Sander Jan van Ruitenbeek
10092994
Sander_van_Ruitenbeek@hotmail.com
Supervisor:
Dr. M. Micevska Scharf
Second Reader:
Dr. D.J.M. Veestraeten
Date of submission:
July 08, 2015
The Endogeneity of Optimum Currency
Area Criteria within the Eurozone
An Empirical Analysis
Statement of Originality
This document is written by Student Sander Jan van Ruitenbeek who declares to take full responsibility for the contents of this document.
I declare that the text and the work presented in this document is original and that no sources other than those mentioned in the text and its references have been used in creating
it.
The Faculty of Economics and Business is responsible solely for the supervision of completion of the work, not for the contents.
Acknowledgments
I am very grateful to my supervisor Dr. M. Micevska Scharf for providing me with useful
feedback on both theoretical-‐ as well as econometrical issues and helping me with searching for suitable databases. I would also like to express my gratitude towards dr. D.J.M. Veestraeten for helping me to narrow down the topic of this thesis.
Furthermore I am indebted to C. Vieira and I. Vieira for providing me with their dataset of the original OCA-‐index variables, which allowed me to focus on extending the model.
Finally, I would like to thank Mr Witlox of the library of the University of Amsterdam for helping me with searching for usable data and Mr Pua of the econometrics and statistics department of the University of Amsterdam for providing me with feedback on certain econometrical issues.
Table of contents
1. Introduction p. 5
Part one:
2. The Theory of Optimum Currency Areas p. 8 2.1. The traditional Theory of Optimum Currency Areas p. 8 2.2. The endogeneity of the Theory of Optimum Currency Areas p. 13
3. The empirical model p. 19
3.1. The Optimum Currency Area Index p. 19 3.2. Extending the model p. 22
Part two:
4. Data and estimation
4.1. Data p. 31
4.2. Estimation p. 35
4.3. The alternative OCA-‐Indices for the Euro area p. 39 5. Main shortcomings of the model and suggestions for future research p. 44
6. Concluding remarks p. 47 References p. 49 Appendices: A1 p. 53 A2 p. 53 A3 p. 54 A4 p. 54 A5 p. 55 A6 p. 55
1. Introduction
"Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough." On July 12, 2012 the European Central Bank’s (ECB) president Mario Draghi successfully calmed down financial markets by using these, by now famous, words. After Draghi’s remark the euro jumped above $1.23 for the first time in two weeks, Spanish and Italian bond yields fell sharply and the index of leading European shares jumped more than two per cent (Milliken and Zaharia, 2012). However as we now know this was far from the end of the current Euro crisis. Recently the ECB had to announce an ambitious Quantitative Easing (QE) program in order to boost inflation and thereby try to prevent a dangerous deflation spiral. This in turn has put more stress on the political situation in Europe, as taxpayers in some of the northern European countries and especially in Germany, fear that they have to cover the possible future losses of the QE program (De Grauwe, 2015).
The driving force behind the creation of the Euro was the idea that greater economic integration would foster political integration and peace, yet in reality further political integration seems far away. “The euro has become an economic trap and Europe a nest of squabbling nations. Even the continent’s democratic achievements seem under threat, as dire economic conditions create a favourable environment for political extremism.” (Krugman, 2012). Krugman argues that economists could and should have seen the problems in the Euro area coming if they had kept the theory of Optimum Currency Areas (OCA) more closely in mind. In fact, some adherents of the traditional OCA theory did ventilate their concerns regarding the Euro project, arguing that the lack of fiscal stabilizers combined with the relatively low degree of labour mobility would threaten the Eurozone’s stability in the presence of asymmetric shocks. However, these concerns were largely dismissed by supporters of the Eurozone who argued that the OCA theory was either wrong, irrelevant or that any concerns it raised could be addressed via reforms (Krugman, 2012). Nowadays the situation is different, as the current Euro crisis has shed new light on the importance of the OCA theory.
