8
are other instruments that make possible the adjustment to asymmetric shocks. These alternative
instruments are enshrined in the several criteria that were detected and developed in the evolution of
the OCA theory.
The first chapter is divided in five main paragraphs. The first paragraph has an introductive function:
it attempts to delineate what is an optimum currency area by breaking down into more
understandable pieces the complex notion of optimum currency area. It then goes on reviewing the
history of OCA theory by tracing the path of the several contributions which made possible the
building of structured benefit-cost model. The second and third paragraphs analyse the criteria set
out in the OCA theory by subdividing them into two main categories taking into account the time
they require to work properly. According to this view, we distinguish between properties effective
in the short- and long-term. When countries willing to join a currency area show the former
properties, they will not have to much time to join since these are operative in the short run. On the
contrary, when the OCA properties displayed by the same countries fall in the latter group, currency
area participation will take some more time. Apart from illustrating how these two types of OCA
features work, Paragraphs 2 and 3 also offer some empirical evidence with respect to their
functioning in the old EU 15 members. The first chapter then continues by surveying those OCA
properties the applicant countries should have in common with the incumbents of the currency
union they wish to join. These concern business cycles and inflation differentials. The conclusive
paragraph is devoted to the benefit-cost model which summarizes the main advantages and
disadvantages facing a country deciding to take part into a currency union.
After having explicated the OCA theory and its functioning criteria in the first chapter, the second
chapter focuses on the road the CEECs rode toward the final objective of EMU participation. The
first paragraph delineates the historical path that brought the CEECs to the release from the Soviet
economic bloc at the end of the eighties. After a brief description of the economic features that
characterized the CEECs during their life in the CMEA centralized system, the section goes on with
9
outlining the first forms of economic relation with western Europe and ends with the decisive step
of the Europe Agreements signature that made come true the association of the CEECs with the
EU. The conclusive paragraphs of the first section deal with the evaluation of the effects deriving
from the association and the future perspective of full EU membership. The second paragraph
sketches the main economic requirements set out by the EU for CEECs participation in the Union.
These are contained in the Maastricht Treaty and in the Copenhagen criteria which provide the
basic economic guidelines for a successful life into the EU and also the EMU: the existence of a
working market economy and consequently its ability to deal with the competitive pressures of the
free market forces together with a sound macroeconomic environment. The third paragraph, taking
into account the above criteria, attempts to value the transitional economic measures put in place by
the CEECs in order to shift from former centrally planned to market ruled economies. The
conclusive section makes the point about the economic situation of the CEECs at the time of their
EU accession and draws the starting line for their route to EMU participation and euro adoption.
The third and last chapter analyses the recent developments of the CEECs in the period 2004-2006.
The first section draws the economic picture of the CEECs economies performance where possible
up to date taking into account the scarceness of available data. The second paragraph, mirroring the
structure of the first chapter, attempt to assess whether new EU members comply with short- and
long-run OCA criteria and are correlated with the euro area in terms of business cycle and inflation
trends in order to gauge their feasibility of euro area joining. The third paragraph puts together the
main benefits and costs stemming from euro area participation. Finally, some conclusions are put
forward in order to judge the overall performance of the CEECs according the benefit-cost
summary put forward in the last paragraph.
11
1 - The optimum currency areas criteria: features and
evolution
1 - What is an optimum currency area?
