Reentering the Optimum Currency Area

by: Dirk Ehnts

With Greece calling in the money doctors and one of the parties that forms the German government calling for Greece to exit the euro zone, it is time to revisit the case for an optimum currency area. Since I cannot do so in a lengthy paper, let me try to stress what I perceive as the main issue. The point of departure is a paper by Robert Mundell on Optimum Currency Areas, not the classic, but a 1997 version available here. Mundell writes:

Another factor is favorable to EMU. As you all know, budget deficits can be calculated in different ways. In its 1996 World Economic Outlook the IMF, relying on a study prepared by Sheetal Chand, underscored the importance of the inclusion of unfunded pension liabilities in calculating budget deficit. This factor is particularly important in the case of such core countries in the European Union as Germany and France. If you make an allowance for financing these future payments in the current deficit, the budget deficits of all countries will be higher, but the impact is very different between countries. It turns out Germany’s and France’s deficits are increased to a much larger extent than Britain’s and Italys for example. Britain could satisfy the Maastricht conditions relatively easily and its problem is that it may not want to enter. But Italy’s position, is no longer as inferior to that of France and Germany as the official figures show.

While there is a lot of talk about budget deficits, there is nothing on capital market integration and possible economic imbalances. What is striking, therefore, is what is missing in this discussion. Of course, from today’s perspective the issue of economic imbalances within the euro zone is crystal-clear. In the recent past, though, it was governments that were supposed to create the disequilibria.

This fits with the general mood of the 1990s. Let governments be constrained, let markets rule and everything will be fine. The internal adjustment of the price level was put with the ECB, which was independent from European government(s), and the external adjustment of the current account was left to markets. It is this mindset that created the gap in theorizing which allowed for error. With the belief in the market being a dogma, nobody could even imagine that the adjustment processes on the external side would not work. If bond markets could rule over government finances, surely financial markets would prohibit imbalances that would leave countries in default territory, creating a problem for both debtors and creditors.

Of course, one might argue that the market did not work because China fixed its exchange rate, German real wages were stagnating, Japan intervened to support its exchange rate, and so on. However, we live in this world, and not in a parallel universe where people are rational, markets unconstrained, information costless and institutions non-existent. A monetary union might work, but the main question is how it deals with imbalances, not whether these are likely to arise (this was discussed at length in the 1990s under the name of asymmetric shocks). Or, in more economic terms, given our economic system, do we get back from disequilibrium to equilibrium, or are we pushed farther away from equilibrium? If we (finally) get back, how long does it take, and what are the costs of adjustment?

I would like to see European economists discuss those questions in public. The future of Europe depends on them.