Does EMU need political authority on economic and fiscal policy?

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Does EMU need political authority on economic and

fiscal policy?

Luca Spanjaard 10057080

Supervisor Koen Vermeylen

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Introduction

Beginning 2010, subsequent to the economic crisis of 2008, the first negative signals on the state of the Greece economy appeared. In March 2010, the IMF and the other EMU members decided to support Greece if it was not able to attract a sufficient amount of money on the market. Due to the downgrading of the Greek government debt to Junk status in April that year, attracting money from the pri-‐ vate market to finance its expenses was no longer realistic for the Greek gov-‐ ernment. Therefore, on May 2010, the EMU members and the IMF agreed on a €110 billion bailout loan for Greece, on conditions of structural change of its economic system (IMF 2010).

The bailout of Greece appeared to be the beginning of a series of bailout loans to several of the weaker Economic and Monetary Union (EMU) members; Ireland followed in November 2010 with a bailout loan of €67,5 billion, Portugal was next in the first half of 2011 to request a bailout loan of €78 billion, then Spain was granted financial support of €100 billion in 2012 and finally Cyprus received a support package of €10 billion in march 2013 (Riegert 2012). The bailouts were one of the many effects of the still on-‐going euro area crisis, more commonly known as the “Euro Crisis”. This crisis is not just a prob-‐ lem of sovereign debt, besides rising bond yields and finance problems for sev-‐ eral EMU governments, there is also a banking and a growth crisis in the euro area. These crises connect with each other; weak bank balances and high sover-‐ eign debt reinforce each other, both are aggravated by the limited economic growth and in turn confine possible growth (Shambaugh, Reis, and Rey 2012). As there is no fiscal union in the EMU, the political leaders of its members are constrained in taking the needed fast and effective measures and are often forced to seek national political support on the sometimes-‐unpopular economic decisions. Besides the retardant effect of the process of gaining national support on needed economic measures, the coming to agreements between the EMU members is often lacking the swiftness for executing short-‐term measures de-‐ manded by the market (Subacchi 2013).

The lack of leadership in the EMU to take fast and effective measures rais-‐ es the question if there shouldn’t be a neutral party within the EMU, with the same independence like the European Central Bank (ECB); not committed to one member in particular but to the wellbeing of the EMU as a whole, with the power to adjust for economic unbalances across EMU countries. The ECB has only one responsibility, the monetary policy in the EMU area. As there is no political au-‐ thority to side the ECB, it is unclear whom to hold responsible for the current economic disbalance across the EMU area. And above all, who is responsible for the prevention of future crises, there is no party that has the authority on eco-‐ nomic policy within the EMU. The research question of this thesis is therefore: “Does the EMU need a supranational, independent institution with authority on

economic and fiscal policy?”

The research question is answered by means of a literature review, which consists out of two parts; the first part provides a brief historical retrospect on initiation of the European Union, and will explain which economic events led to the commencement of the EMU area.

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ion, the Optimum Currency Area (OCA) theory, and will describe the develop-‐ ment of the OCA theory chronologically on the basis of seven of the most influen-‐ tial articles in its scientific field.

Then the results from the two parts are combined to provide the answer on the research question.

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Part 1: Historical Background EMU

To come to an understanding of why and how the political leaders of the euro area came to form a monetary union, this paper will state a brief overview of (economic) historical events, which eventually lead to the formation of the EMU of the European Union.

Bretton Woods System

During the Second World War, in July 1944, the 44 allied nations came together in Bretton Woods, New Hampshire, to plan a new international monetary order to prevent the repetition of three monetary mistakes made during the interwar period; the wild fluctuating exchange rates and the resulting collapse of the gold exchange standard, the international transmission of deflation and the refuge to beggar-‐thy-‐neighbour devaluations, and the subsequent trade and exchange re-‐ strictions and militarism.

To prevent the repeat of these mistakes, the goals of the Bretton Woods convention were to design an international monetary constitution found on sta-‐ ble exchange rates, national full employment policies, and cooperation. A system of adjustable peg was designed that combined the features of the gold standard with flexible exchange rates. Every member was required to establish parity between their national currency and the reserve currency (the US dollar), which in turn was fixed to a gold standard. Members were allowed a 1% plus or minus fluctuation in the exchange rate between their national currency and the dollar, and only the dollar could be converted into gold.

