OPTIMUM CURRENCY AREA

Soyisile Dlulane 201127781
0
OPTIMUM CURRENCY AREA: Lessons from
the European Monetary Union (EMU)
Report submitted in partial fulfilment of a B com honours
In
INVESTMENT MANAGEMENT
In the
DEPARTMENT OF FINANCE AND INVESTMENT MANAGEMENT
Of the
UNIVERSITY OF JOHANNESBURG
By
Soyisile Dlulane
(201127781)
19 October 2012

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Abstract:
The theory of optimum currency area (OCA) has been a study of monetary
integration since the 1960s. The theory tries to answer an exchange rate based
question; what is an optimum currency area and/or what is a decision process for
defining such an area. Since the developments of economic and monetary
integration in the European region, the theory of optimum currency area has been
revisited and referenced with the ambitions to address a number of questions,
including whether a single European currency will ever come to operation. Post 1999
after the succession of the last stage towards the European Monetary Union (EMU)
this theory has been applied in defining the sustainability of the EMU, whether the
EMU is an optimum currency area.
This study objectively address the very same question, is the European monetary
union an optimum currency area? The motivation for this study has been the
transpired European debt crisis of 2008-2011. We develop our arguments by
comparing the construction and operation of the EMU (which is filled with flaws that
are believed to have led to the continuous spreading of the Euro debt crisis) to the
history of monetary unions based on the theory of optimal currency union.
It has been noted that the OCA theory has evolved since the 1960s.Though the
pioneering views are still very applicable, the modern views suggest that the decision
process for defining an optimum currency area does not conclude with a yes or no
answer, but is a developing process that increasingly benefits the parties within the
union. This was supported by the history of the monetary unions (with reference to
the United States of America Monetary Union).
The European Monetary Union (EMU) was found to be aligned with this trend.

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Table of contents
Abstract........................................................................................................................1
Study objectives...........................................................................................................3
Relevance of the study................................................................................................3
Methodology................................................................................................................3
Chapter 1: Theory of optimum currency
1.1 Introduction.................................................................................................5
1.2 The history of optimum currency area........................................................6
1.3 The pioneering phase.................................................................................7
1.4 The modern phase......................................................................................9
1.5 The benefits and costs of joining a monetary union..................................11
1.6 Summary...................................................................................................12
Chapter 2: The creation of monetary unions (lessons from history)
2.1 Introduction...............................................................................................13
2.2 National monetary unions.........................................................................13
2.3 Multinational monetary unions..................................................................14
2.4 Why are monetary unions created and dissolved.....................................14
2.5 Summary...................................................................................................15
Chapter 3: European monetary union
3.1 Introduction...............................................................................................16
3.2 The construction and operation of EMU...................................................17
3.3 The observations of the EMU with reference to the OCA theory..............21
3.4 The future of the EMU (The lessons from creation of monetary unions).25
3.5 Summary...................................................................................................26
Chapter 4: Conclusion............................................................................................27
Bibliography

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Study objectives:
The objective of this study is to discuss the lessons from the shortcomings (costs
and benefits) in the construction and operation of European Monetary Union (EMU)
and thus use the lessons to discover if EMU is an optimum currency area.
In this study the costs and benefits of a monetary union are defined by the theory of
Optimum Currency Area (OCA). A benefiting monetary integration is one that its
construction and operations fulfil the following OCA properties; price and wage
flexibility, production and mobility factors, the degree of economic openness, the
diversification in production and consumption, fiscal integration, and political
integration. Such a currency area is thus deemed an optimum currency area.
Relevance of the study:
The world has been operating under globalised production processes. Many
commentators see a future of global finance and resulting into a global currency. The
creation of the European Monetary Union, after it had been opposed by many
because it is not an optimum currency area, has sparked views that a global
currency will soon two follow even though the world is not an optimum currency area.
Hence the question to be answered is whether there will be benefits for joining a
non optimum currency area, and will it converge to an optimum currency area in
future. The European Monetary Union is the perfect set-up to answer these
questions.
Methodology:
As mentioned above, the objective of this study is to discuss the lessons from the
shortcomings (costs and benefits) in the construction and operation of European
Monetary Union (EMU) and thus use the lessons to discover if EMU is an optimum
currency area. A wide range of literature was the source of this study.
In chapter one, the theory of optimum currency area is discussed. The chapter is
divided into four sections. Section two is the history of optimum currency, where we
discuss the pioneers of the theory. Section three discusses the first developments of
the theory. Section four presents the modern phase of the theory where we discuss

