The economic conditions necessary for nations to join together to form a monetary union

 

 

Saorla Ó Corráin

0210056

 

 

‘So much barbarism … still remains in the transactions of most civilised nations, that almost all independent countries choose to assert their nationality by having, to their own inconvenience and their neighbours’, a peculiar currency of their own’. Thus wrote John Stuart Mill in his book Principles of political economy. It is a statement, which endorses monetary union, of the euro-zone type. In this paper, I shall examine whether the conditions for European monetary union (EMU) could be adapted as a generic model; the value of the theory of optimum currency areas (OCA); the various problems associated with symmetric and asymmetric shocks; and whether the euro-zone is an OCA.

 

In order to analyse the economic conditions necessary for monetary union, it is first necessary to define what monetary union is, for the phrase has been much generalised of late. Lars Jonung, writing for the office of the director-general of the European Commission defines monetary union as,

 

A geographical area within which only one type of currency is circulating, serving as the unit of account, the medium of exchange and the store of value. The exchange rate is by definition irrevocably fixed within the union. Every part or member of the union is using the same currency or currencies tied to each other at truly fixed rates. Towards the rest of the world the monetary union has one exchange rate for converting outside currencies into the domestic money.[1]

 

Of all the monetary unions that have existed, only one conforms to this definition, that of the euro-zone and because of this, one may argue that the economic conditions set out for nations to join together to form monetary union, are the same conditions necessary for EMU integration. If this is true, then the economic conditions necessary for nations to join together to form a monetary union, according to the Maastrict Treaty are:

 

Government deficit and debts must be no more than 3% and 60% of GDP respectively; inflation rates and long-term interest rates must be within 1.5 percentage points and 2 percentage points of the average of the three countries with lowest inflation; the currency has stayed within the Exchange Rate Mechanism (ERM) bands for two years; and countries must also have an independent central bank.[2]

 

Although, these conditions are those of EMU, the only fully integrated and independent monetary union in existence, they would not necessarily suit other groups of nations willing to form a similar monetary union, as they are state specific and were concluded only after intense negotiation. In addition there are cultural and historical aspects that would not necessarily be present in every model of monetary union. Thus I will examine the generic conditions necessary for monetary union.

 

One of the leading theories in the field of monetary union is that of Robert Mundell. His theory on OCAs is one that has been much adopted and refined since its publication in 1961. Mundell’s theory consists of an analysis of a group of areas ‘among which welfare if maximised through internal exchange rates or a common currency and a flexible exchange rate towards the rest of the world’.[3] The fundamental question to be asked for OCA conditions is, under what conditions will the costs be low enough so as not to outweigh the benefits. If the benefits are greater than the costs, then countries are suited to monetary union, according to Mundell’s theory.

 

Countries with flexible labour markets, similar industrial structures, policy preferences, and correlated business cycles are best suited to monetary union. Flexible labour markets are necessary to ensure that labour is mobile and wages are adjustable to unemployment; to treat relative wages as a measure of competitiveness; and to distinguish between nominal and real exchange rates. Similar industrial structures and policy preferences increase the likelihood that economic shocks would be symmetric rather than asymmetric, as adjusting interests rates would no longer be an option.

 

Symmetric shocks affect the designated area similarly and thus a global solution is considered more effect than twelve similar solutions. ‘The reason is that separate policies could lead to problems of competitive depreciations in face of a downward shock’.[4]  This would in turn put pressure on the single market. 

 

Asymmetric shocks, on the other hand, affect areas in different ways. Generally the term is used for economic shocks that affect only certain members of a monetary union. An asymmetric shock can be classified as ‘any serious distortion in a particular country, region or industrial sector that goes against the prevailing cycle in a given economic area’.[5]  The causes of asymmetric shocks are many but certain can influence more than others:

 

A high proportion of the asymmetries … can be attributed to factors under the direct influence or control of governments and political systems: legal differences, the ‘political cycle’, public purchasing, fiscal policies, etc.; and to lack of international coordination between them.[6]

 

Preventing asymmetric shocks within a monetary union should be a relatively easy proposition once there is full coordination of the economic policies of all members. Many sources[7] appear to indicate that the problem of asymmetric shocks would self-regulate in a monetary union over time as business cycles become assimilated and experience common recession and boom periods,

 

Tighter forward and backward trade linkages between countries in a currency union will make their economic structures and business cycles more similar and shocks more symmetric, particularly if demand or other common shocks predominate, or if trade is concentrated within a given industry.[8]

 

However not all analysts agree with this assessment and tend towards the idea that economies of scale may cause asymmetric shocks due to differences in production structures;

 

In a common currency area, there are better opportunities for the exploitation of economies of scale (for example, via localized knowledge spillovers), encouraging the geographic concentration of industries and making it more likely that a given shock will have asymmetric effects on different regions because of differences in their production structures.

 

It is possible that either eventuality may occur. However it is impossible to know which until the system is put into practice. The only monetary union currently in existence is that of the euro-zone. On April 7^th, 2003, Dr. Sirkka Hämäläinen at a seminar on the implementation of the euro in Stockholm had the following to say.

 

Monetary policy decided by an independent central bank and geared to maintaining price stability, prudent fiscal policies, and structural policies aimed at improving flexibility and enhancing the growth potential of an economy, are widely accepted common goals. These goals have greatly reduced the risk of asymmetric developments and of asymmetric responses to common shocks.[9]

 

Thus perhaps it is possible to assume that asymmetric problems within EMU may be resolved rapidly. Perhaps it is truer to say that the euro-zone is, in fact, an optimum economic policy area and those solutions to the problems of modern economics can be found in coordinating national economic management without a dependence on an OCA.[10] 

 

The euro-zone cannot qualify as an OCA; it is too heterogeneous; it lacks sufficient labour mobility; the wage structure is too rigid; and its borders are not negotiable. However this works to its advantage. Lars Jonung states that ‘monetary unions are not created or dissolved according to this approach’,[11] and that the theory of OCAs does not take into account the political and historical aspects to monetary union in this case.[12] The EMU will probably eventually qualify as an OCA but the theory is irrelevant with regard to the euro because economics is but one factor considered.

 

Bibliography

 

Dent, Christopher M., The European economy: the global context (London, 1997).

Eichengreen, Barry, EMU: an outsider’s perspective WP96/26 (Dublin, 1996).

Hitiris, Theo, European Union economics (Essex, 2003).

Jovanović, Miroslav N., European economic integration: limits and prospects (London, 1997).

NESC, European Union: integration and enlargement (Dublin, 1997).

Neary, J. Peter, and Thom, D. Rodney, Punts, pounds and euros: in search of an optimum currency area WP96/24 (Dublin, 1996).

OECD, EMU facts, challenges and policies (Paris, 1999).

Steinherr, Alfred (ed.), European monetary integration (London, 1994)