Due to stable monetary policy of the US, the dollar emerged as the world reserve currency; the dollar was not only used as the intervention currency but was also highly demanded by the private sector to use as international money (Bordo 1993).

European Coal and Steel Community

On the 9th of May 1950, French foreign affairs minister Robert Schumann, pro-‐ posed in a declaration, now known as the “Schumann Declaration”, that the Ger-‐ man and French production of coal and steel should be placed under a suprana-‐ tional institution, with open membership for other European countries

(Schumann 1950). Besides being important factors of production for the resur-‐ rection of a Europe in ruins, coal and steel were important raw materials for war machinery. The incorporation of the two production factors in an European insti-‐ tution would not only benefit the European economy as a whole, but would as well contribute to maintaining peace on the continent.

The Schumann Declaration led to the treaty of Paris in 1951, in which the European Coal and Steel Community (ESCS) was established. The treaty, signed by “the original six”; France, West-‐Germany, Italy, Luxembourg, The Netherlands and Belgium, entered into force on 23 July 1953 and erected the common Euro-‐ pean market for coal and steel. This has been the only European treaty signed for a limited duration, one of 50 years, and thus expired in 2002 (CVCE 2012).

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European Economic Community

In 1957, the six countries signed the treaty of Rome, in which they established the customs union: the European Economic Community (EEC). The treaty, en-‐ tered in force in 1958, states that goods travelling within the union are exempted of customs, and all its members levy the same custom tariff on goods coming in from outside the union. The rate of the customs tariff on goods entering the un-‐ ion is decided upon by the Community, not on state-‐level (European Union 2010). Besides the construction of the EEC, the treaty established the European Atomic Energy Community (EURATOM), for co-‐operation in developing nuclear energy (CVCE 2012).

European Communities

In 1965, the “Merger Treaty” (or “Brussels Treaty”), was signed. The EEC and EURATOM, created separately from the ECSC, were merged together with the ECSC into a single institution. The treaty entered in force in 1967, and from then on the three communities were collectively referred to as the European Commu-‐ nities (EC) (CVCE 2012).

Werner Report

In 1968, at a summit in The Hague, a group is been set up under the Luxembourg Prime Minister Pierre Werner to report if a European Monetary Union (EMU) could be established by 1980. In October 1970, the group set out its plan; a three-‐stage process to achieve EMU within 10 years, with the final objective irre-‐ versible convertibility of currencies, free capital movement and the permanent fixing of exchange rates or an adaptation of a single currency within the EMU. To achieve this, the report called for closer coordination on economic policy

(European Commision 2010).

Dissolvent of Bretton Woods

In 1971, the Bretton Woods system dissolved. Problem with its dollar gold standard was that when the growth of the monetary gold stock was not enough to finance the growth of the world output, the system of pegged currency ex-‐ change rates would become unstable.

This is what happened between 1968 and 1971. Monetary expansion by the US aggravated worldwide inflation; the US did not maintain price stability, thereby breaking the rules of the Bretton Woods system. The rest of the world did not want to absorb dollars and inflate, and as the US did not want to convert dollars into gold, thereby countering their own monetary expansion, the Bretton Woods system was dissolved. Another problem of the Bretton Woods system was that the increasing capital mobility suffered under a system of adjustable peg, speculation against one of the fixed parities could not be stopped by tradi-‐ tional policies or international rescue packages (Bordo 1993).

European “Currency Snake”

The first stage of the Werner report, the narrowing of the exchange rate fluctua-‐ tions, failed. The flaw in the strategy was that it took for granted the fixed ex-‐

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change rate against the dollar. But when the US decided to float the dollar in 1971, the subsequent market instability crushed the hope of converging Europe-‐ an currency rates and meant the end of the EMU project (European Commission 2010).

In 1972, the Community decided to create the ‘snake in the tunnel’, a managed floating mechanism for the currencies ‘the snake’, and the fluctuation margins allowed around the US dollar, ‘the tunnel’. Due to the oil crises, the weakness of the dollar and the difference in economic policy, most of the partici-‐ pating members left ‘the snake’ within two years, leaving behind a Deutsche Mark focused area, with Denmark and the Benelux countries as followers of the German currency rate (Verbeken 2013).

