Wednesday, January 20, 2010

Optimal Currency Area and the Euro

Recently, I talked about the problem of a common interest rate for the Eurozone area. See: problems of Euro and common monetary policy.

A common question is often - How come the United States of America doesn't need a separate interest rate for each individual state? For that matter why don't we have a separate interest rate and currency for London, Norfolk and Yorkshire. (Actually, being a supporter of Yorkshire Independence I think there's a good case of Geoffrey Boycott becoming President of a Yorkshire Central Bank, but, let's leave that for the moment...)

It is all to do with an optimal currency area.

An optimal currency area is a geographical zone where the benefits of a single currency outweigh the disadvantages.

Suppose, Wales experiences an asymmetric shock (coal mines close down). This would cause a recession in the Welsh economy, higher unemployment and lower inflation. Ideally, Wales would have a lower interest rate and a depreciation in a Welsh currency. But, in practise, it is possible for unemployed Welsh workers to move 100 miles east and get work in the Midlands or London. It is also relatively easy for London firms to invest in Wales to take advantage of lower labour costs and surplus labour. The point is there are not many geographical barriers to moving between areas within the UK. (There are, of course, significant geographical immobilities, but, they are not sufficient to justify a separate currency and monetary policy).

However, suppose there is an asymmetric shock in Italy and Greece, meaning their economies are in recession, whilst north Europe is growing strongly. It is much more difficult for Greek workers to move to Germany (language barriers, attachment to native country, poor information e.t.c). Similarly German firms would have much more reluctance to invest in Greece.

Political Problems

In theory, if there is higher unemployment in Wales, the UK parliament would be willing to give subsidies to Wales to help the area recover.

However, if the Basque region in Spain enters a deep recession, how committed would we be to sending more subsidies to Basques?

Even worse, suppose Greece has a serious debt problem (national debt of 123% of GDP would be a good supposition..) How willing would German tax payers be to buy Greek bonds and bailout Greece so that they can continue to spend over 5% of GDP on arming themselves against their Nato ally Turkey? (the point is there are many political problems)

If California went bankrupt, in theory, they would have more chance of getting US federal aid, than if Mexico went bankrupt. This is why the USA is an optimal currency area, But, Mexico, US, and Canada wouldn't.

What is the Eurozones optimal currency area?

There may well be an optimal currency area in Benelux countries and France and Germany. The difficulty comes when the Eurozone includes peripheral members such as the profligate Greeks, Italians and Irish.

The key issue is the degree of geographical mobility, government intervention and degree of economic convergence.

There are some who argue, the USA may not even be an optimal currency area, and would be better off having separate country for east and West.

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