What is an optimum currency area (OCA from now onward)? The best way to frame this economic
concept is to split it into its main elements, i.e. to define the notions of area, currency and
optimality. The term area alludes to the geographical borders within which a group of two or
more countries decide to coordinate their monetary policies. The degree of the participating
countries commitment to harmonize their monetary rules can fluctuate from pegging permanently
their currencies with each other till sharing a common currency. According to this spectrum of
available choices, the currency itself plays the crucial role of the common means offered to
countries member of a currency area with the aim of coordinating their monetary policies. Even if
the usage of the term optimum referring to the currency area varies from author to author in the
vast OCA literature, it substantially pertains to the foremost quality of impermeability to the
dangers brought about asymmetric shock, i.e. internal and external disequilibrium. To sum up, the
fundamental question underlying the OCA theory is the following: what are the main costs and
benefits of giving up the exchange rate tool (i.e. monetary independence) and integrating the
monetary operation when two or more countries decide to constitute a monetary union? The OCA
theory then identifies the conditions under which a monetary union between countries (in our case,
the present euro area members and the CEECs) works smoothly. When countries are hit by different
disturbances (asymmetric shocks), the adjustment process requires that real exchange rates adjust.
Since countries forming a monetary union decide to fix their real exchange rates, in the absence of
real exchange rate adjustability, there are other instruments that make possible the adjustment to
asymmetric shocks. These alternative instruments are enshrined in the several criteria that were
12
detected and developed in the evolution of the OCA theory.
The origin of the notion of OCA has to be sought in the long-standing discussion on the topic of the
advantages and disadvantages concerning the two main policy options available in the field of
exchange rate arrangements: fixed or flexible. Bearing in mind the different nuances existing
between the two case limit regimes, supporters of flexibility, such as Friedman (1953) claim that
through changes in the nominal exchange rates (i.e. devaluation and revaluations), countries
affected by price and wage sluggishness can maintain both internal and external balance. Under
fixed exchange rates, ceteris paribus, any policy attempt aimed at correcting international payments
imbalances would produce unemployment or inflation, whereas in the case of flexible rates the
induced changes in the terms of trade and real wages would remove the payments imbalances
without bringing about the same burden of real adjustments. The above argument backing the cause
of flexible rates gives the idea that any country should adopt flexible exchange rates without much
considering its economic characteristics. Conversely, the OCA theory tries to set out those
optimal economic features (listed below in Paragr aphs 2, 3 and 4) according to which the
countries at issue should adopt fixed exchange rates since they may reconcile internal and external
balance more efficiently than flexible exchange rates.
A question then arouses: what is the proper field of a currency area? The first wave of traditional
contributions made by Mundell (1961), McKinnon (1963) and Kenen (1969) tried to answer this
question by singling out the most crucial economic properties defining an OCA. However, as stated
by Tavlas (1993), this approach suffered from the inconsistency and inconclusiveness problems.
Inconclusiveness stems from the fact that the cou ntries candidate for a currency area cannot
always condense all the qualities recommended by the various contributions and cannot
simultaneously comply with them. Incongruity can appear in the form of conformity to some
properties but not to some others. Inconsistency lies in the fact that some properties can clash
with each other since not all of them are compatible. Basically, some principles can lead to the
choice of fixed exchange rates while some others can persuade the country in question to retain a
13
flexible arrangement.
Starting from the seventies, a new OCA theory beg an to circulate. It recognized the shortcomings
of the traditional approaches concentrated on a single facet of the economy. By way of using the
earlier approaches as a point of departure, it tried to evaluate the costs and benefits of participating
in a currency union from the point of view of the welfare of a particular country or set of countries.
On the whole, according to the main contributors of this rebranded development of the theory, i.e.
Corden (1972), Ishiyama (1975) and Tower and Willet (1976), countries willing to participate in a
currency area can now experience less costs and more benefits. In line with the former, applicants
for a currency area are not worsen by the loss of autonomy of domestic macro policies. Since they
do not face permanent Phillips curve trade off (see below), high inflation country, for instance, has
little to lose (in the long run) and much to gain by tying their hands (De Grauwe (2003)) and
constituting a currency area with a low inflation country. According to the latter, once a country, as
in the above example, has relinquished its monetary independence, it immediately reaps the benefits
of a low inflation reputation without any loss of output and unemployment.