European Monetary System

At the 1978 summit in Brussels, a new attempt was made to establish an area with monetary stability. The European Monetary System (EMS) was created, by which the member’s currency rates were fixed, but adjustable. All members of the community, except the UK, participated in the Exchange Rate Mechanism (ERM 1). The fixed exchange rates were based on central rates against a new Eu-‐ ropean unit of account, the European Currency Unit (ECU). The ECU on its turn was the weighted average of the participating currencies. A grid of bilateral rates was set up on the basis of these central rates, and fluctuations of maximum ±2,25 % around the bilateral rates were allowed (an exception was made for the Italian Lira, a fluctuation of ±6% was allowed) (Verbeken 2013). The national Central Banks had the objective to keep the parities within limits; parities could only be changed through unanimous agreement (Wyplosz 1997).

Single European Act

The Single European Act, signed in 1986, was the first adjustment of the Treaty of Rome, and it set the goal of having established a single market within the community by the end of 1992. Besides more political integration, the act was an important step towards the creation of the EMU. The act required international movement of goods, people and capital within the community to be as facile as national movement of factors of production (European Union 1987).

Introduction of the EMU

At the end of the 80’s, it became clear that pursuing national monetary policy was pointless for the EMS members, monetary policy was dictated by the Ger-‐ man Bundesbank due to the free movement of capital in the EMS area. The other EMS members had to adapt to the German disinflationary oriented monetary policy. Germany became the policy maker of the EMS area, not only on account of its relative economic size in the EMS area (enhanced by the unification in 1989), but also due to the strong reputation of the independent Bundesbank for fighting inflation and keeping strong the Deutsche Mark. For countries with dis-‐ inflation-‐oriented central banks, like the Netherlands, in fact, strict monetary conditions were welcomed, the abandoning of national monetary policy was not considered negative. France and Italy, with more government dependant central banks and an employment objective, realized that the only way they could influ-‐

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ence monetary policy again, was to create a European institution that would su-‐ persede the Deutsche Bank. No EMS member wanted to return to free exchange rates, therefore the economic dependency within the EMS area was to too large, and the exchange rate and trade wars from the interwar period were unanimous perceived to be avoided.

As Germany had to sacrifice the Bundesbank and therewith its own mone-‐ tary policy and its strong currency, for the European greater good, it was going to ask a lot in return. Especially, the future EMU currency had to be as strong as the Deutsche Mark; firm price stability guarantees were demanded. On the road to EMU, Germany set the demands, which were granted, given that it would give up on the Bundesbank (Wyplosz 1997).

Maastricht Treaty

The signing of the Maastricht Treaty on the 7th_{of
February,
1992,
updated
and} incorporated the Treaty of Rome and the Single European act, and changed the name, the European Communities into the European Union (EU), thereby en-‐ dorsing the economic and political union. The union comprised three pillars: the European Communities, the Common Foreign and Security Policy and the Police and Judicial Co-‐operation in Criminal Matters (European Union 2012).

The treaty included a three-‐stage timetable through which the single cur-‐ rency, the euro, had to be introduced by January 1st, 1999. The first stage was the strengthening of the coordination on economic and monetary policies among members. The second stage commenced in 1994, the European Monetary Insti-‐ tute (EMI) was established, which had to oversee that the national central banks would gain their required autonomy, and that they would cease providing direct loans to their nation’s treasuries. The central banks needed to be independent of their national governments, as they then, in stage three, could form the System of Central Banks, together with the to be erected European Central Bank (ECB) (Jovanovic 2013).

The other duty of the EMI was to oversee the “convergence criteria”, five eco-‐ nomic conditions, which member countries had to meet by the beginning of stage three, in order to be allowed to join the monetary union:

• Inflation within 1,5% margin of the three best performing EU countries. • Budget deficit of less than 3% of GDP.

• National debt of less than 60% of GDP.

• No devaluation within the ERM for at least two proceeding years.

• Interest rate has to be within 2% margin of the three best performing EU countries.

The countries that would fulfil these conditions by the 1st of January 1999 would then irrevocably fix their exchange rates and adopt the single currency, the euro (European Monetary Institute 1996).

The erected European Central Bank has been modelled largely to the German Deutsche Bank, its main objective is to monitor price stability within the euro area and its independency is even greater then that of the Bundesbank, changes

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in the statutes of the ECB can only be made if accepted unanimously by all EMU members (de Haan 1997) (Verdun 1998).

Although the definition of price stability is left vague by the ECB, an infla-‐ tion target of a bit below 2% per year is set. As reason for this target the ECB states on its website “Inflation rates of below, but close to, 2% are low enough for the economy to fully reap the benefits of price stability.” (European Central bank 2013).

