What constitutes an optimal currency area has been a matter of debate for many years. Its practical importance has been emphasised by the difficulties of the eurozone and may yet be reinforced by new strains caused by the Covid-19 crisis. In this article, Juan Castañeda1 outlines proposals for an index of macroeconomic integration.
The question of the optimality of a common currency has been discussed for more than half a century. Is it the best monetary arrangement for a set of economies to surrender their national currencies and adopt a common one (often, the only one)? Or would they be better off keeping the additional policy ammunition a national monetary policy conveys, especially in times of crisis? Leaving the political aspects of this question aside, although they are important considerations, there is plenty of traditional and more modern Optimal Currency Union (OCU) literature which offers an economic rationale for the adoption of a single currency. However, there has not been an equivalent level of research on the practical side of this question. We frequently lack the specific metrics to assess what ‘optimality’ actually means and how to measure it. More research is needed in this particular aspect to make progress in assessing the effectiveness of an established (common) monetary area. The emphasis in existing literature has been on analysing multi-State monetary unions in order to assess how ready a country is to join an existing monetary union or how successful a new monetary union might be. More work is needed on studying the optimality of well-formed monetary unions under a single nation state.
Subject to important limitations, the calculation of a proxy for an index of the optimality of a currency would provide valuable information for policymakers: it would inform about the degree of macroeconomic asymmetry within the monetary area, therefore offering a metric to assess its performance and thus recommend policy or institutional changes if such were needed. This information becomes even more relevant in the aftermath of a severe crisis. This is when the different economies sharing the same currency would likely become more divergent in several aspects; such as the state of their public finances, the severity of the crisis and its impact on spending and employment, the availability of credit or the impact upon prices and wages, among others. The index would not be able to offer an explanation of the underlying reasons why these asymmetries may have increased, but it would signal how overall convergence has or has not evolved in the area, as well as the specific indicators that have contributed in one or another direction.
The rationale is quite clear. A monetary union made of more homogeneous economies, whether they are determined by national boundaries across countries or regions within the same country, will make it much easier for the monetary policy makers to set the monetary conditions that will fit them all. This is precisely one of the implications of the seminal work by Robert Mundell in this field back in 1961.2 In a paper3 co-authored with my colleague Pedro Schwartz, we attempt to calculate an overall index of the macroeconomic integration in the Eurozone and the USA dollar monetary areas, as well as several sub-indices, in order to assess their performance since 1999. We measure the degree of macroeconomic integration (or, to put it differently, the size of internal asymmetries) by calculating the dispersion4 in the following chapters and indicators across the Member States in the Eurozone and the fifty continental States in the USA (plus Hawaii and Washington DC): (1) the business cycle (dispersion of the annual real growth of GDP, real GDP per capita and the unemployment rate), (2) public finance (dispersion in the ratio of the public debt and of the deficit on the GDP), (3) competitiveness (dispersion in CPI inflation, labour costs and real exchange rates) and (4) monetary dispersion (as measured by the rate of growth of broad money, the ratio of credit to the private sector, the trade balance on the GDP and Target2 balances/Fedwire for the USA).
In well-established monetary unions, such as those in the UK or the USA, the single currency is part of the political and economic institutional settings of the country, which rarely deserves any attention or is even questioned. Of course, research is devoted to the study of regional asymmetries within these countries and how to achieve a more balanced economic growth model across regions; but this research and its policy implications take the common currency as a given institution within the economy and rather focus on designing economic policies (i.e. industrial policies) to achieve a more balanced economy. If there are significant macroeconomic asymmetries, the economy has built-in mechanisms (the so-called fiscal automatic stabilisers such as employment benefits or income related taxes) to stabilise the level of income and spending in the regions in crisis; and, even more, the government has the ability to use the central budget to implement discretionary policies to assist those regions.
Increased macroeconomic asymmetry within a monetary union can have severe real effects on the economy over the medium to the long term. The calculation of an index of macroeconomic dispersion will be a step forward for single-country and multi-country monetary areas: it will inform policymakers about divergent or convergent trends in markets across the monetary area and the effectiveness and the functionality of monetary policy in addressing them. However, this exercise comes with some important caveats and limitations. History and politics matter in both the formation of a monetary union and its survival. Whereas the US dollar has been the currency of a single (though federal) state for more than 150 years, the euro is quite a recent currency adopted by different (politically sovereign) nation states, with their own history, political traditions and economic record. We need to acknowledge these differences in interpreting the results of our indices in these two very different types of monetary unions. At a more practical level, even though the methodology applied in Castañeda and Schwartz (2020) to measure internal asymmetries in the USA and the Eurozone is the same, the indicators available differ to some extent.5
What the dispersion indices tell: Euro and US dollar, 1999 – 2018
At the time of the launch of the Euro, the expectation among the advocates of the single currency was that it would help to foster macroeconomic convergence across member states. The Euro was a tool to complete the common market and thus further economic integration in the European Union (see the Delors Report, 1989). Even among its supporters, however, there was a consensus among both policymakers and academics that the Eurozone was not an optimal monetary area back in 1999. Therefore, we should not take the levels of asymmetry of 1999 or the early 2000s as desirable, but just as the starting condition from which to improve the performance of the Eurozone as a single monetary area.
According to our calculations, and in line with the literature, from 1999 to the outbreak of the Global Financial Crisis, some convergence certainly took place as regards the business cycle. As shown in Figure 1, business cycle dispersion halved in only seven years. However, the other chapters depict a deterioration of macroeconomic performance even before 2007: public finance and monetary dispersion indices increased moderately, while dispersion in competitiveness across member states escalated right from the very establishment of the Eurozone. In the aftermath of the Euro crisis, new fiscal and macroeconomic instruments were adopted to identify imbalances within the area.6 These new instruments, along with the application of internal devaluation policies by the economies most affected by the crisis, seem to have been effective in reducing fiscal dispersion since the peak of the crisis in 2010 (see Figure 1).
But how about monetary dispersion within a monetary area? In most advanced economies, central banks do not pay much attention to changes in broad money growth in the design of their policies, let alone regional changes. The European Central Bank (ECB) is, to some extent, an exception to the rule. Even though it very much downplayed the role of the so-called monetary pillar in its policy strategy back in 2003, it still uses broad money growth as a medium-term indicator of inflation and in its reports and communications to the public. Since 2006, dispersion in monetary indicators in the Eurozone (with broad money growth being one of them) started to increase and escalated to record levels in 2012. Moreover, the trend towards greater and greater monetary asymmetry has continued since 2015. Both before and after the Global Financial Crisis and the Euro crisis we can identify higher dispersion rates in money growth and in the rate of growth of credit among some Eurozone member states. The so-called peripheral economies registered much greater rates of growth of money than the Euro-19 average before 2007 and much sharper falls afterwards. Another important contributing factor is the adoption of asset purchase programmes by the ECB (so-called Quantitative Easing), and how they were implemented,7 particularly since 2015. As we will see in Figure 2, these programmes did stabilise money growth across the area and helped to stabilise the macroeconomic performance of the Eurozone, but at the cost of exacerbating Target2 imbalances among members states. Once we calculate the average of the results of the four sub-indices in Figure 1, we can see the overall index of dispersion in the Eurozone, as shown in Figure 2 . Once we exclude the effects of Target2 imbalances, the trend in the correction of overall dispersion since 2016 is positive, although, eight years after the crisis, the level of overall macroeconomic asymmetry is still higher than in the pre-crisis years.
The comparison with the performance of the US dollar in the same time period is quite informative. In the pre-crisis period the trend of macroeconomic asymmetries in both monetary areas is similar. The difference, however, is mainly in the effects of the Global Financial Crisis on macroeconomic dispersion. Even if we exclude the effects of QE on Target2 imbalances in the index of dispersion in the Eurozone, the increase in dispersion is much sharper than in the US.8
As mentioned above, these metrics should be taken with caution, especially the comparison of the performance of the Euro with the US dollar. However, the indices provide valuable information about the direction of the level of macroeconomic dispersion in each monetary area, as well as the impact of the Global Financial Crisis and how long it took for each area to return to pre-crisis levels. Once we have more information on the impact of the current Covid-19 crisis, we should be able to assess its impact in both economies’ internal asymmetries and compare it with the Global financial Crisis. However, it is for policymakers to interpret the data and make the changes needed to improve the performance of the currency. The book edited by Castañeda, Roselli and Wood (2020) comprises a collection of papers to improve the functioning of the Eurozone from quite different perspectives.
Notes:
1. Institute of International Monetary Research University of Buckingham. This article is a summary version of Castañeda and Schwarz (2020).
2. See Mundell, R. (1961) and Bordo and Jonung (2003).
3. Recently published in Castañeda, Roselli and Wood (eds.), The Economics of Monetary Unions. Past Experiences and the Eurozone (Routledge, 2020). Chapter 7.
4. The measure of dispersion used is the standard deviation of the above indicators per year.
5. For example, as the US Federal Reserve does not report on broad money per state we have used deposits. Further details on sources and indicators in Castañeda and Schwartz (2020).
6.The so-called ‘Fiscal Compact’ in 2012 to enhance fiscal discipline among members states and the Macroeconomic Imbalance Procedure in 2011.
7. See Cecchetti and Schoenholtz (2018) for further details.
8. We have calculated the same indices for the UK sterling and the preliminary results show a better performance than that in the Eurozone and the US dollar; the indices show that internal macroeconomic asymmetries within the UK have fallen quite significantly and even returned to pre-crisis levels (see further details at https://mv-pt.org/comparison-with-the-uk-monetary-area/).
9. In order to make the comparison easier to interpret, we have adopted 1999 as the base year for the level of macroeconomic asymmetries both in the Eurozone and in the USA. Of course, this does not imply that they started in the same position in 1999.
References:
Bordo M, and Jonung L, (2003): ‘The future of EMU. What does the history of monetary unions tell us?’ In Capie and Wood (eds.): Monetary unions. Theory, history, public choice. (Routledge 2003) pp. 42-69.
Castañeda J, Roselli A and Wood G E, (eds.), The Economics of Monetary Unions. Past Experiences and the Eurozone. (Routledge, 2020).
Cecchetti S, and Schoenholtz K, (2018): ‘Target-2 Masks Reduced Fragmentation Euro- system Should Draw Inspiration from Federal Reserve’. OMFIF Analysis. Available online.
Mundell R, (1961): ‘A Theory of Optimum Currency Areas’, American Economic Review, Vol. 51, No. 4 (September), pp. 657-665.