To give a precise definition of OCA is not an easy task. Kawai (1998) attempts to define it as [ ]
the optimum geographical domain within which the general means of payments is either a single
common currency or several currencies whose exchange values are immutably pegged to one
another with unlimited convertibility for both current and capital transactions [ ] . Our attention
immediately concentrates on two main concepts: the characterization of optimality and the degree
of monetary integration.
What does optimum mean with reference to a curren cy area? Optimality can be described in
terms of the macroeconomic goal of maintaining internal and external balance.
Internal balance is achieved at the optimal trade-off point on the Phillips curve between inflation
and unemployment. This assertion was easily challenged by the monetarist critique put forward by
Friedman in the seventies. The Friedman s critique combats the original proposition of a stable
short-run Phillips curve with stationary expectations which does not shift upward or downward
14
when inflationary expectations augment or diminish respectively. This in turn allowed the
authorities to choose a menu of possible inflation-unemployment combinations since the curve
displayed a stable long-run trade-off. But Friedman focused on the fact that the Phillips curve
should be set in terms of the rate of change of real and not nominal wages since the economic
agents are interested in the former and not in the latter (otherwise they are affected by money
illusion ). According to this interpretation, the c urve was augmented with the expected rate of
inflation and the economic agents started to make their decisions in a rational way, i.e. trying to
anticipate the moves of the authorities through ra tional expectations . Since agents can now adjust
their expectations using all relevant information to forecast the rate of inflation decided by the
authorities, the latter could no more cheat the agents creating unexpected inflation in order to reduce
the level of unemployment. In conformity with this view, the long-term Phillips curve is a vertical
line corresponding to the Natural Rate of Unemployment (NRU). Thus, as already stated above,
authorities in the long run can only have the choice of a rate of inflation rather than of a level of
desired unemployment because the latter is definitely determined by the NRU. Hence, from this
standpoint the inflationary and devaluation tools are ineffective in the long run in accordance with
the monetarist critique of the vertical long-run Phillips curve so that the cost from relinquishing the
monetary policy instrument is low. Thus, since the monetarist critique supports the OCA theory, it
is easier for countries which want to form a currency area to fulfil the OCA criteria given the long-
run vertical Phillips curve proposition.
On the other side, the external balance involves the maintenance of a sustainable balance of
payments. This can be achieved, in case of small and open economies, through fixing the exchange
rate of the currency of the country at issue. According to De Grauwe (2003), the ability of a country
to affect output and employment, and thereby its balance of payments, is a function of its openness.
If we consider the effects of a devaluation for relatively closed and open countries, the major
difference between them has to do with the supply shifts following the devaluation. More than a
relatively closed country, a very open economy will suddenly be faced with the problem that a
15
devaluation raises the domestic price level without affecting its output. Consequently for a very
open economy the exchange rate is a particularly ineffective instrument to bring back the
equilibrium in its balance of payments. Relinquishing this tool brings about little loss.
When we speak about a currency area, there are different stages of monetary integration which
should be taken into account. An important explanation why there are several degrees of integration
on the monetary side is associated with the fundamental incompatibility of the three policy tools
desired by governments: fixed exchange rates, freedom of capital movements and monetary
autonomy. The impossible trinity depicted in Figu re 1 shows the impossibility of assuring the
coexistence of those three policy regimes illustrated above: only two of them can be achieved
simultaneously.
Let us take the European experience as a benchmark. Until the mid-eighties, the European
Community (EC)2 was characterized by capital controls so that only exchange rate stability and
2
The European Community (EC), most important of three European Communities (the European Coal and Steel
EXCHANGE
RATE
STABILITY
CAPITAL
MOBILITY
MONETARY
AUTONOMY
Figure 1 The Impossible Trinity
Capital
Controls
Currency Board
or Common Currency
Floating
Exchange Rates
Source: Pentecost E. J. and Van Poeck A. (2001)
16
monetary policy sovereignty could be attained. Then the speculative attack on British sterling
urging UK to leave the ERM 3 and to float freely, assured capital mobility and autonomous
monetary policy. Finally in the nineties, the greater political pressure on full monetary union
resulted in coexistence of exchange rate stability and capital movements.
