Does euro zone fit what is described in the literature as an Optimal Currency Area. An Optimal Currency Area theory was for the first time developed by Robert Mundell, in “A Theory of Optimum Currency Areas” (September, 1961). The main idea was to define until what extent some countries (EZ countries, for instance) should give up from their independent monetary policy, in order to gain from micro and macroeconomics benefits of a shared currency. These benefits can be briefly referred as “reduced transaction costs, elimination of currency risk, greater transparency and possibly greater competition because prices are easier to compare”  . Still, the main issue is a pure inequation which tries to measure if the positive side of a common currency in EU is higher than the negative one.
If you need assistance with writing your essay, our professional essay writing service is here to help!Find out more
In this review I will not focus only in a singular parameter of this equation because then it would imply a loss of the core significance of the different sources. I will instead analyze the overall opinion of different sources and refer to specific criteria when it seems plausible.
2. Critically annotated literature search
Source 1: Francesco Paolo Mongelli, Senior Advisor for Monetary Policy, European Central Bank (ECB), “”New” views on the optimum currency area theory: What is EMU telling us?”, Working Paper No. 138, April 2002
Francesco Mongelli has followed the euro progress over the years and he strongly contributed to different analysis published under ECB stamp. In his review he does not clearly take a position about the euro area. However, he seems to be more positive about the conditions of Europe for a common currency. Especially after the euro adoption, he states that “the members of the European Union that have removed all trade and financial barriers among each other and share a single market” due to the common currency enjoyed a steady increase in “reciprocal trade” which allows them to experience stable growth.
He does not ignore the so-called “”Krugman specialisation hypothesis””, which implies that the adoption of euro will lead member countries to fall in an extreme specialized level, leading to further lack of diversification and it will leave these countries would be worse off. Nevertheless, he clearly emphasizes that this is “a paradox as this is not what is observed in reality” (referring to Frankel, 1999).
With this argumentation Mongelli puts the euro area in the same side of the US States in the OCA graph regarding two main issues which for him are decisive (see Graph 1). This means, even though not as much as US States, the EZ countries “draw net benefits from (â€¦) the euro”
When facing the critics from the general literature to the optimal conditions for a common currency in EU, Mongelli supports the other side of the literature saying these reviews might be biased since “they are mainly backward looking”. As he states: “Some authors believe instead that the OCA test could be satisfied ex post even if it is not fully satisfied ex ante”.
In sum, this ECB advisor seems to support the idea that “for the group of countries now forming the euro area this has brought considerable benefits but has also required a long period, although some countries that joined the process later than the others caught up very rapidly with the rest.”
This led him to think the euro area might be suitable for a common currency because, even though there are some structural differences among countries, they can be managed overtime and optimal conditions can be achieved.
Further analyses also reported by Francesco Mongelli  on the eve of the global financial crisis refer that in the last years there was a clear improvement of the euro area members or even its candidates. He points out as main improvement signals: “no ever-rising inflation differentials and inflationary expectations”, “changes in competitiveness within the euro area are occurring at a sustained pace”, and that “the risk of pro-cyclicality of fiscal policies is under control”. Once again, he stills believe that “all in all the balance seems positive: the benefits outweigh the costs”. Still, his main point continues to be based on future expectations and not really on observable facts.
Source 2: Paul Krugman, “Revenge of the Optimum Currency Area”, The New York Times, June 24, 2012
Many tried to analyze if shocks were symmetric or asymmetric in the meantime of euro currency implementation, although there is probably another reason which led to shocks’ asymmetry. Despite the fact that European countries could be already in an asymmetric position when adopting the euro, Krugman emphasizes that this asymmetry tends to increase over the years among EZ countries. He argues that most of the political power around EZ “chose to believe that asymmetric shocks would be a relatively minor problem”.
Therefore Krugman identified another shock which is as important as the others that existed before. This shock was, “in a bitter irony, caused by the creation of the euro itself.”
“In essence, the creation of the euro led to a perception on the part of many investors that the big risks associated with cross-border investment within Europe had been eliminated. In the 1990s, despite the absence of formal capital controls, capital movements and hence current-account imbalances within Europe were limited. After the creation of the euro, however, there was massive capital movement from Europe’s core – mainly Germany, but also the Netherlands – to its periphery, leading to an economic boom in the periphery and significantly higher inflation rates in Spain, Greece, etc. than in Germany.”
In Krugman’s opinion this lack of burdens among euro area countries led to the creation of more asymmetric shocks which countries were not able to manage. Especially countries in the periphery, since they abdicated from their independent monetary policy, they could not use open market operations to deal with such problems like higher inflation. Even though those countries could make pressure on leading institutions in order to adapt their policy to those situations, they would face resistance by “Europe´s core” countries. Thus, this pressure would not be turned into any positive outcome for the periphery.