The OCA theory originates from Robert Mundell’s 1961 paper entitled: “A theory of optimum currency areas”. In his paper Mundell (1961) argues that the territory of a currency does not necessarily has to match the territory of the nation the currency serves, in order to be effective. Phrased differently, what the OCA theory does is weigh the benefits against the cost of forming a monetary union. If the benefits outweigh the costs in a specific region we can speak of an optimum currency area. At first glance this is a very simple definition. However, identifying all costs and benefits of a common currency is a rather complicated task and quantifying all these costs and benefits is even more ambitious. In his paper Mundell (1961) emphasized the importance of factor mobility, and especially the mobility of the factor labour, in order to
counter asymmetric shocks. Ronald McKinnon (1963) and Peter Kenen (1968) contributed to the OCA theory respectively two and eight years after Mundell’s paper by adding criteria such as the degree of openness, the notion of product diversification and the importance of fiscal
integration. After their contributions the OCA theory advanced only minimally for nearly two decades (Bayoumi and Eichengreen, 1997), mainly due to the loss of momentum towards monetary integration. In the mid 1980s and early 1990s, when the debate over European monetary integration re-‐emerged the analytical framework behind the OCA theory was revised and a ‘new’ OCA theory started to emerge (De Grauwe and Mongelli, 2005). Despite these advances of the OCA theory, it remained difficult to move from theory to empirical work and policy analysis, as a proper operationalization of the theory lacked. To solve this issue Bayoumi and Eichengreen (1997) proposed the Optimum Currency-‐Area Index (OCA index), an elegant model that combined and quantified some of the main aspects of the OCA theory into one simple index. More details on this model will be discussed in section two.
The question whether or not the Eurozone could act as an OCA is highly relevant in this current Euro-‐crisis, both from a political-‐ as well as an economical point of view. Quite a lot of research has been done in order to assess whether or not the Eurozone is an OCA. The majority of the papers in the current literature conclude that the Eurozone is not operating as an
optimum currency area, as the OCA criteria are not met. However, recent studies have shown that the OCA criteria might be endogenous and that joining the Eurozone in itself could lead to more favourable conditions regarding the fulfilment of the OCA criteria. One of these studies is by Frankel and Rose (1997) who studied the effect of joining a monetary union by looking at past data. They found that monetary integration leads to highly significant deepening of
reciprocal trade. Frankel and Rose (1997) draw the following conclusion: “Countries which join EMU, no matter what their motivation may be, may satisfy OCA properties ex-‐post even if they do not ex-‐ante!” In other words, although the Eurozone members do currently not fulfil the OCA criteria they may do so in the future.
This thesis will contribute to the current literature by assessing to what extent the Eurozone members have met the OCA criteria during the past 30 years. This assessment will be made by suggesting an alternative version of Bayoumi’s and Eichengreen’s OCA-‐Index. This proposed index will add variables such as openness, labour market flexibility and interest rate differentials to the estimation equation. These additions to the OCA-‐index will improve the model since they will enable the model to capture the main insights of the OCA theory to a greater extent. This alternative OCA-‐index (AOCA-‐index) will be calculated for a diverse group of European nations for different time periods. Based on these indices I will assess to what extent the OCA criteria are endogenous. Put differently, if it turns out that the calculated values of the AOCA-‐Index move closer to the optimum value (i.e. zero), this will be considered as evidence
regarding the endogeneity of the OCA conditions. Therefore the central question of this thesis is: “Is there a sign of a converging pattern over time in the extent to which the countries that form the Eurozone meet the optimum currency area criteria, according to an alternative OCA-‐index?”
This thesis will consist of two parts. Part one (sections two and three) will provide a theoretical motivation for the alternative OCA-‐index calculated in part two (sections four to six). The structure of this thesis will be as follows: Section two will elaborate on the theory of
optimum currency areas, starting at its origin (Mundell’s paper) I will briefly discuss the major advances of the theory. This way the reader will be presented with a clear view of the theory underlying the model that will be constructed in section three. Section 3.1 will review the original OCA-‐Index by Bayoumi and Eichengreen (1997). Section 3.2 will extend the OCA-‐Index and will theoretically motivate the suggested extensions. Section four will estimate the
coefficients of the newly proposed OCA-‐Index; these coefficients will be used to calculate the indices for the Eurozone members in section 4.3. Furthermore section 4.3 will discuss whether or not there is evidence of endogeneity. Section five will discuss some of the main shortcomings of the empirical analysis applied in this thesis and will suggest some ideas for future research. Finally section six will state some concluding remarks.