To prevent risky behaviour by the governments of EMU members, a no-‐ bailout clause was put in the Maastricht treaty. The ECB is not allowed to bailout an EMU member to prevent its bankruptcy. This prohibition is decided in order to prevent moral hazard (Wyplosz 2009).

The euro was launched in digital form on the first of January 1999, as an accounting currency for cash-‐less payments, while the former national curren-‐ cies were used for cash-‐payments. On the first of January 2002, the euro was in-‐ troduced as physical form and replaced the national currencies.

There are currently 17 EU countries that adopted the euro as their cur-‐ rency, which are: Austria, Belgium, Cyprus, Estonia, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Malta, the Netherlands, Portugal, Slovakia, Slovenia and Spain (European Commission 2013).

Concluding Historical Background

With the introduction and adaptation of the euro by the beginning of 2002, the process of creation of the EMU has been finalized. Seventeen EU members have adopted a single currency, a system of central banks headed by the European Central Bank has been established, and with the free movement of goods, people and capital in the European Union, economic integration on the continent has made tremendous progress since the signing of the treaty of Rome, a little over 50 years ago.

Recent economic turmoil has cast a shadow over the economic integra-‐ tion of the EMU members. After long international debate, the proscribed bailouts, done by the ECB (with the help of the IMF), of five of its members have occurred. More international help might be necessary for Greece in order to pre-‐ vent further deepening of its economic problems (Brown 2013).

Due to the nature and the heaviness of the recent crisis in the EMU, sever-‐ al economists emphasise the lack of a political authority which can be hold re-‐ sponsible for the economic disbalances in the EMU (Verdun 1998) (Bordo and Jonung 1999) or question the high level of independency of the ECB (Berman and McNamara 1998) (Martin 1993).

To understand why economist raise their eyebrows, the second part of this paper introduces and explains the economic theory behind the EMU and its single currency, the Optimum Currency Area (OCA) theory. This exposition will be done on the basis of seven of the most influential scientific articles, in chrono-‐ logical order.

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Part 2: Optimum Currency Area Theory

In part 1, a brief overview has been provided of several important (economic) events that lead to the creation of the EMU. Part 2 will explain the economic the-‐ ory behind the EMU and the economic motivation for one single currency within the EMU. At last, part 2 will provide economic arguments for the establishment of a supranational institution with the authority on economic policy within the EMU. This will be done by a chronological literature review of eight of the most influential articles on the Optimum Currency Area (OCA) theory. The OCA theory addresses the question if a certain geographic area (e.g. the EMU) should pursue a single shared currency (e.g. the euro) in order to maximize economic efficiency within the area.

The literature reviews starts with an article by Robert Mundell (1961), who emphasised the stabilizing argument of the flexible exchange rate system and regarded the level of internal and external factor mobility as the decisive element in designating optimum currency areas. Economist McKinnon (1963) further develops the concept of optimality in his article. He examines the influ-‐ ence of the openness of the economy on the difficulty of harmonizing external and internal balance, emphasizing the need for internal price-‐level stability. Ishiyama (1975) distinguishes two approaches to answer the question of the appropriate domain of an optimal currency area; the cost-‐benefit approach and the single criterion approach. Krugman (1992) questions the need for monetary integration of the EMU and the rationale behind the criteria of the Maastricht treaty. Tavlas (1993) distinguishes (and answers) two questions central to the OCA-‐theory: (1) Under what conditions should countries consider monetary in-‐ tegration, and (2) what are the additional costs and benefits of monetary integra-‐ tion? The second article of Tavlas (1994) reviews theoretical and empirical re-‐ search on monetary integration with a focus on (1) the effects of shocks on coun-‐ tries participating in a currency area, and (2) reputational considerations of join-‐ ing a currency union. Wyplosz (1997) describes the economic problems at the origin of the monetary integration of Europe and discuses the criteria of the Maastricht Treaty. A concluding part will summarize the findings of the OCA-‐ theory.

Mundell, A Theory of Optimum Currency Areas, 1961

The Canadian economist Robert Mundell is regarded the intellectual father of the OCA theory; its origin (McKinnon 2004) lies in his article A Theory of Optimum

Currency Areas (1961). In 1961 the Bretton-‐Woods system was in charge; ex-‐

change rates were fixed. Nevertheless there was scientific debate on the benefits of flexible exchange rates (Friedman, 1953; Meade, 1957; and Mundell, 1960). Canada was the first of the initiating countries to leave the Bretton-‐Woods sys-‐ tem in 1952 and to adopt a floating rather than fixed exchange rate against the dollar (Helleiner 2006). The established flexible exchange rate between the Ca-‐ nadian and US dollar made Mundell believe that if the exchange rates worked between two countries, they should hold as well amongst regions within that country (Mundell 1997).