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how the theory has evolved. The last section of the chapter discusses the benefits
and costs of joining a monetary union as suggested by the theory.
Chapter two presents the history of monetary unions, aimed at discussing the
lessons from the historical monetary unions those that have been created and
dissolved, and as well as distinguishing between the two types of monetary unions
(national and multinational monetary unions). The chapter is divided into three
sections. Section two present the national monetary unions, where the United States
monetary union is discussed. Section three presents multinational monetary unions.
Section three we discuss lessons from history why are monetary unions created and
dissolved.
In chapter three, the European Monetary Union (EMU) is discussed with a focus on
its construction and operation. The aim of the chapter is to reflect the set-up of the
EMU (construction and operation) to the OCA theory and the lessons from the
history of monetary unions, while providing empirical evidence from the Euro depth
crisis. Section two presents the construction and operation of the EMU according to
the Maastricht treaty convergence criteria. The shortcomings to the construction are
discussed and evidenced by discussing the impact of the debt crisis. Section three is
the observation of the EMU according to the properties of the OCA theory. We
discuss how the EMU has achieved these properties in order to define if it is an
optimum currency area. Section four is the future of EMU as per lessons from the
history of monetary unions. This section we discuss if the EMU will converge to an
optimum currency area.
Chapter four presents the conclusions.

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Chapter 1: Theory of Optimum Currency Area
1.1 Introduction
Optimum currency area (OCA) is a term that was first introduced in Mundell 1961 to
define a geographical region that would maximize economic efficiency through
integration of monetary operations. The integration of monetary operations is defined
by Mundell as the adoption of a single currency or several currencies whose
exchange rates are pegged. The theory of optimum currency area presents
properties which are used as gauge measures for determining the probability of a
geographic region (optimum currency area) forming a successful monetary
integration and hence maximizing economically, by reducing shocks impact
(economic disequilibrium) to the region. The probability of success for a monetary
integrated geographic region is based on the regions balance of benefits and costs
and measured by the properties of OCA theory.
The theory relating to monetary integration was first talked about around 1950 during
the debates of fixed versus floating exchange rate regimes. Economist such as
Mundell, Friedman and Meade debated the benefits and cost of alternative exchange
rate regimes to achieve external balances, free policy tools, obsolete of trading and
exchange controls. These discussions presented two types of regional monetary
integration (1) national and (2) multinational monetary integration.
However as was in 1950, an optimum currency area (as defined above) is still a
very ambiguous region even with today’s developments of the theory referencing the
practicality of European Monetary Union (EMU).
This chapter discusses the theory of Optimum Currency Area. The chapter is divided
into four sections. The first section overviews the history of the OCA theory. The
second section discusses the pioneering phase of the OCA theory. The third section
discusses the new views of the OCA properties, and finally from the development of
the OCA theory we present the benefits and costs of joining a monetary union.

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1.2 The history of Optimum Currency Area.
In 1950 under the Bretton Woods system of fixed exchange rates began the debates
by economists such as James Meade (1957), Milton Friedman (1953), Robert
Mundell (1961) McKinnon (1963) and Kenen (1969). The debates were encouraged
by the need for free policing and free capital controls for better balance of payments,
free trading and exchange rate controls. Pegged and adjustable exchange rates
were some of the characteristics of the Bretton Woods exchange rate regime. Hence
the question of optimum national and multinational exchange rate regimes was
asked.
James Meade (1957) and Milton Friedman (1953) both endorsed the idea of flexible
exchange rates suggesting that flexible exchange rates are a device for achieving
external balance while freeing policy tools for the implementation of nation planning
objectives and getting rid of exchange rate and trade controls (Mundell, 1997).
Robert Mundell however disagreed with the idea of using exchange rates as a
mechanism of economic management, suggesting a need for mechanism that
results into minimum adjustment of exchange rates. Mundell, 1958 argued that the
Canadian dollar which was then floating was still implicated by the United States of
America’s (USA) business cycle.
In 1953 Maltin Friedman published his paper “the case for flexible exchange rates”
which is attributed to have influenced the exchange rate views to be latter known as
OCA theory.
In 1961 Robert Mundell published his work titled “the optimum currency area”. In this
paper Mundell proposed the joining of countries by a single currency or by fixed
exchange rate regime (several currencies pegged), but only for those countries that
fit a set of properties that he named the OCA theory.
The development of OCA theory is divided into two phases, the pioneering phase
(1950), and the Morden phase of starting from early 1990.