Part one
This first part, consisting of two sections, will discuss the OCA-‐index as proposed by Bayoumi and Eichengreen (1997) and will start by briefly reviewing the ‘traditional’ OCA theory upon which this index is based. In addition the endogeneity hypothesis of the ‘new’ OCA theory will be discussed, this will act as a theoretical motivation for the goal of this thesis, i.e. assessing the endogeneity of the OCA criteria. Finally some of the weaknesses of the standard OCA-‐index will be discussed and an alternative OCA-‐index will be proposed.
2. The Theory of Optimum Currency Areas
In this section the major advances of the theory of optimum currency areas will be briefly discussed in chronological order. Section 2.1 will elaborate on the traditional OCA theory, starting with the aforementioned paper by Mundell (1961). Section 2.2 will expand upon the new OCA theory, with an emphasis on the endogeneity of the OCA criteria. This section will not propose any new insights in the OCA theory, as it will merely be a summary of previous
contributions.
2.1. The Traditional Theory of Optimum Currency Areas
As mentioned before, the theory of optimum currency areas started with the seminal contribution of Mundell (1961). However, it should also be noted that some of the original insights were already stated in earlier work such as Meade (1957) and Friedman (1953). Mundell (1961) suggested that the borders of a currency need not necessarily coincide with the borders of a country. In his paper Mundell tried to identify when countries should have their own currencies and what the appropriate domain of a common currency is. Mundell notes that in the presence of a common currency, exchange rate adjustments can no longer be used to counter asymmetric shocks and thus other adjustment mechanisms are required. Mundell emphasised factor mobility and especially labour mobility as main adjustment mechanisms. To illustrate why these adjustment mechanisms are required and how for instance labour mobility could act as such a mechanism, Mundell considered the following scenario. Consider a simple model of two countries, A and B, each producing a different good using labour as the sole production factor and initially in full employment and balance of payment equilibrium.
Furthermore, assume that prices and nominal wages cannot be reduced in the short run without causing unemployment; in addition assume that the monetary authorities act to prevent
inflation. If a shift in demand caused by a change in consumers’ preferences from the good produced by A towards the good produced by B occurs, then demand in A will go down and demand in B will pick up. This asymmetric shock will raise unemployment in A and cause inflationary pressure in B. This situation is illustrated in graph one.
Source: European Parliament (2015)
If prices were allowed to rise in B this would counter the effect of the exogenous increase in demand in B and reduce the exogenous decrease in the demand in A as the latter nation becomes more competitive, i.e. ceteris paribus the terms-‐of-‐trade of A will improve. If however, the monetary authority in B tightens monetary policy in order to prevent the price level in B to rise, the complete burden of adjustment is thrust onto country A. To illustrate this trade-‐off between unemployment and inflation more clearly, suppose that instead of separate countries, A and B are now two regions within the same country. Furthermore assume that the national
government pursues a full-‐employment policy. The shift in demand from A towards B again causes unemployment in A and inflationary pressure in B. In order to correct for unemployment in region A the monetary authority increases the money supply. This monetary expansion prevents unemployment to rise in region A as demand increases, however, it also aggravates the inflationary pressure in region B.
The previous analysis shows that either inflationary pressure rises in a specific
country/region or unemployment rises in the other country/region. But a currency area cannot prevent both unemployment as well as inflationary pressure among its members simultaneously using a single instrument (in this case monetary policy). Mundell therefore stresses the
importance of symmetry among members of a currency area: “the optimum currency area is not the world” (Mundell, 1961).
Mundell argues that restoring equilibrium after this asymmetric shock has occurred requires a change in the relative prices. If both regions possess their own, separate, currencies an alteration of the exchange rate, i.e. a devaluation of currency A vis-‐à-‐vis the currency of B, would change the relative price levels in both regions and thereby restores equilibrium. Country A would recover its competitive position through lower real wages and prices, causing demand to rise and unemployment to fall (European Parliament, 2015).