In his 1961 article, Mundell underlines that a flexible exchange rate sys-‐ tem can be used as a device whereby appreciation can replace inflation when the

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balance of payments is in surplus, and depreciation can take the place of unem-‐ ployment when the balance of payments is in deficit.

To illustrate this stabilization argument, Mundell sketched a simple model of two entities (regions or countries), initially in full employment, balance-‐of-‐ payments equilibrium and fixed exchange rates. He posed the question what happens when this equilibrium is disturbed by a shift of demand from the goods of entity B to the goods of entity A. The demand shift from B to A results in un-‐ employment in B, and inflationary pressure in A. To the extent that prices are permitted to increase in A the change in the terms of trade will alleviate B of some of the burden of adjustment. But if A narrows credit restrictions to stop prices from rising, all the burden of adjustment is forced onto country B; what is needed is a reduction in B's real income and if this cannot be accomplished by an alteration in the terms of trade because B cannot decrease, and A will not in-‐ crease prices it must be realized by a decline in B's output and employment. With a system of flexible exchange rates, if demand shifts from B to A, a depreciation by B or an appreciation by A of its currency would correct the external imbalance and also relieve unemployment in country B and restrain inflation in country A. And thus the system of flexible exchange rates is used to stabilize the balance of payments.

This raises the question whether all existing national currencies should be flexible. Therefore Mundell poses the question under what circumstances it is beneficial for a number of regions to relinquish their monetary sovereignty in favor of a common currency.

Mundell states that if factor mobility is high internally but low externally and currencies are national, the flexible exchange rate system is effective in keeping stable the balance of payments, the inflation and the interest rate. But if factor mobility is insufficiently internally then flexibility of the external price of the national currency cannot be expected to perform the stabilization of the bal-‐ ance of payments, and varying rates of unemployment or inflation in the differ-‐ ent regions could be expected. Thus Mundell argues that if the world can be split up into regions with high internal and low external factor mobility, then each of these regions should have a separate currency, which fluctuates relative to all other currencies. These regions with high internal and low external factor mobil-‐ ity are what Mundell names optimum currency areas. However, Mundell points out, the concept of an optimum currency area can only be applied in areas where political organization is in continuous change. As in the real world currencies are mainly expressions of national sovereignty, actual currency reorganization would be feasible only if it were accompanied by profound political changes. But, Mundell states, with both geographical and industrial dimensions, factor mobility (and hence the designation of regions) is most usefully consid-‐ ered a relative rather than an absolute concept and is likely to change over time with variation in political and economic conditions. When the goals of internal stability are rigidly pursued, it follows that the larger is the number of separate currency areas in the world, the more successfully will these goals be achieved (presuming that the stabilization argument for flexible exchange rates as such is valid). A problem then arises, as this seems to imply that regions should be de-‐ fined narrowly as to consider every miniature area with unemployment arising from labor immobility as a separate region, each of which should thus have its own currency. Therefore Mundell declares that not only should the stabilization

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argument be considered, to which end it is preferable to have many currency areas, but also the increasing costs, which are likely to be, associated with the maintenance of many currency areas.

Mundell provides three factors which impede the creation of an arbitrary large number of currencies: 1) If every good has its own currency, money loses its value and the economy might just as well change into a barter economy (ulti-‐ mately, one world currency would be optimal, regardless of the number of re-‐ gions it is composed of). 2) The market for foreign exchange must not be so thin that any single speculator can affect the market price; otherwise the speculation argument against flexible exchange rates would assume compelling dimensions (speculation can be destabilizing for an economy and the incentive to speculate is very small when the exchange rate is fixed). 3) The stabilization argument of the flexible exchange system itself limits the number of currencies. People do not accept changes in their real income through alterations in their money wage rate or in the price rate. However, due to money illusion people do accept the same changes in real income if these changes are made through variations in the ex-‐ change rate. When import goods make up a small part of the total living expens-‐ es, then this assumption is conceivable, but when the number of currencies is large and therefore the regions small, import goods will make up a greater part of living expenses and the assumption becomes implausible. In order for the as-‐ sumption to be correct, the needed degree of money illusion will rise to unrealis-‐ tic levels when the number of currencies increases.

