiable for all parties. As a consequence one country would probably end up with a slightly higher and the other with a slightly lower interest rate with both economies feeling an influence. To take an example from the eurozone: Policy decisions in France could change economic conditions in Germany and vice versa.
Another crucial assumption is capital substitutability. This is NOT the same as capital mobility. The latter means that capital may flow unhindered to wherever return is the highest. Substitutability means that except for price differences there is no reason to prefer one financial product over the other. There is only one financial product, which is money, and in investors’ view there is no difference between German money and Greek money. Both must cost the same.
By contrast, a region with a whole range of financial markets and products with characteristics, risk profiles and degrees of uncertainty differing between and across countries offers opportunities for policy influence which so far are theoretically widely unexplored and which may explain why at times policy effectiveness appears higher than expected. Central banks intervening in derivatives markets in support of their currencies and debates about providing the EFSF with a lever to strengthen its capacity are two examples of policy makers and monetary authorities beginning to exploit the opportunities markets offer beyond theory.
Why is the variety of financial markets and products neglected by theory? One explanation is found in history. In the 1950s when the Canadian Robert Mundell wrote his seminal paper (see here for a genesis of the article) many exchange rates were fixed under the Bretton-Woods System. An exception was the floating Canadian dollar. Capital movements were strongly restricted and mostly related to international trade. Economic relations between countries were bilateral by nature. Neither the political nor the technical prerequisites for globalization or only internationalization (see here for the difference between the two) of banks and businesses as is known these days existed.
In Europe countries were in the process of forming a common market for goods and services. There as elsewhere macroeconomists were more interested in the “real” side of the economy. Financial markets were, and still are, widely considered as a microeconomic issue. The unfortunate dichotomy between “real” and “monetary” phenomena set the course for the deplorable failure to develop a strand of research to understand and explain the crises which again and again plague the region and hamper the integration process.
Financial markets seem the poor cousin of macroeconomic research. Even money was and still is widely regarded with suspicion: Isn’t it only the veil disguising real processes? Does it matter at all for economic developments? Do we need to understand the transmission of monetary policy to the economy in all detail or is it a “black box” of which we only need to know what is put in and coming out?
The result of this neglect is a flood of misunderstandings and misinterpretations which stand in the way to meaningful crisis analyses and solutions. To give an example: In a recent BIS article, Claudio Borio and Piti Disyatat argue against singling out global current-account imbalances as key factor contributing to the global financial crisis as several authors do. They stress the failure to distinguish sufficiently clearly between “saving” as defined in national accounts as income not consumed and “financing” as a cash-flow concept describing access to purchasing power in the form of money and borrowing.
To cite from the paper’s abstract: “… the main contributing factor to the financial crisis was not “excess saving” but the “excess elasticity of the international monetary and financial system: the monetary and financial regimes in place failed to restrain the build-up of unsustainable credit and asset price booms (“financial imbalances”).”
Optimum euro area?
Is there an optimum currency area in Europe? Would a North/South divide help calm markets and regain confidence in the euro? To which extent and in which form could eurobonds contribute to a crisis solution in this context? An enlarged EFSF? A fiscal union?
The answer is: no one knows. Theory’s failure to provide a solid frame for analyzing these and other questions uniting the financial and “real” sphere of regional economic relations leaves policy makers and analysts confronted with a black hole sucking in every new plan and concept without response. Under these circumstances the only sensible strategy is retreat to the last secure line of defence against market attacks before all powder is shot: The retreat to national currencies.