If however both A and B share a currency, i.e. in the absence of exchange rate adjustments, other adjustment mechanisms are required. Mundell emphasises geographical labour mobility as well as price and wage flexibility as possible adjustment mechanisms. In the presence of a high degree of labour mobility full-‐employment equilibrium will be restored by the migration of a part of the labour force. After the demand shock has occurred, the decline in demand in A would again lower production in A and thus reduce labour demand in A. In B the increase in demand for its product increases the need for extra production and this naturally increases labour demand. However, instead of creating unemployment in A and inflationary pressure in B labour would now migrate from A to B, causing an outward shift of the supply curve in B and an inward shift of the supply curve in A. Price levels do not change in either country and unemployment remains absent. This situation is illustrated for country A in graph two.1 Put differently, in the
presence of labour mobility a currency area is able to maintain a stable price level as well as low unemployment.2
Source: European Parliament (2015)
Mundell also emphasised wage flexibility as a possible mechanism to counter
asymmetric demand shocks. If wages are fully downward flexible, unemployment would not arise in the above scenario as wages in A will decrease until the economy is back at full
1 For country B the exact opposite will happen, the situation in this country can be illustrated by graph two as well.
However in B the initial equilibrium is located in point 3, after the labour force in B has increased the supply curve will shift out. The new equilibrium for country B is situated in point 1.
2 Note that the price level is unaffected in graph two, as the new equilibrium is located on the same point on the
equilibrium. This again works through an increase in competitiveness of A. Combined with a tight monetary policy, both unemployment and inflationary pressures could be prevented simultaneously in this situation. Thus, Mundell concludes that, if either labour mobility or price and wage flexibility are present in a specific region there is no need for exchange rate
adjustments within that region. And thus the costs of monetary unification, i.e. the loss of independent monetary policy, in that specific region are relatively low.
The analysis so far suggests that in an optimal world many small currency areas would exist. In other words, so far only the reasons for keeping currency areas small, not the reasons for increasing the size of a currency area, have been discussed. Mundell states a few reasons for why it is optimal to increase the size of any given currency area. First of all Mundell argues that the costs of valuation and money changing increase with the number of currency areas. If
foreign goods are expressed in foreign currencies the prices of these goods need to be translated into domestic prices in order to be comparable to domestic prices. Thus, the smaller a currency area is, the less transparent prices become. Mundell argues in a similar way that money loses its role of medium of exchange as the number of currencies increase. In the most extreme case in which each single commodity is traded in its own currency, the usefulness of money as a unit of account and a medium of exchange would completely disappear and trade might as well be conducted in terms of pure barter. Another factor, which increases the optimal size of any given currency area, noted by Mundell, is that foreign exchange markets must not become too thin. Thin foreign exchange markets would enable any single speculator to have an effect on the market price, causing the currency to become very vulnerable to speculative attacks. Finally, in line with the previous arguments, Mundell assumes that labour unions bargain for nominal rather than real wages. As the number of currencies grows larger and thus the fraction of imports expressed in foreign currency grows larger, nominal wages become meaningless. Mundell calls this the degree of money illusion in the bargaining process and states that this money illusion imposes an upper limit to the number of currency areas. As the degree of money illusion becomes greater as currency areas become smaller.
A few years after the paper by Mundell, McKinnon (1963) further refined the OCA theory by distinguishing factor mobility into two distinct senses. On the one hand McKinnon noted factor mobility among regions, just as Mundell did. However, McKinnon also recognizes factor mobility among industries (Broz, 2005). To see why this distinction makes sense, reconsider the above scenario in which countries A and B are hit by an asymmetric demand shock. If labour is immobile across regions, but mobile across industries, the two goals of low unemployment and a stable price level could still be achieved simultaneously. After the demand shock has occurred
country A faces a lower demand for its product. As labour (the only production factor) is assumed to be mobile across industries, country A could prevent unemployment simply by producing the same product as country B does.
In addition McKinnon added the degree of openness as an important OCA criteria, which he defines as the ratio of tradables over non-‐tradables. McKinnon reasons that it is more
beneficial for an open economy to form a monetary union, the opposite holds for a closed economy for which it is more beneficial not to enter a currency area. He argues that for open economies it is more likely that foreign prices of tradables are transmitted into the domestic cost of living. So the effect of exchange rate fluctuations onto the domestic economy are much more pronounced, as wage contracts and price levels will be set more dependent of the exchange rate. Changes in the exchange rate would then cause changes in wages and price levels, implying that changes in the exchange rate are less efficient in changing the terms of trade and thus less useful as an adjustment mechanism (Broz, 2005). McKinnon concludes that small open economies would benefit most from joining a currency area. Finally he also notes that such economies should rely more heavily on for instance fiscal policy as an adjustment mechanism.
