Is the Euro Area an optimal currency area?

The sovereign debt crisis, see also my blog post on the sovereign debt crisis that focused on deficit spending, has made more evident than ever that the Euro Area is deficient in many respects and one could reasonable state that it is far from an optimal currency area.

But, what is an optimal currency area? The theory dates back to the work by Mundell  who determined the conditions under which a currency area would be optimal. These conditions are basically the mobility of labor across the regions of that area, capital mobility, wage and price flexibility, the possibility of fiscal transfers (from richer to poorer regions) as well as common characteristics of business cycles.

Some of the characteristics are hard to be reached in the real world. Take for example the issue of wage and price flexibility. This is one of the foundations of New Keynesian economics and there is widespread evidence that every economy has some degree of wage and price rigidity.

Some other requirements are simply hard to be met given the realities of Europe; namely the fact that it is composed from national states which have quite different characteristics (think about the differences between the Nordic countries and the Southern ones).

Finally, only a few requirements can be truly met. Capital mobility is one of them, as there is a tendency in the world for free capital movements. However, for others it would take a lot of coordinated effort to implement them. For example, only in the aftermath of the sovereign debt crisis, the previous interdiction about fiscal transfers has been annulled. There is also the issue of business cycles similarities. The recent financial crisis has indicated that the member economies can react quite differently to the shocks affecting the monetary union. For example, Greece has passed through more 5 (five!) years of recession, Spain through a double-dip recession, while other economies like Germany started to grow, though with in weakly manner.

These things were quite known even before the Euro Area came to life. The famous critique by Friedman made clear that the Euro Area is doomed from the very beginning, the main reasons being the impact of asymmetric shocks, as well as the lack of true mobility of labor. The much earlier study by Eichengreen (1991) found the same weakness of the common currency area in Europe. Recently, Krugman also shared a similar point of view, pointing to the differences between the member states of the Euro Area with respect to key issues: labor mobility and fiscal integration.

The Euro Area seems an experiment made by politicians who largely ignored the economic realities. But the political ambitions cannot escape for too long the economic realities. No one knows exactly when the Euro Area will disappear, but one thing is clear for everybody: the Euro Area won’t remain for long as it currently is.

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