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1.3 The pioneering phase
The pioneering phase is the period between the mid 1950s and the late 1970s. This
period in the history of economics was characterised by debates of fixed versus
flexible exchange rate regimes. The division between those who endorsed fixed
exchange rates (Milton Friedman) and those who endorsed flexible exchange rate
regimes (Robert Mundell) encouraged the question of “what is the optimum
exchange rate regime for a given country”.
Mundell 1961 was the first to suggest that the currency area does not necessary
have to be a country but a geographic region whose borders need not necessary
coincide with country boarders and such a region would have permanently fixed
exchange rates, hence achieve economic rebalancing following disturbance (shock)
without the use of exchange rate policy adjustment instead using OCA properties.
The theory of optimum currency area is the decision to form a currency area by
adopting a single currency or several currencies whose exchange rates are pegged.
The optimality of a currency area is the degree to which it satisfies the following
proprieties;
a. Price and wage flexibility.
Price and wage flexibility defines the stickiness of trading between countries, and
the determining factor of inflation and employment balances. Mongelli 2002
suggest when nominal prices and wages are downward flexible between and
among countries contemplating a monetary integration, the transition towards
adjustment is less likely to be associated with sustained unemployment in one
country and/or inflation in another. According to Friedman 1953 achieving price
and wage flexibility between two countries would in turn diminish the need for
exchange rate adjustment.
b. Mobility factors (labour and production).
Mundell emphasised on labour mobility as the most important mechanism to
restore equilibrium in a monetary integrated region, and very dependent on the
size of the region. He illustrates factor mobility with the used of an example
between two regions (region A and region B) by suggesting, at prevailing market

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shocks there is a shift in demand for region A products towards region B
products, therefore creating inflation in region B and unemployment in region A.
Using exchange rate regimes to restore equilibrium sacrifices one region for the
other, while using labour mobility would only need a shift of region A’s labour to
region B. Corden 1972 questioned the practicality of labour mobility based on
cost, and difference in language and culture between the two regions.
Further development of this property was presented by McKinnon (1963) by
distinguishing mobility into labour and production. Suggesting production mobility
would restore equilibrium in regions A and B, by developing region B products in
region A.
c. The degree of economic openness.
Broz 2005 defines economic openness as the enabling factor for transmission of
international exchange rates to domestic cost of living, hence reducing money
illusion in the wages contracts and prices given that the currency regions are at
flexible exchange rate regime with the world.
Economic openness according to Broz (2005) can fully be achieved to the degree
required for fixing exchange rates (or monetary integrating), only by small
economies. He argues, it is often inefficient for a small economy to produce all it
needs, and advantageous to engage in foreign trade and produce only those
goods in which it has a competitive advantage, while this may create
specialisation. On the other hand, a large economy is more self sufficient and
usually marginally engaged in foreign trade, hence minimum economic openness
or less influence by international exchange rates.
d. Fiscal integration.
Fiscal integration is a public risk sharing arrangement. Public risk sharing allows
transfer of funds to a member of currency area affected by an adverse shock and
hence facilitating in the adjustment process that requires less monetary policy
(interest rate) variation. Bordo and Markeiwicz (2011) suggest that such
integration would require an advance degree of political integration and
willingness to undertake risk sharing withstanding possible moral hazards and
other operational difficulties.

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e. Political integration.
The political will to integrate is regarded as the stem of monetary unification. It is
defined as the similarity of policy attitudes among partner countries, including
monetary and fiscal policies. The imperial observations from the recent European
Monetary Union have streaked a new direction in political integration as a result
of its unique arrangement. This new direction calls for a new benchmark for
assessing the satisfaction of political integration. Mongelli 2002 presented this
new assessing benchmark as; (1) functional political integration, (2) transferred
sovereignty over several elements of the member’s economy, and (3) Increased
need for policy co-ordination.
1.4 The modern phase
Remarks on the pioneering theory of optimum currency area have been made, many
questioning the practicality of the monetary unification decision process proposed by
the theory. There questioning mainly due to the suggested ambiguousness of the
properties, the highly diverse economies of countries and hence a lack of practical
examples. Tavlas 1994 observed the problem of inconsistency and inconclusiveness
of the properties, Mongelli 2002, observed the problem of measuring and evaluating
the properties. Due to the above shortcomings of the OCA theory the 1960s to
1970s initial research interest decreased to a level of almost forgotten in the
literature of economics.
The birth of the European Monetary Union (EMU) in the 1990s brought back the
research interest on the topic of monetary integration, mainly to determine the cost
and benefits of countries joining the EMU.
The modern phase became an in-depth study of the application of the pioneering
phase Theory. “These economic developments (the EMU) have allowed the original
optimum currency area approach to be cast in a new light” (Tavlas, 1993). The
difference between the views about the OCA theory in the pioneering phase and the
modern phase is that the pioneering phase was a debated theory on potential cost of
monetary unification, while the latter is an empirical test on potential benefits of
monetary unification referred to as the endogeneity of OCA. Frankel and Rose