In 1969 Kenen improved the OCA theory by adding the notion of fiscal integration and the importance of a well-‐diversified economy. First Kenen developed the idea that fiscal
integration should be an OCA criterion, as fiscal transfers could act as an automatic stabilizer. In simple terms this works as follows. Let us again look at the case in which country A suffers from a demand shock. However, this time assume that both countries are fully fiscally integrated, i.e. they share the same tax system. After the demand shock, production and consumption in country B picks up at the expense of country A, this causes tax revenues to increase in B and to decrease in A. In addition unemployment benefits expenses will likely increase in A, as
unemployment grows. These automatic effects could be interpreted as a fiscal tightening in B and a fiscal stimulus in A, causing a slowdown of the economy in B and a stimulus of the
economy in A. This way fiscal transfers will reduce the impact of the asymmetric demand shock, creating less asymmetry of business cycles.
Kenen also stresses the importance of a well-‐diversified economy since these economies are less affected by sector specific shocks, forestalling the need for adjustment mechanisms. A negative shock in a specific industry could be cancelled out by a positive shock in another industry within that same country. Furthermore sectorial diversification might be needed to provide destinations to which labour has an incentive to move, as consumers prefer to have varied consumption possibilities (Dellas and Tavlas, 2009). Broz (2005) points out that this criterion could be translated into McKinnon’s openness criterion, as one could say that a well-‐ diversified economy is likely to be a large, relatively closed economy. In that same line of
reasoning one could imagine that a small, less well-‐diversified economy has to be more open in order to be able to import the goods consumed by households. This would cause the need of terms of trade adjustments to be higher for small open countries, as they are more likely to be affected by sector specific shocks. The previous implies that the costs of monetary unification are higher for small open economies. This stands in sharp contrast with the reasoning of McKinnon who argues that small open economies benefit more from joining a monetary union when compared to large closed economies.
Mundell (1961), McKinnon (1963) and Kenen (1969) are considered to be the most important contributors to the traditional OCA theory. Although several other authors have made contributions to the traditional OCA theory, their work will not be discussed here in detail. As it is not the goal of this thesis to provide a literature review of the traditional OCA theory. Moreover these later contributions are much in line with the work discussed above. The interested reader is referred to the following papers for a detailed description of the later contributions of the traditional OCA theory: Cordon (1972), Mundell (1973), Ishiyama (1975) and Tower and Willet (1976). For convenience appendix A1 summarizes the main traditional OCA criteria discussed in this section.
Finally, it is important to briefly note a more recent contribution by Mundell (1973) who argues that financial integration reduces the impact of asymmetric shocks. He argues that if all regions of a monetary union hold financial claims on each other’s assets a potential sector specific shock will not only affect the nation active in this sector, but also the other nations that hold financial assets of the former nation. Thus if countries hold financial assets of each other, their business cycles will become more symmetrical. This implies that symmetry of shocks, even though desirable, is no longer a firm precondition in the presence of a high degree of financial integration (Broz, 2005). More on financial integration will be discussed in section 3.2.
2.2. The Endogeneity of the Theory of Optimum Currency Areas
Section 2.1 discussed the main contributions of what is considered to be the traditional OCA theory. This section will expand upon the new OCA theory and will emphasize the endogeneity of the OCA criteria. This emphasis is made because the goal of this thesis is to search for endogeneity of OCA criteria within the Euro area, for which this section provides a theoretical motivation.
The traditional view of the OCA theory was largely based on the idea that nations with a flexible exchange rate were able to choose an optimal point along the Phillips curve.3 However,
this traditional view of a permanent trade-‐off between unemployment and inflation was, over time, undermined by several developments (Tavlas, 1993). For instance the Friedman-‐Phelps hypothesis states that the steady-‐state unemployment is not related to the steady-‐state inflation rate if the expected inflation is being taken into account during wage negotiations. In other words, labour negotiates on the basis of expected real-‐ rather than nominal wages and thus takes into account expected future price levels (Tavlas, 1993). Moreover, the experiences of many countries during the 1970s and early 1980s with rising inflation combined with increased unemployment shows that this assumed trade-‐off between inflation and unemployment of the traditional OCA theory is not realistic. Another problem with the traditional OCA theory is that on several points it contradicts itself. One example of this is the aforementioned contradiction where on one hand McKinnon argues that small open countries benefit the most from joining a monetary union, while on the other hand small open countries are most fragile with respect to asymmetric shocks as they are most likely less well diversified. In addition Dellas and Tavlas (2009) argue that economic developments in smaller monetary union member nations are less important for the monetary union as a whole when compared with economic developments in a larger member nation. Therefore the common central bank pays much more attention to
economic developments in the larger member nations. Hence one can argue that small countries are less well suited for monetary unification, as the costs of losing independency of monetary policy are much higher for these countries.
