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Optimum Currency Areas. Optimum Currency Areas I. A theoretical construct, no country conforms to the ideal but the US with high labor and capital mobility comes much closer to the ideal than Europe.
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Optimum Currency AreasI • A theoretical construct, no country conforms to the ideal but the US with high labor and capital mobility comes much closer to the ideal than Europe. • In a currency area (with one single currency), asymmetric economic shocks are dealt with through the internal redeployment of resources rather than currency realignments.
Optimum Currency Areas II • Example from the US: the rise in the price of oil in the 70s affected Texas differently than the Midwest (Asymmetric effect of external shocks). Energy-poor Midwest: output fell and unemployment rose. Energy-rich Texas: high oil prices raised output and employment of the oil producers and increased energy production. • In an open and flexible economy such as the US; • a) with high level of labor and capital mobility: Unemployed Midwest workers migrated to Texas in search of employment while capital flowed to Texas to finance construction and investment. Overtime, a new equilibrium with converging unemployment and wage levels were established in Texas and Midwest (labor costs fell in Midwest and rose in Texas). • b) with fiscal federalism in the US: Existence of a unified federal budget acts as an automatic economic stabilizer that counters recessions in lagging regions and somewhat dampens economic activity in booming regions, thereby smoothing out economic imbalances in two different regions. For example: If Midwest is in recession, amount of federal taxes paid in this region falls automatically while payments from DC to Midwesterners for unemployment insurance and welfare increase. If California is experiencing a boom at the same time, its tax payments to the federal treasury rise and receipts from DC in the form of unemployment insurance etc. falls.
Optimum Currency Areas III • In either case, the federal budget in the US dampens disparities between regions. • The counter-cyclical effects of the federal budget offset somewhere between 20 and 40 percent of differences in economic performance in the US. • Other federal systems like Germany: Within Germany, states make direct transfers to each other and less adjustment is left to the automatic workings of income taxes and benefit programs.
Optimum Currency Areas IV • A unified fiscal system must exist alongside a single currency and a centrally operated monetary policy for EMU to work. • Before the single currency, an asymmetric shock with a preference shift towards German products away from French products would be handled through currency realignments. Germany experiencing a demand boost would generate a trade surplus and an appreciation of DM. Whereas France experiencing a fall in demand would generate a trade deficit and a depreciation of FF. (ASSUMPTION: No wage flexibility or labor mobility in France and Germany Need for exchange rate parity changes to correct for the effects of asymmetric shocks).
Optimum Currency Areas • Case with wage flexibility and labor mobility within Germany and France. There may be no need for a currency realignment. • If wage flexibility, fall in demand for French products leads to a decline in wages in France (how likely is this given the observed downward rigidity of wages), increasing supply of French products, reducing their prices and making French goods more competitive. Hence, French trade deficit may be reduced. Germany by contrast experiences an increase in wages, which shifts its supply to the left creating inflation and loss of competitiveness for German products, eventually reducing the size of its trade surplus. End result: Less need for a currency realignment for FF and DM parity.
Optimum Currency Areas • If labor mobility exists between Germany and France, then unemployed workers in France can relocate to Germany. No need to pay unemployment benefits in France (budget deficit does not have to increase in France) and trade deficit need not increase. • If none of these two factors work, then France suffers from unemployment and twin deficits (in government budget and trade account) while Germany suffers from inflation and experiences a trade surplus. Pressure on FF for a depreciation and on DM for an appreciation. Exchange rate alignments solve these problems remarkably well. • But this is no longer an option under single currency. • As long as such asymmetric shocks affect the economies of the Union, there exists a case for a) increasing labor mobility and b) creating a federal budget for automatic transfers from one region to another within Europe (fiscal federalism). • This last case is politically unacceptable: Germans may be expected to raise taxes to finance transfers to France suffering from unemployment, budget deficit and trade deficit. Can this work politically within the EU?
Why is Europe not an “optimum Currency Area”? • No significant federal budget for the EU as a whole: EU budget amounts to a few percentage points of the combined EU GDP. • Limited amount of labor mobility (though getting more flexible) • BUT capital mobility is almost full. • The case for fiscal federalism at the EU level? • How likely is this? Political constraints? Issue of sovereignty?
