What Is an Optimal Currency Area?
An optimal currency area (OCA) is the geographic area in which a single currency would create the greatest economic benefit. While traditionally each country has maintained its own separate, national currency, work by Robert Mundell in the 1960s theorized that this might not be the most efficient economic arrangement. In particular, countries that share strong economic ties may benefit from a common currency. This allows for closer integration of capital markets and facilitates trade. However, a common currency results in a loss of each country's ability to direct fiscal and monetary policy interventions to stabilize their individual economies.
How Global Stock Markets Affect The Euro
- An optimal currency area (OCA) is the geopolitical area over which a single, unified currency will provide the best balance of economies of scale to a currency and effectiveness of macroeconomic policy to promote growth and stability.
- Economist Robert Mundell first outlined criteria for an OCA, which are based on the degree of integration and similarity between economies.
- The euro is an example of an application of an OCA, though events such as the Greek debt crisis have put this to the test.
Understanding Optimal Currency Areas
In 1961, Canadian economist Robert Mundell published his theory of the optimal currency area (OCA) with stationary expectations. He outlined the criteria necessary for a region to qualify as an optimal currency area and benefit from a common currency. In this model, the primary concern is that asymmetric shocks may undermine the benefit of the OCA. In this theory, if large asymmetric shocks are common and the criteria for an OCA are not met, then a system of separate currencies with floating exchange rates would be more suitable in order to deal with the negative effects of such shocks within the single country experiencing them.
According to Mundell, there are four main criteria for an optimal currency area:
- High labor mobility throughout the area. Easing labor mobility includes lowering administrative barriers such as visa-free travel, cultural barriers such as different languages, and institutional barriers such as restrictions on remittance of pensions or government benefits.
- Capital mobility and price and wage flexibility. This ensures that capital and labor will flow between countries in the OCA according to the market forces of supply and demand to distribute the impact of economic shocks.
- A currency risk-sharing or fiscal mechanism to share risk across countries in the OCA. This requires the transfer of money to regions experiencing economic difficulties from countries with surpluses. This may prove politically unpopular in higher-performing regions from which tax revenue will be transferred. The European sovereign debt crisis of 2009–2015 is considered evidence of the failure of the European Economic and Monetary Union (EMU) to satisfy these criteria as original EMU policy instituted a no-bailout clause, which soon became evident as unsustainable.
- Similar business cycles. Cyclical ups and downs that are synchronous, or at least highly correlated, across countries in the OCA are necessary, since the OCA’s central bank will by definition be implementing a uniform monetary policy across the OCA to offset economic recessions and contain inflation. Asynchronous cycles would unavoidably mean that a uniform monetary policy will end up being counter-cyclical for some countries and pro-cyclical in others.
Other criteria have been suggested by later economic research:
- A high volume of trade between countries implies that there will be correspondingly high gains from the adoption of a common currency in an OCA. However, a high volume of trade can also suggest large comparative advantages and home market effects between countries, either of which can lead to heavily specialized industries between countries.
- More diversified production within economies and limited specialization and division of labor across countries reduce the likelihood of asymmetric economic shocks. Countries that are heavily specialized in certain goods that other countries do not produce will be vulnerable to asymmetric economic shocks in those industries, and might not be suitable for membership in the OCA. Note that this criteria can come into conflict with some of the above criteria, because the greater the degree of integration among countries' economies (mobility of goods, labor, and capital) the more they will tend to specialize in different industries.
- Homogeneous policy preferences across countries in the OCA are important because monetary policy, and to some extent fiscal policy in the form of transfers, will be a collective decision and responsibility of the countries in the OCA. Major differences in local preferences for how to respond to either symmetric or asymmetric shocks can undermine cooperation and political will to join or remain in the OCA.
Europe, Debt Crises, and the OCA
The optimal currency area (OCA) theory had its primary test with the introduction of the euro as a common currency across European nations. Eurozone countries matched some of Mundell's criteria for successful monetary union, providing the impetus for the introduction of a common currency. While the eurozone has seen many benefits from the introduction of the euro, it has also experienced problems like the Greek debt crisis. Thus, the long-term outcome of a monetary union under the theory of optimal currency areas remains a subject of debate.
Subsequent to the rise of the EMU and the adoption of the euro by participating European countries in 2002, the European sovereign debt crisis in the wake of the Great Recession is cited as evidence that the EMU did not fit the criteria for a successful OCA. Critics argue that the EMU did not adequately provide for the greater economic and fiscal integration necessary for cross-border risk-sharing. Technically, the European Stability and Growth Pact included a “no-bailout” clause that specifically restricted fiscal transfers. However, in practice this was abandoned early on in the sovereign debt crisis. As Greece’s sovereign debt crisis continued to worsen, there was discussion suggesting that the EMU must account for risk-sharing policies far more extensive than the current provisionary bailout system.
Overall, this episode implies that due to the asymmetry of the economic shock to Greece relative to other countries in the EMU and apparent shortfalls in the EMU’s qualification as an OCA under Mundell’s criteria, that Greece (and perhaps other countries) might not actually fall within the OCA for the euro.