The previously discussed problems with the traditional OCA theory combined with the loss of momentum towards monetary integration led to a pause in the advance of the OCA theory after the various contributions in the 1960s and the first half of the 1970s (De Grauwe and Mongelli, 2005). In the words of Tavlas (1993): “The subject was for years consigned to intellectual limbo.” But the theory had its rebirth in the 1990s with the birth of the European monetary union, when more and more researchers became interested in the OCA theory (Broz, 2005). Moreover, developments in macroeconomic theory allowed the traditional OCA theory and its contradictions to be cast in a new light and could solve some of the theory’s problems (Tavlas, 1993).
There are many issues that the new OCA theory deals with including, but not limited to: the effectiveness and credibility of monetary policy; the correlation and variation of shocks; the character of shocks; the effectiveness of exchange rate adjustments; political factors and the endogeneity of the OCA criteria. This thesis will only go into detail on the last issue, the endogeneity of the OCA criteria. Other new insights of the OCA theory are beyond the scope of
this thesis. For more details on the new OCA theory the interested reader is referred to: De Grauwe and Mongelli (2005), Broz (2005), Tavlas (1993), Dellas and Tavlas (2009) and McKinnon (2004).
OCA criteria such as openness, labour mobility, price flexibility, financial integration and the degree of economic diversification are not constant over time, and may very well be fostered by monetary unification. This is called the endogeneity hypothesis of the OCA theory (Matthes, 2009). The true debate on the endogeneity of OCA criteria started with a paper by Frankel and Rose (1997). The authors focus on the effect of trade on business cycle synchronicity. They argue that from a theoretical point of view closer international trade, resulting from monetary unification, could either lead to tighter or looser correlations of national business cycles. Based on economies of scale, an increase in trade could result in countries becoming more specialised in the goods in which they have a comparative advantage. This causes economic divergences between countries, causing countries to become more sensitive to industry specific shocks, thereby creating more idiosyncratic business cycles.
On the other hand, trade integration could result in spillovers, which lead to more synchronized business cycles. For example, in the case of a positive demand shock, the booming country is likely to increase its imports, causing the demand in other countries to rise along with the demand in the booming country. In addition, it is likely that intra-‐industry trade intensifies, because higher incomes foster demand for income-‐elastic goods, which are often differentiated goods for which economies of scale are relevant (Matthes, 2009). According to new trade theory these types of goods are often traded within the same industry, i.e. intra-‐industry trade.
Countries involved in more intense intra-‐industry trade naturally become more similar in terms of sectorial structures (Matthes, 2009), as all countries produce different varieties of the same goods and are thus all affected by the same sector specific shocks. This would also imply that the conditions with respect to Kenen’s (1969) diversification criteria will become more favourable after monetary unification, as intra-‐industry trade picks up. For these reasons Frankel and Rose do not believe that monetary unification leads to more specialization. Instead they believe it to be more likely that either common shocks would become predominant or that intra-‐industry trade would account for most trade. This would result in more synchronized national business cycles. Frankel and Rose (1997) test their view using a panel of bilateral trade and business cycle data for twenty industrialized countries over thirty years. They conclude that the aforementioned ambiguity is theoretical rather than empirical, as they have found a strong positive relation between bilateral trade intensity and bilateral correlations of business cycles. And although the authors do recognize that their work is subject to the famous Lucas Critique
their work still has considerable relevance.4 For instance, based on historical data a country may
appear to be a poor candidate for EMU entry, but entry in itself may substantially expand trade; resulting in more highly correlated business cycles. Thus countries might be more likely to satisfy OCA criteria ex post rather than ex ante (Frankel and Rose, 1997).
