Optimal Currency Areas Costs and Benefits compared

1. Optimal Currency AreasCosts and Benefits compared Lotte Ovaere Louvain Institute for Ireland in Europe – Spring 2012

2. Introduction • Evaluate decision of EU countries to form a monetary union • Evaluate economic desirability for new EU member states to join the EMU

3. Costs and benefits compared • Relating benefits and costs to openness of a country • Critical level of openness • Shape and position of cost curve depend on view about effectiveness of national monetary policies in dealing with asymmetric shocks • Monetarist view • Keynesian view • Popularity of monetarism since 1980s

4. Intra-EU trade

5. Monetary union, flexibility and mobility • Degree of wage and price flexibilities influences cost benefit analysis of MU • Countries with low price and wage rigidities experience lower costs entering MU • Similarly, higher labor mobility lowers costs of being in a MU

6. Asymmetric shocks and labor market flexibility • Degree of labor market flexibility (wage flexibility and labor mobility) determines attractiveness of MU • But! Size and frequency of asymmetric shocks equally important • Asymmetric shock = differences in industrial structures between countries • Cost line shifts to the right • Relation labor market flexibility and asymmetric shocks in a monetary union

7. Asymmetric shocks and labor market flexibility • Central insight Theory of OCA: Benefits of monetary union depend on balancing asymmetric shocks and labor market flexibility • Downward sloping OCA curve • Zone to the right of OCA line: OCA zone • Location of EU-25? • Of Euro zone? • And USA?

8. Challenge of EU-25: Move into OCA zone • Two strategies • Reduce degree of asymmetric shocks • Increase degree of flexibility (real wages/labor mobility) • Difficulty with first strategy: little influence of policy makers • Exception: Political unification • Special problem: Organization of labor union in a MU • Two opposite requirements for optimal organization: • In the presence of asymmetric shocks • In the presence of symmetric shocks • Centralized wage bargaining system @ EU level?

9. Case study: Adjustment process after asymmetric shock • Early 1980s: severe recession in industrial world • Economic downturn had very different effects on different countries/regions • Michigan (US) vs. Belgium (EU) • Increase in unemployment much higher in Michigan and Belgium than in US and EU (respectively) • How did two regions adjust?

10. Michigan • Outward migration: Sizeable fraction of unemployed moved • Very little real depreciation (few percentage points) • Only possible through prices (common currency!) • Fiscal policy: Automatic transfer of purchasing power to Michigan via US Federal transfers and taxes  Inter-regional solidarity

11. Belgium • Real exchange rate changes: Real depreciation of Belgian Franc of 20-25% • Restore competitiveness, gradual recovery, significant narrowing of unemployment difference between Belgium and EC • Real depreciation: partly nominal devaluations, partly lower cost and price developments relative to main trading partners • Very little outward migration of unemployed • Fiscal policy: No EU-federal redistribution  Intergenerational solidarity

12. Costs and benefits in the long run • Dynamic analysis • Relation between degree of economic integration and occurrence of asymmetric shocks • Predicts whether progress towards economic integration leads to economic convergence • European Commission view of monetary integration • Optimistic • Krugman view of monetary integration • Pessimistic • Self-fulfilling character of joining the MU

13. Challenge of EMU enlargement: New members • Degree of openness • New member states (Central Europe) at least as open to EU-25 as ‘old’ EU • New member states more integrated than ‘opt out’ countries (UK, Sweden and Denmark ) • Asymmetric shocks • Correlation pattern of demand and supply shocks for some central European countries very similar to Euro zone • Integration and satisfying optimal currency criteria made easier by joining Euro zone • Import monetary and price stability • Staying out leads to large exchange rate volatility

14. Challenge of EMU enlargement: Original members • Wait longer until they reach OCA zone • ECB policy less aligned with their needs (less perceptive to their national shocks) • Both in optimistic and pessimistic view

15. Challenge of EMU enlargement • Role of ECB • Can only set one interest rate: fine tuning interest rate impossible • Make sure individual member countries have instruments to deal with asymmetric developments • Progress towards labor market reform: Flexibility probably only available instrument to adjust to asymmetric shocks

16. Should UK join EMU? • Cost side • Openness: UK lowest degree of openness towards rest EU (except Greece) • Asymmetry: • Demand shocks UK negatively correlated with those in rest of EU (independent monetary policy) • Supply shocks only weakly correlated with those of Euro zone • Flexibility: • UK labor markets more flexible than major Euroland countries (Germany, France, Italy) • Illustration: UK inflation and unemployment after oil shock (1979) and recession (1990s) performed much better than in Germany and France (more rigid labor markets) • Lack of desire to join a MU

17. Should UK join EMU? • Benefits • Similar to those of other countries, but smaller: Benefits of MU in function of openness • Compensation by special position of City of London as major financial centre • Conclusion • If other countries came to a positive cost-benefit analysis, why not UK? • Remark! Existing EMU members would not benefit from UK entering: UK represents 20% of Euro zone’s GDP +significant asymmetric shocks  ECB decisions less consistent with their needs

18. Thank you and good luck with the exam!