Mundell concludes that the subject of flexible exchange rates can be di-‐ vided into two separate questions. The first is whether a system of flexible ex-‐ change rates can work effectively and efficiently in the modern world economy; meaning that the international flexible exchange rate system can be used as a device to stabilize the balance of payments. The second question concerns how the world should be divided into currency areas.

According to Mundell, for an international system of flexible exchange rates to be effective it must be demonstrated that: 1) After taking speculative demands into account, an international price system based on flexible exchange rates is dynamically stable. 2) The exchange rate changes essential to abolish normal disturbances to dynamic equilibrium are not so large as to cause violent and reversible shifts between export and import-‐competing industries (this is not ruled out by stability). 3) The risks generated by variable exchange rates can be offset at reasonable costs in the forward markets. 4) Central Banks withhold from monopolistic speculation; buying large amounts of one currency in order to immediately sell a small part at a very inflated price (heavily destabilizing the dynamic equilibrium in the process). 5) Monetary discipline will be maintained by the threats of the unfavourable political consequences of continuing deprecia-‐ tion. 6) Reasonable protection of debtors and creditors can be secured to main-‐ tain an increasing flow of long-‐term capital movements. 7) Profits and wages are not tied by a price index in which import goods make up a large part.

On the second question Mundell writes that if the world can be divided in regions with high internal factor mobility and low external factor mobility, then every region should have its own currency and a system of flexible exchange rates is preferred. If a region has low internal factor mobility or high external factor mobility, then a system of flexible exchange rates will not reduce instabil-‐ ity.

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McKinnon, Optimum Currency Areas, 1963

Economist Ronald McKinnon elaborates Mundell’s idea on optimum currency areas and further develops the concept of optimality in his article of 1963. He examines the influence of the openness of the economy, i.e., the ratio of tradable to non-‐tradable goods, on the difficulty of harmonizing external and internal bal-‐ ance, emphasizing the need for internal price-‐level stability.

McKinnon uses “Optimum” to describe a single currency area within which monetary-‐fiscal policy and flexible external exchange rates can be used to give the most appropriate resolution of three (sometimes conflicting) objectives: (1) The maintenance of full employment. (2) The maintenance of balanced inter-‐ national payments. (3) The maintenance of a stable internal average price level. Objective (3) assumes that any capitalist economy needs a stable valued liquid currency to assure efficient resource allocation. Possible conflicts between (1) and (2) had already been well discussed in economic literature, especially by J. E. Meade (1951), but joint consideration of all three objectives was not usually done.

The incorporation of objective (3) made the problem as much a part of monetary theory as of international trade theory.

McKinnon uses the expression “the ratio of tradable to non-‐tradable goods” as a simplifying concept, which assumes all goods can be categorized into those that could enter into foreign trade and those that do not because transpor-‐ tation is not practicable for them. By tradable goods McKinnon means: (1) ex-‐ portables, which are goods produced domestically and, to some degree, export-‐ ed; (2) importables, which are both produced domestically and imported. The surplus of exportables produced over exports will depend directly on the quanti-‐ ty of domestic consumption, which is presumably to be small when exportable production is heavily specialized in few goods. Similarly, the surplus of importa-‐ bles consumed over imports will depend on the specialized character of imports. Therefore, even in the case of balanced trade where the values of imports and exports are matching, the value of exportables produced need not be the same as the value of importables consumed. However, the total value of tradable goods produced will equal the value of tradable goods consumed under balanced trade. Thus, “the ratio of tradable to non-‐tradable goods” can apply unambiguously to production or consumption.

In order to test the practicability of the ratio of tradable to non-‐tradable goods McKinnon sets up a simple model, which considers two single currency areas, a small and a very large area (the latter can be regarded as the outside world). Practicability is whether or not the small single currency area should maintain flexible exchange rates with the outside world. Two cases are present-‐ ed.

In the first case, exportables X1 and importables X2 together make up a large part of the goods consumed domestically. Furthermore, a flexible ex-‐ change-‐rate system is used to maintain external balance and the price of non-‐ tradable good X3 is kept constant in terms of the domestic currency.