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(1997) are attributed as the biggest influence of what has evolved to modern OCA
theory.
There are multiple issues that the modern phase theory of optimum currency tries to
address in attempts to optimise the decision process of monetary unification,
including; endogeneity of OCA theory, effectiveness of monetary policy, credibility of
monetary policy, political factors. This study will focus on the endogeneity of OCA.
1.4.1 Endogeneity of OCA theory
The endogeneity of OCA theory is defined as a correlation study between countries
economic factors that are said to inspire monetary integration. These factors include;
the level of trade between the countries, the similarity of the stocks and business
cycles experienced between the countries, the degree of labour mobility, fiscal and
political will. The endogeneity of OCA theory concludes that there is an existing
interaction process or correlation between these factors, which suggests that
monetary integration is a self reinforcing process and hence the optimality/benefits of
a currency area increase with time. Frankel and Rose 1996 studied trade integration
and income correlation, see Figure 1.
Figure 1: Trade integration, income correction and OCA line
Source: Tanja Broz 2005
Sweden, UK,
Denmark
Advantages of
monetary
independence
dominate
Advantages of
common currency
dominate
EMU
US States
OCA line
Extent of trade among
members of group (x-axis)
Correlation of
income among
members of
group (y-axis)

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The downward sloping OCA line indicates that the advantages of adopting a
common currency depend positively on the level of trade and income correlation
between countries. Thus meaning if countries that trade a lot between them and
have a high income correlation they might find it advantageous to form a currency
area, and for those countries that are not advantageous to form a currency area
(below the OCA line) once they join the currency area further trade integration will
increase the income correlation and become an optimum currency area (move
above the OCA line). They concluded that countries could satisfy the OCA criteria
ex-post, even though they did not ex-ante.
1.5 The Benefits and costs of joining a monetary union
In the introduction of this chapter it was noted that OCA theory is a framework that
tries to systematically define the benefits and costs of joining a monetary union. The
depth of the chapter presented views from both the pioneering era and the modern
era of OCA theory. The difference and broadness of the views, regarding the correct
properties for measuring the optimality of a region, suggest that benefits and costs
are of varying profiles over time and thus cannot be measured statistically. However
the main benefits and costs can be classified as follows:
1.5.1 Benefits;
a. Benefits from improvements in microeconomic efficiency. This is a result of
one currency circulating over a wider area as a unit of account, medium of
exchange, standard of deferred payments and store of value. Thus increasing
liquidity, price transparency, while discouraging price discrimination and
promoting markets competition. Effectively the microeconomic
competitiveness strengthens the internal market for goods and services,
promotes trading, while lowering investment risks.
b. Benefits from increased macroeconomic stability. This is a result of improved
overall price stability, the access to broader and more transparent financial
markets increasing the availability of external financing. The increase of
symmetric shock within different markets of the currency area.
c. Benefits from positive external effects, as a result of savings on transaction
costs due to a wider international circulation of the single currency.

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1.5.2 Cost;
a. Costs from the deterioration in macroeconomic efficiency. The primary
objective of monetary unification is to share risk and reduce asymmetric
shocks. Hence it is only normal that a supra-national central bank is
established to manage monetary policies for the currency area. In the
presents of a central bank, therefore the main cost to national governments is
relinquishing monetary policy independence. In a monetary unification, no
country can pursue some real adjustment in the wake of asymmetric
disturbance. Therefore the cost of relinquishing monetary policy
independence depends critically on the nature of future shocks and
characteristics of the new economy.
1.5 Summary
The chapter presented the theory of optimum currency area, highlighting five
properties for the monetary integration decision process, and the modern theory. The
benefits and costs to members, in terms of OCA theory are defined as; benefits from
savings on transaction costs as a result of wider international circulation of the single
currency, and costs from giving up national monetary sovereignty.
Over the past 51 years since the pioneering views by Robert Mundell, the theory has
evolved and focused on the empirical evidence from the European Monetary Union.
The pioneering theory is still adopted in defining currency areas. The overall OCA
theory is still very limited, ambiguous and thus still much challenged in its application
to measure the cost and benefits for joining a currency area. The modern phase
theory has discovered that even non optimum countries wanting to form a monetary
integration can proceed and form a currency area as their optimality will increase
with time, due to increased correlation between members economic factors.

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Chapter 2: The creation of monetary unions (Lessons from history)
2.1 Introduction
A monetary union or currency area is the extreme version of a fixed exchange rate
regime. The essence of a monetary union is that all the member states adopt the
same currency as a unit of account, medium of exchange and store of value. This
implies that the monetary union has one exchange rate towards the rest of the world.
The history of monetary unification dates back to the 19th
century and is rooted in the
history of political cohesion. For example after the American revolutionary war which
generated problems of exchange rate risk, and high transactions cots, led to the
creation of the US monetary union. The political will to create an independent
Germany resulting from the creation of a German currency.
The history of monetary unions is best understood by making a distinction between
national and multinational monetary unions.
2.2 National monetary unions
A national monetary union can be distinguished by the rule of single monetary
authority, usually a central bank. In a national monetary union political and monetary
sovereignty are the basis rational for wanting to establish a monetary union, and
hence national monetary union is mostly at best interest for the parties.
a. The united states of monetary union (USMU)
The United States of America is often forgotten that it is a monetary union, which has
been through multiple shocks resulting to its dissolution (1861) and finally reuniting in
1879. The sustaining of the union from a non optimum currency area to an optimum
currency as we know it today is attributed to integrated political will.
Prior the revolutionary war (1776 – 1783) the currency of the United States varied in
every state. After the war, as a result of exchange rate risk and high transactions
costs, states paper money was banded. In 1789 the United States Monetary Union
(USMU) was created by the signing of the constitution. The constitution gave the
congress the sole power to issue money and regulation of its value. The USMU
experienced are number of shocks, including 1837 banking crisis and 1839