The following is a classification of the various steps to be taken toward full monetary integration
taking into consideration the alternative arrangements of the impossible trinity .
First come exchange-rate unions where exchange rates between the participants are irrevocably
fixed and bands of fluctuations are not contemplated. Nevertheless, there is no need for
coordination among monetary policies. As a consequence, some kind of capital controls are
requested to influence domestic liquidity conditions.
Pseudo exchange-rate unions rank second. This expression is ascribed to Corden (1972) who
defines them as [ ] an arrangement where the membe r countries agree to maintain fixed
exchange-rate relationships within the union but there is no explicit integration of common policy,
no common pool of foreign-exchange reserves and no single central bank. . This arrangement
implies fixed exchange rates, free capital movements and assurance of policy coordination. In any
case, official integration of monetary policies is not envisaged.
The third stage is embodied by monetary integration. This term is equivalent to the concept of
currency area and involves exchange rate unification, i.e. irrevocably fixed rates and absence of
margins of fluctuations. Monetary integration also includes the following features: full and
Community (ECSC), the European Economic Community (EEC), and the European Atomic Energy Community
(Euratom)), was originally founded on March 25, 1957 by the signing of the Treaty of Rome under the name of
European Economic Community. The ’Economic’ was removed from its name by the Maastricht treaty in 1992, which
at the same time effectively made the European Community the first of three pillars of the European Union, called the
Community (or Communities) Pillar.
3
The European Exchange Rate Mechanism (or ERM) was a system introduced by the European Community in March
1979, as part of the European Monetary System (EMS), to reduce exchange rate variability and achieve monetary
stability in Europe, in preparation for Economic and Monetary Union and the introduction of a single currency, the
euro. The ERM is based on fixed currency exchange rate margins, but with exchange rates variable within those
margins. Before the introduction of the euro, exchange rates were based on the ECU, the European Unit of Account,
whose value was determined as a weighted average of the participating currencies. A grid (known as the Parity Grid)
of bilateral rates was calculated on the basis of these central rates expressed in ECUs, and currency fluctuations had
to be contained within a margin of 2.25% on either side of the bilateral rates (with the exception of the Italian lira,
which was allowed a margin of 6%). Determined intervention and loan arrangements protected the participating
currencies from greater exchange rate fluctuations.
17
irreversible currency convertibility, financial market integration, total liberalisation of movements
on current transaction and a common monetary policy. So, as foreseen by the Maastricht treaty,
monetary integration and the third stage s arrangement considered by the Economic and Monetary
Union (EMU) coincide.
With monetary unification, we reach the top of the monetary integration ranking. This concept
entails monetary integration together with a single currency and a common central bank. In this
case, the monetary policy is completely appointed to and centralised at the community level: no
monetary independence is left to member states. The responsibility for exchange rate policy and the
balance of payments is also assigned to the community institutions.
Considering that monetary integration is the concept which most often refers to currency area
participation in the literature, two are the central questions concerning the OCA theory: what are the
conditions under which countries make a currency area work smoothly and what are the costs and
benefits of doing so? This is the question we will try to answer in the next paragraphs.
2 - Properties effective in the short term4
The aim of this section consists in delineating those OCA properties that a country or a group of
countries may exhibit in order to constitute ex novo or to participate in an already existing currency
union. In particular, this section focuses on those optimal attributes which make possible for a
country or a set of countries to enter or form in the short run a currency union without running into
the costs deriving from relinquishing the monetary policy tool. In other words, we will attempt to
answer this central question: which of the OCA features available to countries are operative in the
short run? We then attempt to give some empirical content to the theoretical framework outlined
comparing the different records of the below analyzed properties taking as benchmark the EU and
US experiences.
4
This section in some parts heavily draws from De Grauwe (2003).
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