Exchange rate fluctuations will change the domestic prices of X1 and X2 directly by the amount of the fluctuations. Thus, if the domestic currency is devalued 5 percent, the domestic money prices of X1 and X2 will rise by 5 percent and thus rise 5 percent relative to X3. The motivation for devaluation is it enlarges the produc-‐

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tion of X1 and X2, and decreases the consumption of X1 and X2, thereby improv-‐ ing the balance of payments.

In the second case, the production of non-‐tradable goods is supposed to be very large compared to importables and exportables in the given area. This time the optimal currency arrangements perhaps is to peg the domestic currency to the body of non-‐tradable goods, i.e., to fix the domestic currency price of X3 and alter the domestic price of the tradable goods by changing the exchange rate to better the trade balance. A currency devaluation of 5 percent would cause the domestic prices of X1 and X2 to rise by 5 percent, but the effect on the general domestic price index is much smaller than in Case 1, as X1 and X2 make up a much smaller part of the domestic consumption.

Thus in a small open economy, where importables and exportables make up a large part of the domestic consumption, a flexible exchange rate will contra-‐ dict the objective of a stable internal average price level; fluctuations in the ex-‐ change rate lead to changes in the domestic prices of the importables and ex-‐ portables and thus to changes in the domestic price index. But in a large econo-‐ my where the ratio of importables and exportables to non-‐tradable goods is ra-‐ ther low, devaluation of the domestic currency would have an effect on the pric-‐ es of the importables and exportables, but due to the low ratio of tradables to non-‐tradables the effect of the devaluation on the domestic price index is small.

The core of the argument is that when one moves across the spectrum from closed to open economies, flexible exchange rates become both less effec-‐ tive as a control device for external balance and more damaging to internal price level stability.

McKinnon remarks that the sharp distinction between tradable and non-‐ tradable goods makes the above model analytically much more practicable, but that in practice there is a large amount of goods between the tradable and non-‐ tradable extremes. He states that loosening of this sharp distinction does not nullify the basic idea of the openness of the economy influencing optimum eco-‐ nomic policies; but the empirical quantification of the ratio of tradable to non-‐ tradable goods becomes more complicated. Additionally, when the area was large enough to affect external prices, the idea of openness would have to be al-‐ tered.

McKinnon states that the discussion concerned the way by which relative price changes in tradable and non-‐tradable goods can be brought about, and the conditions under which monetary and fiscal policy can be used efficiently to maintain external balance. Minimizing the real cost of modifications needed to maintain external balance depended to a large extent on reducing necessary fluc-‐ tuations in the over-‐all domestic price level. Thus the argument has to do with the liquidity properties of money. One of the aims of monetary policy is to estab-‐ lish a stable kind of money whose value in terms of a representative bundle of economic goods remains more balanced than any single physical good. The pro-‐ cess of saving and capital accumulation is greatly impeded unless a suitable unit of account exists. It may be still more problematic if another more desirable money is available, e.g., from a larger currency area.

If the area under consideration is large enough so that the body of non-‐ tradable goods is abundant, then pegging the value of the domestic currency to this body is sufficient to give money liquidity value in the eyes of the residents of that area. If the area in question is small so that the ratio of tradable to non-‐

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tradable goods is large and the prices of the first are reasonably well fixed in the outside currency, then the monetary result of pegging the domestic currency to the non-‐tradable goods is less sufficient. Such grouping of non-‐tradable goods may not be equivalent to a representative bundle of economic goods. The class of importables may be more indicative, and a currency of a small area pegged to maintain its value in terms of importables might have a higher liquidity value than one pegged to the domestically produced non-‐tradable goods. However, pegging a currency of a small area to preserve its value with regard to a repre-‐ sentative bundle of imports from a large outside area is in effect similar to peg-‐ ging it to the outside currency. Though if this peg is not credible in terms of the currency of a larger area, and therefore its liquidity value is less, then domestic nationals will try to obtain foreign bank balances, even if investments in the small area provide a higher profit than in the outside world. Besides small size, the illiquidity of domestic currency may also reflect monetary mismanagement.

In either case, it can be expected that small countries with fragile currencies have a proneness to subsidize the balance-‐of-‐payments deficits of larger countries with more desirable currencies, due to flow of money from the small to the large countries caused by the demand in the small countries for the more stable, se-‐ cure currency of the larger countries. Thus, capital outflows occur from countries where the demand for capital may be rather large and which arise from mone-‐ tary considerations (holding money in a more stable, secure currency), rather than real considerations (profitable investment opportunities). Authorities then are generally obliged to maintain rather stern exchange controls unless the cur-‐ rency can be pegged in a credible manner to that of the larger area.

