‘Optimal’ Currency Area: What Does It Mean?

Abstract

The original theory of an ‘Optimal Currency Area’ was presented by Mundell (A theory of optimal currency areas. Am Econ Rev 51: 657–665, 1961). Conclusions were drawn using a neoclassical general equilibrium framework. This theory was employed when the Euro-monetarists, dominating the Delors-Commission (Report on economic and monetary union in the European community, Office for Official Publications of the EC, Luxemburg, 1989), recommended the establishment of a European Monetary Union, an independent European Central Bank, defined convergence criteria and the rules of public sector balanced budget. The theory has failed to foresee the current Euro crises. Alternatively, Euro-realistic theory, which takes analytical inspiration from Keynes’s macroeconomic methodology by using consistent stock-flow modelling, would have led to other and much less optimistic conclusions with regard to the outcome of imposing a common currency on the EU countries.

Appendix: Two Schools of Euro-Macroeconomics

Introduction

We cannot fully engage in a macroeconomic discussion about a monetary union within the EU (EMU) without being aware that two very divergent analytical frameworks are in use:

• 1. A neoclassical framework we could call euro-monetarism, developed by Robert Mundell and supported by a number of scholars, using a general equilibrium model as their analytical starting point.

• 2. A realist framework, taking its inspiration from post-Keynesian and institutional theories, and supported by a number of realists taking their departure from empirical evidence.

Euro-monetarism

Euro-monetarism takes as its point of departure the very simple demand and supply diagram well known to neoclassical microeconomics. This diagram is then used to explain the equilibrium in a number of macro-markets:

• 1. Labour markets

• 2. GDP markets

• 3. Capital markets

• 4. Foreign exchange markets

The equilibrating variable is the ‘macro price’ for each market, the money wage rate, the GDP deflator, the interest rate and the exchange rate.

In a general equilibrium macroeconomic model, all the assumptions of the conventional neoclassical ‘perfect’ market model are represented:

• 1. Individual optimisation

• 2. Perfect foresight, that is, rational expectations

• 3. Many competitors and perfect competition

• 4. Flexible price/wage adjustments (equilibrating each market)

In addition, this is important:

• 5. A general equilibrium solution to the entire model is taken for granted. If all market prices are fully flexible, then the model will – by itself – generate a general equilibrium, which, according to the microeconomic foundations and related assumptions is a so-called Pareto Optimal solution.

According to this general equilibrium model, countries will always subscribe to the idea of an ‘optimal currency area’. Here, the permanent benefits of the common currency providing lower transactions costs will always outweigh the costs of short-term macroeconomic mal-adjustment; that is, as long as we hold the assumption that the macroeconomic system is self-adjusting. Any macroeconomic deviation from the general equilibrium is then assumed to be caused either by a lack of price-/wage-flexibility or by a policy encroachment.

We have presented a prime example of how euro-monetarists do not connect their arguments to reality. Even a relatively open-minded euro-monetarist like Paul De Grauwe writes, in a fairly recent edition of his textbook, that ‘The recent Eurozone crisis lends some credence to the view that the present Eurozone is not an optimal currency area’ (p. 78).

Euro-realism

Realist macroeconomics asks the question: What can we know from real-world observations in regard to macroeconomic imbalances? Here it becomes obvious that unemployment, a budget deficit and imbalances of payments are all integral to the understanding of the economic developments in the EMU countries. Moreover, serious macroeconomic imbalances are not only a post-crisis situation. They have been a part of reality ever since the EMU was established. It is important also to emphasise that the imbalances have grown within the EMU as a whole and also between the participating countries during the 17 years of EMU.

In general, reality simply does not support the neoclassical assumption of a self-adjusting macroeconomic system. In fact, the empirical data indicate that the exact opposite is the case:

• 1. Unemployment is close to its highest ever for the entire EMU period.

• 2. The variance of unemployment amongst the EU countries has never been higher.

• 3. Balance-of-payments imbalances and foreign debt have grown between member countries.

• 4. Differences in real effective exchange rates have exceeded 30  percentage points compared to 1999.

• 5. Real economic growth rates are deviating more and more.

• 6. Long-term interest rates are more diverse than ever.

Moreover, a neoclassical general equilibrium model is of little use in explaining these macroeconomic developments. One should instead set up an analytical framework where persistent imbalances can be explained and, to that end, a post-Keynesian analytical model is useful. Here, effective demand is the driving force (see Jespersen 2012). The textbook ‘Introduction to Macroeconomics’ (Jespersen 2013/2007, English version) provides a fundamental/comprehensive/basic starting point for such an analytical endeavour.

Effective demand could be thought of as the analytical pivot insofar as it is defined as the output of goods and services on the part of the private sector, given a set of uncertain expectations: aggregate domestic and foreign demand, profitability, availability of credit, finance, technology and qualified labour. In the original Keynes model, entrepreneurs will hire people after having decided on how much to produce in the coming period. Hence, where 80 percent of workers constitute unskilled labour, the employment function has rather a simple relationship in this model. In contrast, the ‘employment function’ is much more complicated for a modern society with more diversified labour and a higher degree of foreign competition. In the end, employment is determined by effective demand.

Hence, together with profitability, entrepreneurs’ expectations of future sales constitute the crucial variables for consideration. However, expectations about the future cannot, in reality, be assumed with any degree of certainty (i.e., the neoclassical assumption). One would take quite the contrary to be the case, being that expectations of the entrepreneurs are by nature uncertain; that is, they are related to the unknowable future. Hence, the most challenging question to pose is how entrepreneurs form expectations in an environment constituted by uncertain information about the future and, in particular, the impact of a common currency.