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recession. It was only until 1861 during the Civil war that the USMU dissolved, and
reunited in 1879 to gold standards. After this period the USMU faced a number of
political related oppositions and economic pressures, the 1890 and 1930 great
depressions.
2.3 Multinational monetary unions
A multinational monetary union is an international monetary arrangement between
independent countries based on permanently fixed exchange rates between their
currencies. Multinational monetary unions occur when independent nation states link
their monies together through a perfectly fixed exchange rate so that one member’s
money is perfectly exchangeable for another member’s at a fixed price. An extreme
example of this would be that all member states use the same currency.
Some of the historical examples of multinational monetary unions are;
a. The Latin Monetary Union
b. The Scandinavian Monetary Union
2.4 Why are monetary unions created and dissolved
Monetary unions have been created and dissolved for a number of reasons this is
evident in the entire history of monetary unions. Multinational union brake ups have
been the most common. Multinational union brake ups cost less due to already
established members central banks and domestic currencies. The process proves to
be much costly for national unions and thus such brake ups have been minimal.
From the lessons in history of monetary unions, the creation of monetary unions is
inspired by one of the following factors (and thus dissolved when they are violated);
a. Political integration
Political integration is mainly the reason for national monetary unions.
b. Economic reasons
Economic reasons include transaction costs, trade benefits, and wider
markets. Economic reasons inspire both national and multinational monetary
unions.
c. Non economic reasons (demographics)
This includes, common history, a common language, culture and religion, and
greatly inspires multinational unions.

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2.5 Summary
In this chapter we presented the lessons from the history of monetary unions. The
main focus was to use the history of the United Sates monetary union to illustrate
how a monetary union evolves over time. The most important lesson from this
chapter is that, the difference between sustaining and dissolution of a monetary
union is positively related to the degree of political integration, economic reasons
and demographic reasons.
The history of the United States monetary union shows that benefits of monetary
integration increase with time, which is supportive of the OCA theory endogeneity
presented in section 1.4.1.

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Chapter 3: European Monetary Union
3.1 Introduction
The history of the European region up until the end of the Second World War was
dominated by power disputes over the countries. This era saw large areas of Europe
being united by empires built on force, such as the Roman Empire, Frankish Empire
and later the Nazi Germany. In many cases these power disputes resulted into wars
that would later have greater cost to the region. Thus unity by peace had been
inspired within many countries of the region before the idea of European region.
Post the Second World War, European leaders in many ways had acknowledged the
negative impact of non-unity in the region, including labour costs, industrial and food
costs and the future of monetary stability post the dissolving of the Brent Wood
standard of fixed rates.
The European leaders of the era 1945 – 1957 learning from the United States of
America (which post the Second World War dissolved its monetary unity but
remained politically united) were inspired to achieve political unity rather than
monetary unity. Effectively political unity would preserve peace and ensure to never
have wars. The first call for such action was the treaty of Paris (1951) creating the
European Coal and Steel Community and establishing the very first European unity
comprising six countries. The Merger treaty which was signed in 1965 creating a
community of shared courts and common assembly.
These are pioneering developments that have inspired the current European
Monetary Union. They signify how the construction and operation of unity has
evolved over time compared to the current Maastricht treaty (1993). The construction
and operation of treaty of Paris and Merger treaty called for political unity, but the
Maastricht treaty entitles political independency under monetary unity.

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3.2 Construction and operation of the European Monetary Union.
In its construction the EMU has been very unique compared to historical monetary
unions. The first stumble regarding the EMU is whether it should be classified as a
national or multinational monetary union. The European Monetary Union was
created by the signing of the Maastricht treaty in 1993. The Maastricht treaty is made
up of five convergence criteria, which defines the benchmark that only European
region countries must comply by in order to join the EMU.
Maastricht Treaty;
a. Each country's rate of inflation must be no more than 1.5 above the average
of the lowest three inflation rates in the European Monetary System (EMS).
b. Its long-term interest rates must be within 2% of the same three countries
chosen for the previous condition
c. It must have been a member of the narrow band of fluctuation of the ERM for
at least two years without realignment.
d. its budget deficit must not be regarded as 'excessive' by the European
Council, with 'excessive' defined to be where deficits are greater than 3% of
GDP for reasons other than those of a 'temporary' or 'exceptional' nature.
e. Its national debt must not be 'excessive', defined as where it is above 60% of
GDP and is not declining at a 'satisfactory' pace.
3.2.1 Shortcomings of the European Monetary Union
Economists have pointed to a number of shortcomings, also termed, flaws or
potential fault lines in the construction of EMU. There are by now a multiply areas of
concern in the EMU that have become transparent as the result of the European
debt crisis. In this study we only focus on the most common flaws, those that pertain
to the EMU once it was established and are believed to have resulted to the
spreading of the European debt crisis.
a. Lack of authoritative power.
EMU lacks a central authority to supervise the financial systems, including the
commercial banks, of Europe. The Maastricht treaty gives the ECB some