Source 3: Martin Feldstein, Professor of Economics, Harvard University, “Optimal Currency Areas”, Cambridge, MA, 2008
Surely we cannot avoid the economic differences among European countries, although we might not only focus on economic issues. Feldstein credited part of the euro related problems to political issues, instead of merely economic problems such as shock asymmetries. Feldstein has a wide background as academic and political associate in US, this allows him to have an external view of the euro situation and the individual pressures exercised by individual countries.
The political outcome identified by Martin Feldstein, as described below, could be directly related with the shocks created by euro implementation plan as argued by Krugman (see Source 2).
“Not all EMU countries will be affected equally by the evolution of the European economy or by the policies of the ECB. (â€¦) Because of a limited willingness to make sacrifices for the benefit of other EMU nations or for the EMU as a system, some of those governments or politicians may seek to exit the EMU or may threaten that they will do so unless policies are changed.”
Our academic experts are ready and waiting to assist with any writing project you may have. From simple essay plans, through to full dissertations, you can guarantee we have a service perfectly matched to your needs.View our services
This view shows another approach on the OCA issue which might be against the idea that there are optimum conditions in the EU for a common currency, however not for the most frequent reasons referred in the literature. We can say that Martin Feldstein is mainly introducing a political dimension into discussion, which sometimes can be the most decisive one.
Source 4: Hüseyin Mualla Yüceol, “Why European Union is not an optimal currency area: The limits of integration”, Ege Academic Review, Mersin University, 2006
Besides referring many of the points that are mentioned in the literature supporting Krugman’s view (see Source 2), in which, he is mainly identifying that “there is a widespread skepticism surrounding the long-run practicality of the EMU.” This well-known Turkish academic also refers another important issue related with the OCA debate that sometimes is forgotten. According to him, even though the European Commission was aware of macroeconomic discrepancies, there was a clear lack of enforcement in order to reduce these real asymmetries.
“Thus, the so called EMU “convergence criteria” are more concerned with examining transitory cyclical movements in financial indicators, rather than concentrating upon fundamental convergence in real economy. However, examining the extent to which EU member states have actually met the MCC since 1990s, a period including both a recession and boom, makes disappointing reading for supporters of European monetary integration.”
The evidence shows that the lack of enforcement of the “convergence criteria” led to an unsustainable macroeconomic situation in the EZ. This unsustainable situation implies that the EZ is not an optimal currency area and it also means it is more difficult to achieve these conditions.
“This is because, the achievement of convergence depends on particularly certain institutional and structural features and the degree of development of market mechanisms.”
Yüceol also refers that there are probably two different groups among euro area countries. One that would most likely fit in a common currency and the periphery which will face strong barriers to keep at the same pace without the monetary tools lost for the monetary union. “Thus, EMU will divide Europe because no mechanism exists for achieving real convergence between national economies.”
3. Tentative conclusions
From the parts of the literature referred in this review it is easy to understand that both positions in favor or against the OCA conditions in the euro zone can be argued.
It is important to underline that most of the studies on this matter are actually focusing in the same vectors, as mentioned before. However, they come up with quite different results. It is not straightforward which side is deriving misleading conclusions. We can mainly identify two different ideologies: the one shared by the European Commission and other European institutions (e.g.: ECB) and the opposition which is mainly referred in the literature as the Krugman’s view. From reading the different sources we can briefly state that the EC defends that higher integration among countries would increase the probability of the OCA criteria being satisfied, while the other view states that higher integration would lead to a over specialization problem which would become a negative shock itself.
Thus, my tentative conclusion would be that the arguments against the optimal conditions for a common currency in the euro zone are stronger than the others. The main reason to point this out would be that most part of the arguments in favor of OCA conditions in EZ are based in forward looking expectations. Therefore I should agree that one of the main problems with the euro area was that it was established under future expectations. This assumption led countries, like the ones from the periphery, to be integrated in the EMU and they actually did not have conditions to do so.
The requirements established by the theory, such as the symmetry of shocks, labor market flexibility and so on, are right indeed. I would say the misleading problem was not a theoretical problem. It was instead an out of time phasing-in process carried out by the EMU which is not over yet.
Graph 1 – Two Key Optimum Currency Area Properties
Source: Francesco Paolo Mongelli,””New” views on the optimum currency area theory: What is EMU telling us?”,
European Central Bank (ECB), Working Paper No. 138, April 2002
Cite This Work
To export a reference to this article please select a referencing stye below:
Related ServicesView all
DMCA / Removal Request
If you are the original writer of this essay and no longer wish to have your work published on UKEssays.com then please: