The crisis in Greece has uncovered weaknesses in the grandest currency union of modern history, the EU Economic and Monetary Union (EMU), writes Oxford Analytica in this guest post.
OCA theory. The fundamental connections between Greece’s crisis and membership in a currency union are contained in the optimum currency area (OCA) theory put forward by Robert Mundell in 1961. The main point of the theory is the need for adjustment mechanisms to replace the exchange-rate adjustment mechanism:
- Labor mobility. A member might become uncompetitive due to a peculiar local shock or an external shock that disproportionately affects that member, causing labour to move to parts of the union that are performing better.
- Common shocks. If labour mobility is not practical, then it is important that members of the currency union are exposed to common external shocks and are affected in similar ways.
- Fiscal transfers. There must be a mechanism to transfer income within the union to help the disproportionately affected members while their economy adjusts to the shock.
The key is that the burden of adjustment in the absence of a currency unique to the affected area must fall on local prices and wages. With a unique currency, a fall in the exchange rate reduces prices across the economy at one fell swoop.
Currency union. When a shock leaves domestic prices and wages at levels that are uncompetitive internationally, they must fall to restore competitiveness. (In the case of Greece, the shock was the credit boom.) However, coordinating this reduction is difficult, as various sectors will only accept wage cuts if they see other sectors doing likewise. In the meantime, although wages and incomes are falling, the amount owed to creditors is not. Indeed, it is rising in real terms. This situation rarely ends without a default and devaluation. In a currency union, the latter is possible only by exiting the union.
Other monetary projects. The most ambitious proposals for currency union are among high-growth economies with strong international creditor positions:
- Gulf monetary union. For a subset of members of the Gulf Cooperation Council (GCC), a common currency was once slated to launch this year. That plan fell behind long before the Greek crisis unfolded. Meaningful steps towards a common Gulf currency are being taken, including the establishment of a central bank for the currency union. However, the project has suffered numerous setbacks, not least the withdrawal of the United Arab Emirates.
- Asian monetary union. Discussions over creation of a pan-Asian or East Asian monetary unit gained momentum in the aftermath of the East Asia financial crisis (1997-98). They have gone nowhere. The main reason is the heterogeneity of the countries involved.
Outlook. Proponents of both projects will take pause from the difficulties now besetting the euro-area. Whether they should be dissuaded is less clear. Euro-area difficulties do not weigh against monetary union per se, but do underline the importance of the OCA criteria that are likely to make such a project sustainable. Realistically, there is an endogeneity between the OCA criteria and currency union.
The United States did not meet OCA criteria when the dollar replaced a multitude of state and private monies. However, the act of monetary union itself may have been a catalyst for the changes towards OCA fulfilment. This endogeneity is at the heart of contentions that EMU may be an unspoken initial step towards political union in Europe.