18
supervisory functions but they are primarily the task of the union members.
This state of affairs remarks that a European financial crisis may not be
efficiently resolved, consequently threatening the sustainability of the
European Monetary Union. Lessons from the recent European debt crisis the
inefficiency of resolving was evident when it took months for a consensus
decision among national leaders to be reached and prevent the asymmetric
shock spread.
b. Lack of lender of last resort
The ECB has not been granted power by the Maastricht treaty to serve as a
central lender of last resort. This stands in sharp contrast with modern central
banks, which exercise lender of last resort responsibilities to guarantee the
liquidity and functioning of the payments system. During the out brake of the
European debt crisis in 2010 the European Financial Stability facility (EFSF) was
created with €1 trillion aimed to prevent the collapse of member’s economy, and
future shadowing the accountability of the ECB.
c. Danger of members political interest
According to the Maastricht treaty the exchange rate policies for the EMU are
to be set by the council of the European Union which is made up off the
financial ministers of each member of the EMU. Bordo 1999 suggest that this
invites danger that will result in political discussion, tensions and political
pressure on monetary policies.
d. Lack of fiscal unity
The absence of central co-ordination of fiscal policies within EMU in
combination with strict convergence criteria for domestic debt and deficits, as
set out in the Maastricht rules implies that EMU will not be able to respond to
asymmetric shocks in a satisfactory way. In most cases in literature non fiscal
integration is referred to a lack of public risk sharing arrangement. According
to Bordo and Markeiwicz (2011) there is a positive relation between monetary
and fiscal policies, thus requiring a single independent body to manage both.
They argued that the arrangements of historical monetary unions have given

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the Central bank the responsibility of both monetary and fiscal policies, which
makes the European Monetary Union a unique and unprecedented set-up.
e. EMU not an optimum currency
This point has been acknowledged by most researches beyond 1999
highlighting that Europe is too large a geographical area to unify optimally
based on the theory of optimum currency. Yuceol, 2002 concluded that the
efficiency gains from increased trade do not outweigh the costs of
surrendering control over national monetary policies. Off course the European
Monetary union has expanded the membership post the European debt crisis,
to current 27 countries. However the point suggested by Yuceol (2002) was
very evident in the case of Ireland. Ireland achieved gains after joining the
EMU in the form of debt to GDP ratio declining steadily from 65% in 1997 to
25% in 2007, hence being one of the EMU countries with the lowest public
debt burden. In the pick of 2008 its debt to GDP ratio balloon from 25% in
2007 to 95% in 2010, proving to outweigh the early gains.
3.2.2 Empirical evidence from the 2008 – 2011 European debt crises.
It is often assumed that the European debt crisis was primarily a result of
government spending. Really, the origins of the European debt crisis can be directly
traced back to the global financial crisis of 2007-2010, which spilled over into a debt
crisis in several European countries in early 2008.
Based on this observation the interest of this section is to present the empirical
evidence of the theatrical flaws of the European Monetary Union presented above.
The most highlighted shortcoming of EMU in recent literature is the lack of unified
fiscal policy structures such as common taxations, budget, and pension and treasury
functions. The lack of such fiscal policy structures is argued to have been the reason
the global economic shock of 2007-2010 established it’s self in the European
economy as asymmetric shocks that resulted to different consequence to countries
within the EMU.
According to theory of optimum currency area integrated fiscal policies for adjusting
from asymmetric shocks is one of the main criteria for joining a monetary union,

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because it stems on political integration. As a result of lack of integrated fiscal
regulation, the member countries of EMU continue to exercise considerable
sovereignty in several economic areas. The most important ones are the budgetary
and taxation. As a result, asymmetric shocks were created that lead to inflated
budget deficits.
The increasing budget deficits
In the Maastricht treaty one of the convergence criteria is to limit budget deficit to not
exceed 3% GDP. However due to the independent fiscal regulation countries
including Greece and Italy, were able to by-pass these rules and hide their deficit
and debt levels through the use of complex currency and credit derivatives
structures. The structures were designed by prominent U.S. investment banks. As a
result, between 2007 and 2010, the debt to GDP ratio of the European region
increased from 66% to 85% (Figures 2)
Figure 2: Public debt as a percentage of the GDP (1995 – 2010)
Source: Ulrich Volz 2012
Figure 2 shows that the level of Greek debt was already very high before the global
crisis, at 105% of GDP in 1999. Greek debt, which has been on a continuous rise