Ishiyama, The Theory of Optimum Currency Areas: A Survey, 1975

In his article on the OCA theory, the Japanese economist Ishiyama distinguishes two approaches to answer the question of the appropriate domain of an optimal currency area; the traditional and the alternative approach. The traditional ap-‐ proach tries to indicate one single economic characteristic by which an optimum currency area can be defined (E.g. Mundell’s factor mobility requirement). Ishiyama criticises the traditional approach for lacking the idea of balancing the positive gains of a common currency against the losses of domestic policy in-‐ struments, in particular independent monetary policy. He advocates the alterna-‐ tive approach as it does exactly that; it evaluates the costs and benefits of a single shared currency from the perspective of the self-‐interest of a specific region or country, and recognizes the shortcomings of a theory based on a single economic feature.

Ishiyama provides a critique on Mundell's factor mobility requirement. According to him Mundell heavily underestimates the costs of immigration, a cost that reduces labour mobility significantly. Ishiyama states that it is unrealis-‐ tic to expect that when the economy declines in country A and grows in country B, the residents of country A will immigrate to country B. The high costs of immi-‐ gration, and thus the reduced level of factor mobility will prevent the stabilizing of the balance of payments.

Ishiyama points out a weak assumption in McKinnon’s ratio of tradable to non-‐tradable goods; Prices are stable in the rest of the world. Ishiyama argues that if the international economy is unstable, fixed exchange rates would channel

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the international instability to the domestic economy, therefore flexible ex-‐ change rates would be preferred in this case as they insulate the domestic econ-‐ omy for macroeconomic disturbances. Ishiyama thus states that McKinnon’s ra-‐ tio is an attractive theory only when the small open economy in question is less stable or less disciplined then the outside world, as then a fixed exchange rate would stabilize the balance of payments or discipline the monetary authorities. According to Ishiyama there are five important benefits to gain by sharing a single currency: (1) The shared currency is more liquid than the individual cur-‐ rencies. Besides decreased conversion costs and an increase in price stability as exchange rate fluctuation decreases, a broadly accepted currency will provide “access” to a larger number of goods. (2) A shared currency will result into a larger currency market and thus reduce the chance on speculative success, therefore authorities will be less opposed in their monetary control. (3) There will be a decrease in the need for foreign currency reserves; all reserves for the original foreign currencies can be monetized. (4) Risks will be pooled which leads to less costly payments adjustment and results in more efficient resource allocation and money holding. (5) It can be expected that sharing a currency will accelerate the process of fiscal integration.

Ishiyama also provides four disadvantages: (1) Sharing a single currency results in loss of autonomous monetary policy, and (2) loss of national fiscal pol-‐ icy. (3) If assumed that every nation has its own Phillips-‐curve, sharing a single currency could lead to unwanted outcomes, regarding the unemployment-‐ inflation relation; low-‐inflation countries with a surplus on the balance of pay-‐ ments could dominate the stage and force other countries to adjust their infla-‐ tion rates at the cost of rising unemployment. 4) Deterioration of the regional economies is possible, as capital is more mobile than labour and is assumed to flow away from low-‐growth to high-‐growth areas due to their relatively lower unit labour costs, thereby worsening the unemployment rate of the former.

Krugman, Second thoughts on EMU, 1992

The signing of the Maastricht treaty in 1992 led economist Paul Krugman to question the need for monetary integration by the EMU and the rationale behind the criteria of the treaty (1992). Krugman doubts if EMU is an optimum currency area; he states that there is no new evidence that the European nations would be better off giving up their monetary independence. He writes that there has been little progress in economic analysis or empirical results in the past 10 or 20 years that make the case for EMU stronger.

Krugman criticizes the use of the US as empirical evidence for the EMU. He provides three arguments why Europe experiences larger asymmetric eco-‐ nomic shocks than the US: (1) Due to the large economic diversity in Europe the economies are likely to suffer from instability inflicted by different origins and thus on different moments. Therefore the countries would benefit of flexible ex-‐ change rates, as fixed exchange rates would spread economic instability throughout the area. (2) Interregional labour mobility within Europe is lower than within the US, and therefore cannot adequately provide stabilisation on the balance of payments. (3) The proposed monetary integration in Europe is not accompanied by a political integration as in the US. This will lead to serious con-‐

Does EMU need political authority on economic and fiscal policy?