On the other hand, several other economists, such as Krugman (1993) and Bayoumi and Eichengreen (1992) believe more strongly in an increase in specialization as a result of
monetary unification. Krugman (1993) interpreted the experience of Massachusetts during the 1980s and early 1990s as an example of what could be expected for the Eurozone. During that period the New England area was booming as the result of its specialization in mini-‐computers, advanced medicine and military hardware. At the end of the 1980s there was a severe downturn in demand for these products, partly due to the invention of micro-‐computers and a change in policy towards less military spending (Handler, 2013). Krugman does acknowledge that US regions were more specialized than comparable European nations. However, he suggested that the completion of the Single European Market combined with the planned monetary unification would enhance specialization, resulting in more asymmetric shocks. In addition Krugman argues that the increased labour mobility caused by monetary unification could very well be a bad thing, as labour migrates from regions that perform poorly to regions performing above average. According to Krugman this causes temporary demand shocks to have a more permanent effect on output. In that same line of reasoning Krugman (1993) also notes that increased capital mobility will probably result in more pro-‐cyclical capital movements and thus more pro-‐cyclical investments, reinforcing regional business cycles.
However besides Frankel and Rose (1997) several other empirical studies have found a positive association between trade integration and more tightly correlated business cycles.5 The
empirical evidence suggests that the negative indirect effect of increased specialization seems to have little effect on business cycle synchronicity and that increased trade does enhance business cycle synchronicity (Mathhes, 2009).
The previously discussed papers focus on the effect of trade integration on the
synchronicity of business cycles. However, several authors, for instance Mongelli (2002), argue that the endogeneity of OCA criteria is associated with a large amount of progress in many different areas, i.e. it is certainly not restricted to trade integration and business cycle
correlations. Another area besides trade integration, which is often mentioned with respect to the OCA endogeneity, is the effect of financial integration on business cycle synchronicity. As was the case for trade integration, the theoretical mechanisms behind the effect of financial
4 The Lucas Critique basically criticizes the use of past data to forecast the future effects of a change in economic
policy.
integration on business cycles are ambiguous as well. As discussed in section 2.1, financial linkages can cause spillovers that lead to more symmetrical business cycles. This happens when investors in a slow growing country profit from their investments in a booming country and spend their profits domestically (Matthes, 2009). On the other hand this kind of risk sharing might induce more production specialization, as a better international diversification of financial assets mitigates the increased risk of production specialization and thus could be seen as a substitute for a diversified production portfolio (Matthes, 2009). However, empirical evidence suggests that financial integration leads to more synchronized business cycles and thus once more the ambiguity seems to be merely theoretical.
This is also in line with the findings of De Grauwe and Mongelli (2005). These authors define the OCA endogeneity as “a set of interacting processes improving the OCA-‐ratings of a currency area.” Therefore De Grauwe and Mongelli do not restrict their research to sources of endogeneity resulting from trade and financial integration. They look instead at the empirical literature on OCA endogeneity in four different areas. The study of De Grauwe and Mongelli is very extensive and presents a broad overview of the empirical evidence regarding the OCA endogeneity. Their main findings and conclusions will be stated briefly in what follows.
The first field the authors discuss is the endogeneity of economic integration. As a measure for economic integration De Grauwe and Mongelli primarily looked at the effect of the Euro on intra-‐Eurozone trade and price level convergence. They found that within the Eurozone prices are becoming increasingly more homogeneous in product markets, which could imply that in the long run inflation levels within the Euro area are converging. Convergence of inflation rates makes it easier for the ECB to keep the Eurozone’s wide inflation level on the targeted value, close but just below 2%. With respect to trade De Grauwe and Mongelli conclude that a monetary union is a strong force towards additional trade creation. This, in turn, leads to more synchronized business cycles according to several other studies such as Frankel and Rose (1997), as discussed above.
The second field De Grauwe and Mongelli analyze is the integration of financial markets. As stated at the end of section 2.1, financial market integration could reduce the impact of asymmetric shocks. This way financial integration would significantly reduce the costs of monetary unification. De Grauwe and Mongelli find that although the Eurozone is far from a unified financial market there is some progress towards financial integration. One example of such progress is the increase in intra-‐euro area FDI. In addition the authors find that both the bond-‐ and money markets have integrated swiftly. In the case of the bond markets even before the introduction of the Euro, most likely due to investors anticipating the unification. The authors argue that there is no doubt that this progress has been due to the introduction of the Euro, especially in the bond-‐ and money markets. They conclude that financial markets did
become more integrated after the introduction of the euro and the evidence of risk sharing remains modest, yet encouraging.