21
since 2003, reached a level of 150% of GDP in 2010. Similar to Greece, Italy had a
debt level above 100% of GDP prior to the crisis, but unlike in the case of Greece the
debt to GDP ratio of Italy fell between joining of the euro in 1999 and 2007.
On the brake of the Irish banking crisis in 2008 as a result of Irish government put
under pressure over €440 billion worth of liabilities. As a consequence, the Irish
deficit ballooned and the debt to GDP ratio shot up from 25% in 2007 to 95% in
2010. However in the history of Ireland there had never been any fiscal or debt
problem until 2008, which shows the cost of joining a monetary union. Accordingly
from figure 2 the Irish debt to GDP ratio declined steadily from 65% in 1997 to 25%
in 2007, hence being one of the EMU countries with the lowest public debt burden.
Spain very similar to Ireland it had never recorded fiscal or depth problem up until
2008. Spain was one of the countries at the time that had not violated the Maastricht
treaty rules, have an annual budget deficit no higher than 3% of GDP and a national
debt lower than 60% of GDP. The circumstance occurring in Spain could be
explained as the repercussions of the asymmetric shocks in the European economy
resulting from global crisis.
3.3 The observations of the EMU with reference to the OCA theory
In this section we discuss the construction of EMU with respect to the optimum
currency area presented in chapter 1. The objective of this study is based on this
section, to observe the EMU under the debt crisis circumstances with respect to the
OCA theory and compare with similar circumstances that the history of monetary
unions experienced.
a. Price wage flexibility
In chapter 1, Price and wage flexibility was defined as the stickiness of trading
between countries, and the determining factor of inflation and employment
balances. It was also noted that in the existence of price-wage flexibility, the
need of varying fiscal policies to adjust for shock is minimal.
The concept of price and wage flexibility can be better understood through
analysis of interest rates between the members of the Union. Figure 3 shows
long term interest rates between 2009 and 2012, and a reflection of the

22
attempt by the ECB to reduce the debt crisis through fiscal changes. The
proposed fiscal plan was to change tax and interest rate regulations to only
those countries that were suffering from budget deficits. In theory this plan
would increase trading or price wage stickiness between the members and
thus exacerbating the impact of asymmetric shock. This is because there is a
positive link between fiscal policies and employment legislations.
Comparing the EMU to historical monetary unions, Mongelli (2002) concluded
that the United States of America Monetary Union (USAMU) achieved a better
position in flexing prices and wages, while experiencing similar shocks, than
what the EMU has achieved.
Figure 3: Long-term interest rates (2009 – 2012)
b. Labour market integration
Labour mobility was defined as the ability of the currency area to migrate the
labour force from regions of low growth to regions of high growth, while in the
process off-setting shock impact, and minimising the need for fiscal
interventions. In the case of the EMU this factor is very unlikely to ever be
achieved. This is due to the lack of homogeneity in the demographics of the

23
European Monetary Union. Language, wages and employment being the
most important factors towards achieving labour integration. Figure 4 shows
labour cost in the European Union and positively argues the point that labour
integration is unlikely to be achieved within the near future. For example
assuming homogeneity in other factors (including language) except for labour
costs, thus moving Italian labour force to Germany would prove more
problematic. The Contrast between the EMU and historical monetary unions
(USAMU) is that, the EMU was unable to make use of labour mobility to
manage the shock of debt crisis.
Figure 4: Labour cost among EMU members (2000 – 2010)
c. The degree of economic openness
Economic openness is a factor for transmitting international exchange rates to
domestic cost of living, hence reducing money illusion in the wages contracts and

24
prices given that the currency regions are at flexible exchange rate regime with
the world. Mongelli 2002 found that, economic openness as measured by the
ratio of exports plus imports of goods and services to GDP is quite high across all
European countries. De Grauwe 2011 reported that the ratio of exports plus
imports to GDP ranges from 40 percent in Spain, to over 150 percent in
Luxemburg, and compared with 65 percent to over 210 percent between the
states of USA.
d. Fiscal integration
Fiscal arrangement of the EMU has been under enormous heat ever since the
Euro-debt crisis. Prior to the Euro crisis some economist argued that the fiscal
integration of EMU was the best fitting arrangement for such a monetary
arrangement. These economists suggested that due to the type of
arrangement the EMU is, as set out in the Maastricht treaty. Therefore its
fiscal integration was of two folds; (1) fiscal convergence, and (2) fiscal unity
(public risk sharing factor). Fiscal convergence is the benchmark to be
satisfied in order to join the EMU, including having an annual budget deficit no
higher than 3% of GDP and a national debt lower than 60% of GDP. Thus
because of fiscal convergence fully achieved by members and continuously
monitored the latter (public risk sharing factor) could be a responsibility of
countries.
The contrast to this is what transpired as a result of the Euro crisis. Firstly,
fiscal convergence was violated by many countries, and secondly the crisis
was managed through bailout (federal governmental budget), which is a form
of fiscal unity. This shows the significance of having a fiscal integration based
on fiscal unity. According to the history of monetary unions, monetary
unification does not best benefit member without fiscal unity.
e. Political integration
The history of monetary unions has shown that political integration is the most
important property of OCA theory. From the history of monetary unions we
concluded that, the sustaining and dissolving of monetary unions had been

