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Europe Union as an Optimum Currency Area

Years ago, before all this globalized uncertainty crisis, the idea of an unified Europe sounded really appealing, however these dream days did not last and problems started to appear. By linking Optimum Currency Area (OCA) theory with European Union characteristics I will try to explore the flaws and explain why EU is not an OCA.
An OCA (Robert Mundell, 1961) is defined by a group of regions with large trading size and factor mobility. Let’s now see why Europe doesn’t fit this definition:

  • Trading size: The majority of European countries only exports between 10% and 20% of their GDP for other European countries, which are small numbers compared to USA inter-states trading percentages. Moreover, prices of goods and services differ among EU countries, for instance, a car in Spain is cheaper than a car in Netherlands or Portugal.
  • Factor mobility: Capital circulation works fine, due to Maastricht Treaty and the introduction of the Euro there was an improvement of financial assets flow. However, we cannot say the same about labor: Employment laws are heterogeneous among EU countries and furthermore different cultures and languages complicate citizens’ circulation. Once more, mobility between USA states is higher than in EU, as table [2] suggests.
  • Asymmetric Macroeconomic Shocks: The ECB’s monetary policy has different consequences among countries (mainly between southern and northern countries). The main two are, heterogeneous real interest rates, which are lower in southern countries due to higher inflation rates (with converged nominal interest rate, by Fisher equation we easily confirm this result) and the second consequence is an appreciation of the real exchange rate of southern countries (with nominal exchange rate fixed and by PPP: R= e x (P*/P)). These two consequences are an incentive to an increase in demand in southern countries, which turns out into higher debt and current account deficits (as can be seen nowadays). Graph [3] shows the evolution of real interest rates in terms of Germany’s real interest rate evolution.
  • Fiscal Federalism and Economic integration: These two points are not in OCA definition, however they are essential for an healthy Economic system.  Fiscal federalism helps to offset the economic  stability loss due to fixed exchange rates regime (countries no longer are able to loosely use monetary policy). Economic integration is fundamental for long run sustainability of the system, it has to exist convergence of ideas and policies, in the sense that countries will help and balance each other.

After this brief analysis, it is easily concluded that EU does not fit in this theory. So the question is, why did we went forward with this adventure? Well, as P. Krugman [i] argued on his blog, European leaders thought that this flaws were manageable at the time, by engaging in structural reforms and fiscal policies, labor markets (wages) would become more flexible. Furthermore, this analysis is just on the economic side, we also have to take in consideration the political and social view. For instance, Portugal may thought that  joining EU would strengthen economic characteristics as lower inflation, lower interest rates and higher GDP growth. However, until now this integration is not being that successful, lack of convergence is intensifying the economic flaws and social/ political tensions. In that sense, as mentioned by Francisco Torres in his paper [ii], politics have a really important role on countries integration and mutual aid to reach the proposed goals.

References:

[i] http://krugman.blogs.nytimes.com/2012/06/24/revenge-of-the-optimum-currency-area/

[ii] http://novaeconomicsclub.files.wordpress.com/2012/11/emu-20nov12-nova-ft.pdf   http://novaeconomicsclub.files.wordpress.com/2012/11/iv-emus-legit-draft-nov12-ftorres.pdf

Krugman, Obstfeld & Melitz, International Economics, 9th edition, Pearson (Chapter#20)

 

Hugo Palma # 563

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Author: studentnovasbe

Master student in Nova Sbe

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