Critically assess the current Euro-Area as an optimum currency
area. What are the economic policies that can be adopted to
stabilise and sustain the union?
Introduction
Optimal currency theory highlights the necessary conditions for economic stability of a
region that considers adopting single currency. It was developed by Mundell (1961) and
elaborated by McKinnon (1963) and Kenen (1969). The peak of theory’s popularity came
during continuous debates regarding the establishment of European Monetary Union and
single currency – euro. Today, Eurozone is considered to be the biggest and economically the
most influential area with a single currency. The aim of this essay is to assess whether or not
Eurozone satisfies the underlying criterion of the optimal currency theory and discuss
prospective policy options that could improve the prevailing situation.
To begin with, it is essential to outline the criterion of sustainability of the region’s economy.
According to Mundell (1961), the main feature of the region has to be the mobility of factors
of production (labour) and flexibility of wages. McKinnon (1963) highlighted the openness
of the economies, whereas Kenen (1969) was primarily concerned about specialisation of
production within the region. Further criterion could be exemplified by similarity of
economic structure (Baßeler et al., 2006) and homogeneity of preferences. The main focus of
this essay, however, would be to consider the primary criterion: labour mobility and
flexibility of wages.
Labour mobility
The essence of labour mobility could be demonstrated through the following example. There
are two imaginary countries: A and B. If A starts experiencing trade surplus, B would
inevitably head towards deficit. The impact of this could be illustrated through the following
diagrams:
As it is shown above, rise in exports of country A leads to a surge in Aggregate Demand from
AD1 to AD2 on the first diagram, as a result of which there is hike in output and prices
beyond equilibrium level (Y1>Ye; P1>Pe). This leads to inflationary pressures in country A
and higher unemployment in country B. Yet, demand for currency A rises as well. The
, second diagram shows that this rise in demand leads to an appreciation of currency A from
P1 to P2, which reduces the competitiveness of all goods exported by A. Eventually, this
would result in a long-run contraction in exports and Aggregate Demand, until the economy
returns to its initial equilibrium Ye. In this case, thus, the exchange rate is the necessary
anchor that ensures automatic adjustment to equilibrium. Opposite applies to country B.
However, if countries adopt a single currency, exchange rate manipulations would be
impossible. If labour is fully mobile, unemployed from country B could simply move to
country A and create the necessary hike in Aggregate Supply to offset inflation. Equally,
country B would resolve the problem of unemployment and both economies would,
subsequently, be at their equilibriums. Therefore, under single currency regime, the mobility
of labour becomes the key to restoration of equilibrium positions.
The problem with the Eurozone, on the other hand, is that labour is not very mobile. The net
migration within the Eurozone was on average 3.1 person per 1000 people, which constitutes
roughly 0.31%. This implies that workforce prefers to rather remain within the same region
than travel across in order to find a job. The potential reasons for such phenomenon could be
barriers in mentality and languages. This is further illustrated by the fact that Germany took
the majority of 1.5 million Syrian refugees in order to cut its labour shortage, whereas
unemployment rate in Greece accounted for 19.3% with the Eurozone average being 8.2% in
2018. Finally, McKinnon (1963) also highlighted the mobility between industries, which is
crucial for transferability of skills. Also, workers in different countries tend to have different
productivities. Jager & Hafner (2013), for example, found that workers in Germany are twice
as productive as workers in Portugal. These factors could reduce the competitiveness of
workers from one country, even if there is labour shortage in another country.
Flexibility of wages
In terms of flexibility of wages, one potential policy option was the so-called ‘internal
devaluation’. Under single currency regime, nations would not be able to devalue their
currencies individually. However, these countries could manipulate the wage rate within the
economy. This would reduce the costs for the private sector, which could, eventually, lead to
plunging prices. In other words, the prices of domestically produced goods would fall and,
consequently, the competitiveness of domestically produced goods would surge, which would
create automatic adjustment to the equilibrium through the Aggregate Demand schedule. This
is partially shown by the Balassa-Samuelson effect, which aims to show the relationship
between labour productivity and inflation. The key anchor in this mechanism is the wage rate,
which rises as a result of higher productivity of labour and which leads to soaring prices and
vice versa. Consequently, wages can and do affect the general price level. This shows that
flexibility of wages could play an essential role in adjustment mechanism and a region with
flexible wages is more likely to succeed at maintaining stability within itself.
This, on the other hand, may not be the case for the Eurozone. Krugman (2013), for example,
mentioned the difficulties of changing individual labour contracts. This, therefore, implies
that wages in the EU are likely to be rigid downwards. In addition to that, one cannot dismiss
the institutional factors within the nations as well. Namely, trade unions and collective
bargaining may be more powerful in certain member countries in comparison to others. For
example, collective bargaining coverage in Spain and Germany varies between 50% to 75%,
whereas it is only 10% in Greece. This shows that trade unions are more powerful in the
former nations and, hence, the rigidity of wages is likely to be higher in those nations as well.