25
mainly influenced by the political will. Political will in most cases insures,
compliance with joint commitments, sustains co-operation on various
economic policies, and encourages more institutional linkages.
The European Monetary Union has shown positives signs on political
integration, as a result of minimal differences in policy preferences to save
Greece, Ireland, Italy, Portugal and Spain from the Euro depth crisis.
According to Bordo and Jonung (1999), the convergence criteria set by the
Maastricht treaty is difficult for many countries to satisfy, thus needing political
integration. Base on this point Jonung (1999) concluded that the EMU
achieved political integration set out in the OCA theory.
In the introduction of this chapter we pointed that the desire for the European
Union had change since the pioneering fathers of the idea, from political will to
monetary will. This is due to the current framework governing the EMU, which
allows political sovereignty for joining members. Based on this, the degree to
which the EMU satisfies the political integration property has been
questioned. In resent literature political integration has since been assessed
different with different benchmarks.
3.4 The future of the EMU (The lessons from creation of monetary unions)
In the history of monetary unions we learnt that monetary unions are classified either
as national or multinational monetary unions. The case of the EMU was noted as
very unique and unprecedented in history of monetary unions. However the
Maastricht treaty criterion puts the EMU closer to a national monetary union than to a
multinational union. Most obvious reasons are, the EMU has a common central bank
(ECB) that issues the only circulating money in the Euro-region and holds
accountability for monetary policy. The previous central banks of the members of
EMU have been diminished and their membership is permanent.
Therefore we are more inclined to believe that the EMU holds close ties to the United
States monetary union.
a. The EMU will dissolve from major shocks
In the history of monetary unions we discussed that the United States
monetary union (USMU) went through a number of challenges, including

26
political disputes during the Civil war that resulted to it first dissolution, and
after reuniting was hit by the 1930s great recession. The USMU until this day
remains intact as a result of retained political integration. In that case the EMU
can as well with stand any shocks as long as they don’t result into political
disputes.
b. The EMU will not be an optimum currency area
In chapter one we learnt from the modern phase of OCA theory, that over time
the benefits of joining a monetary union will over weigh the costs, and thus
converging the union into an optimum currency area. This idea is very evident
in how the United States monetary union evolved over time to being classified
as an optimum currency area. Even though we classify the European
Monetary Union as a non optimum currency area, because it currently does
not achieve any of the OCA properties, we can argue that should it retain its
political integration and remain intact as the United States Monetary Union
did, it will converge to an optimum currency in the future.
3.5 Summary
In this chapter we have weighed the benefits to costs of the European Monetary
Unification, presented as the shortcomings of construction and operation of EMU,
based on the OCA theory and compared to the history of monetary unions. We
focused our analysis on the effects of the Euro-debt crisis to show the empirical
evidence of the shortcomings of EMU suggested in theory. The European Monetary
Union has been acknowledged as a very unique set-up and thus not obvious of
whether it is a national or multinational monetary union.
On its first economic shock what has been prevalent is the real existence of flaws in
the construction of the EMU. These include, the lack of authoritative power, fiscal
unity and not an optimum currency are. Evidence provided in section 3.2 where we
show how the Euro-depth crisis evolved as asymmetric shock thus spreading to
most parts of the European region as a result of lack in above monetary factors.
The optimally of the EMU in section 3.3 is discussed showing that, price wage
flexibility has not yet been achieved, labour mobility factor is very low compared to

27
the historical monetary unions as a result of heterogeneity in demographic factors.
Fiscal integration still lacks fiscal unity and thus not achieved. Similar political
integration lacks political will towards forming the EMU and thus also not achieved.
Chapter 4: Conclusion
 The theory of optimum currency area lacks direction and clarity in measuring
benefits and costs from joining a monetary union.
 The properties in the theory are still the only criteria for measuring benefits
and costs, and prove that benefits will over weigh cost over time.
 The European Monetary union does not achieve any of the OCA theory
properties discussed in this study for defining a benefiting monetary
unification. Thus is not an optimum currency area.
 The European Monetary Union will follow the history of monetary unions and
later become an optimum currency area.

28
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