The Future of the International Monetary System and Optimum CurrencyArea Theory, Case Study: EUROZONE

The Future of the International Monetary System and Optimum Currency Area Theory

Case Study: Eurozone

By: Emily Kaput

Optimum Currency Area theory- Major contributors, Criteria

Optimum Currency Area Theory was popularized by the work of economist Robert Mundell in 1961, and conceptualized by theorists such as Paul de Grauwe and Barry Eichengreen. The theory holds that nations who share borders (general geographical area) and adopt a fixed exchange rate regime or a single currency within their boundaries stand to benefit from increased trade and share the stress from exogenous financial shocks (like to a currency, trade deficit or an attack on foreign exchange reserve holdings abroad). However, the benefits of joining an Optimum Currency Area (OCA) must outweigh the costs- most notable of which is the sacrifice of monetary autonomy. Giving up monetary autonomy is to give up the ability to sterilize the domestic monetary base against exogenous shocks due to trade, foreign exchange speculation, and attacks on foreign reserves. This also means that nations in the OCA would only be able to rely on sound fiscal policy to maintain economic stability.

Literature on OCAs was not “quantifiable” at its conception and it experienced a “dead time” where no one was paying any attention to it. However, in 1991, theorists picked it back up and re-conceptualized the theory and operationalized data based on fixed exchange rates and pegged exchange rates (linking one’s currency to a dominant currency- most commonly the US dollar, which has historical dominance). The graph below and to the right is a table Eichengreen and Bayoumi created to show the resurgence of OCA theory papers in production over time in five year periods[i]:

There are three criteria for Optimum Currency Areas:

     1.     wage flexibility

     2.     labor mobility

     3.     insurance mechanisms[ii]

Popular vote categorizes the United States and the Eurozone as the only major OCAs in existence, using the US Dollar and the Euro, respectively. In this post I’ll use a Difference-in-Differences analysis to test the theory on its basis that it provides financial stability to its member countries.

Studying the theory of Optimum Currency Areas is important because the future of the International Monetary System rests on the success or failure of these Optimum Currency Areas.

Optimum Currency Areas- Case Study, Eurozone

I use the Eurozone as my treatment group (OCA) and the remaining members of the European Union as my control group. Because the members in each group in the years 2008-2010 are not equal in number, I use an average of all data. *I include in this analysis the countries who experienced severe internal shocks as a result of the crisis (Greece, Italy, Portugal, Spain, Cyprus, Ireland) because they are members of the Eurozone and as such are necessary to include to test the OCA framework. 

In mid-2009, the European Union as a region experienced what is now known as the sovereign debt crisis. The unveiling of Greece's sovereign debt (along with Italy, Cyprus, Spain, Ireland and Portugal) caused a devastating lack of confidence in the European monetary system, exhibited in the mass asset dumping of the regions most indebted countries. This caused an exponential increase in the interest rates of sovereign bonds in the general Euro Area, most concentrated on the highly indebted countries. Thus, capital flows were stunted. The lack of confidence displayed towards the members of the Euro Area was devastating to the financial markets in this segment of the International Monetary System and the economies contributing to it. Media outlets across the world nay-said the OCA enthusiasts, believing that this massive, devastating shock would prove that the Euro was a terrible idea and that nations should maintain their own currencies and exchange rates.

Before these nay-sayers can be proven correct, they should look at the welfare of the nations involved. For my analysis, I use the Debt to GDP percentages and Inflation rates in each of the member countries in the control and treatment groups in the years 2008, 2009 and 2010 to determine the welfare of the nations- were members of the OCA (Eurozone) better off than non-members?

If OCA theory proves correct, then Eurozone members would experience less increase in debt to GDP percentages post-crisis (mid-2009),  and lower rates of inflation (either positive or negative). [iii]

The Eurozone members experienced higher Debt/GDP percentages post-crisis (Table 2). This is unsurprising considering that several of the most indebted countries belong in the Eurozone. For a better look at economic health, we will look at inflation (Table 3). 

Inflation rates in both the Eurozone and the remaining European Union members decreased. This is interesting. A negative movement in inflation rate means they both experienced Deflation, or, a general fall in prices across the economy (too little money chasing the same amount of goods in an economy). Deflation is as much an indication of economic health as inflation- and the extent to which deflation occurs is an important indicator.

Non-OCA members experienced higher rates of deflation than OCA members. They experienced 3.739% more deflation than the Eurozone. Deflation is the falling of prices in the domestic economy. This is important, because the monetary base was severely affected by the shock even though these countries could practice sterilizing monetary policies to stabilize their economies. Essentially, the shock affected the domestic economies in its most basic terms- the availability of money. Less money was chasing the same amount of goods.