Thirdly the symmetry of economic shocks is discussed. The main conclusion in this section is that past increased integration has led to more symmetry in shocks. Whether this remains to be the case in the future is unclear, as economies of scale might cause further agglomeration, i.e. specialization, which enhances asymmetry.
The final area De Grauwe and Mongelli investigate is the endogeneity of labour market flexibility. In other words, the authors attempt to see whether monetary unification enhances labour market flexibility. They find that empirical evidence suggests that there has been a significant progress towards wage moderations, implying that labour markets have become more flexible, as more flexible labour markets causes wages to converge.
Overall the conclusion of this paper concerning the endogeneity of OCA criteria is moderately optimistic. Product markets prices have become more homogeneous, mainly due to an increase in trade. In addition business cycles do show signs of convergence, although
economies of scale might enhances specialization in the future. Two important stabilizing factors, financial integration and labour market flexibility have increased. As discussed in section 2.1 these factors could significantly reduce the impact of asymmetric shocks, and thus reduce the costs of monetary unification.
Some authors do also point out specific weaknesses in the endogeneity hypothesis. One of those authors is Jürgen Matthes (2009) who states that since the start of the EMU there has been little evidence of increased business cycle synchronization, mainly due to the lack of significant increases in trade.
The goal of this section is to identify the main sources and mechanisms, which might foster the conditions regarding the OCA criteria, or put differently, the endogeneity of OCA criteria. For convenience this section will conclude by briefly restating the main sources of endogeneity. First Frankel and Rose (1997) have shown that more intense trade linkages lead to more business cycle synchronicity. Matthes (2009) does agree with Frankel and Rose, however, he does point out that this effect is not significantly present in the EMU due to a lack of increased intra-‐Eurozone trade. Secondly both this section as well as section 2.1, show that financial integration could significantly reduce the impact of asymmetric shocks and is likely to foster business cycle synchronicity. De Grauwe and Mongelli (2005) find that financial integration did improve in the EMU after the monetary unification, in addition they have found modest evidence of increased risk sharing. Thirdly increased labour market flexibility might enhance business cycle synchronicity, as labour mobility, both among production sectors as well as production
locations, reduces the impact of asymmetric shocks. In their literature research De Grauwe and Mongelli (2005) have found evidence of increased labour market flexibility within the EMU. Finally monetary unification could enhance price level flexibility, as prices are more easily compared and goods more easily traded after monetary unification. Empirical evidence shows that price levels are becoming increasingly more homogeneous within the EMU, indicating more flexible product markets and resulting in more equal inflation levels.
3. The Empirical Model
The previous section has described the main advances of the traditional OCA theory and emphasized the endogeneity hypothesis of the new OCA theory. This section will describe the empirical model applied in this thesis (an adjusted version of the OCA-‐index), which is based on the insights of the OCA theory discussed in section two. First section 3.1 will elaborate on the OCA-‐index developed by Bayoumi and Eichengreen (1997), section 3.2 will then argue why and how the OCA-‐index could (and should) be extended. The extended OCA index that will be formulated at the end of this section, will be used in section four to answer the central question of this thesis:
“Is there a sign of a converging pattern over time in the extent to which the countries that form the Eurozone meet the optimum currency area criteria, according to an alternative OCA-‐index?”
3.1. The Optimum Currency Area Index
The intuition behind the OCA theory is clear and straightforward, as is illustrated by the relatively simple examples in the previous section. However, despite the intuitive reasoning behind the OCA theory, it remained difficult to move from theory to empirical work and policy analysis, as a proper operationalization of the theory lacked. Because of the lack of a common operationalization of the OCA theory most of the empirical work has focused on specific aspects of the theory that are more easily operationalized, such as business cycle synchronicity. See for instance De Grauwe and Mongelli (2005) for an overview of such empirical papers.
In their paper “Ever Closer to Heaven? An Optimum-‐Currency-‐Area Index for European Countries” Bayoumi and Eichengreen (1997) managed to operationalize the OCA theory. They developed a procedure for applying the core implications of the (traditional) theory of optimum currency areas, with an intuitive model. In order to capture the essence of the OCA theory their approach basically analyzes the main determinants of exchange rate variability. This makes