Considering the deflation rates exhibited in the OCA members and non-OCA members, exchange rates in these groups are a necessary supplemental piece to this puzzle.

To the right are the average exchange rates of the OCA members and non-OCA members in the same months/years that the Debt/GDP and Inflation data were taken. The average total depreciation of exchange rates in the non-OCA members increased by 3.43 vis-a-vis the dollar, whereas OCA members experienced an average total depreciation of 0.076 from 2008-2010. This means that the currencies in the non-OCA member states devalued against the US dollar much more than the value of the Euro; rather, their currencies became weaker.

Conclusion:

The economic and financial integration in the Eurozone under the OCA framework did contribute to its response to the debt crisis in 2009. The lower rates of deflation and lower depreciation of the Euro vis-a-vis the dollar compared to non-OCA members is proof of this. 

However, revisiting the OCA criteria (e.g. real wage flexibility, labor mobility, and fiscal transfers), I am certain the Eurozone does not fulfill all criteria in the framework. If the Eurozone were better integrated in all the criteria specifications their stability, when compared to nations in non-member countries, would have been more guaranteed. In the United States there is labor mobility, fiscal transfers, and real wage flexibility. In the Eurozone, there is labor mobility, theoretically. However, welfare systems and non-transferable social welfare programs act as a disincentive for citizens of nations within the Eurozone to become a truly mobile labor force. In addition to this, members of the Eurozone do not share political ideologies and fiscal government spending programs, and there is no overarching authority dictating fiscal spending across the nations, thus the fiscal transfer criteria is not fulfilled.

The path of the Euro, while it is not steady, is a financial instrument to watch. The Eurozone has two paths to choose from; to become more integrated or to disintegrate. A move towards disintegration is the possibility of the Greek exit from the Eurozone- colloquially known as “Grexit.” [vi]

 But! Leading voices in this debate (Ann Krueger, Christine Lagarde, Greek FM) put the probability of Greece exiting the Eurozone very low (AEI Panel Discussion, April 2015).

The Eurozone (a partially fulfilled OCA) has exhibited more stability than non-OCA nations in the European Union. The main take away from this exercise is that Optimum Currency Area framework (if followed more closely and by more regions) could lead to a more stable and transparent International Monetary System, the stability of which would benefit the entire global economy.

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[i] Eichengreen, Barry, and Tamim Bayoumi. "Exchange Rate Volatility and Intervention: Implications of the Theory of Optimum Currency Areas." Journal of International Economics 45 (1998): 191-209. Http://people.ucsc.edu/. University of California Santa Cruz. Web. <http://people.ucsc.edu/~hutch/241B/2003/Journal%20Articles/Bayoumi-Eichengreen.pdf>.

[ii] De Grauwe, Paul, and Francesco Mongelli. "The Enlargement of the Euro Area and Optimum Currency Areas." (2004): n. pag. European Central Bank. Web. <http://www.mnb.hu/Root/Dokumentumtar/MNB/Kutatas/mnbhu_konf_fomenu/mnbhu_conference/degrauwe.pdf>.

[iii] My model is simple: Y_DCGMY=α +β(treatment) + ϒ(post) + δ_dd(treat*post)+Z_DCGMYπ+e_DCGMY

   Where D= debt ratio in the

C= country within the

G= group (Eurozone, EU member) in the

M= month in the

Y= year.

*Treat { 1 for treated state, 0 for control state.

*Post_y { 1 for post treatment, 0 for pre-treatment.

*My second model for Inflation Rates substitutes I for Inflation rate for Debt/GDP Percentages.

*Common trends assumption necessary to perform a DD analysis are established- countries in the European Union/Euro Area share trade, borders, and most peg to the Euro or the US Dollar (inherently connected vis-a-vis the value of the dollar because the US dollar and the Euro are the most commonly held liquid reserve currencies in the world).

[iv] Data collected April 13, 2015 http://www.x-rates.com/historical/?from=USD&amount=1&date=2009-05-20.

[v] Data collected April 13, 2015 http://www.x-rates.com/historical/?from=USD&amount=1&date=2009-05-20.

[vi] Chambers, Clem. "What Will Happen To Greece If There Is A Grexit?" Forbes. Forbes Magazine, n.d. Web. 30 Apr. 2015. <http://www.forbes.com/sites/investor/2015/02/02/what-will-happen-to-greece-if-there-is-a-grexit/>.