Asses the Claim that the Countries Using thr Euro Constitute an Optimal Currency Area - Essay Example

?Introduction An optimum currency area is a geographical region where it would be economically most efficient to have single currency. One of the final stages in the economic integration is the creation of monetary union and as such it becomes important first to assess whether the region will be an optimum currency area before creation of a unified economically integrated region. (De Grauwe, 1997) In order to create an optimum currency area there are four important criteria which need to be fulfilled. Labor mobility, capital mobility, transaction costs as well as risk sharing systems. These are important criteria which need to be fulfilled in order to ensure that any geographical area is optimum currency area. Euro is the official currency of the Eurozone comprising of 17 members out of 27 members of the European Union. Euro therefore has not been adapted by all the members of the European Union however; it is still the second largest reserve currency in the world. It is also the second largest circulated currency after the US Dollar thus significant part of the transactions takes place by using Euro as a currency. Before the current economic crisis, Euro was considered as a strong currency with relatively smaller probability of disintegration. However, the sovereign debt crisis of different countries especially of Greece created strong doubts over the viability of Euro as the optimum currency area. This paper will therefore argue that countries constituting the Eurozone and using Euro as a single currency is not an optimal currency area. Optimum Currency Area The concept of optimal currency region or optimum currency area is one of the key concepts outlining the economics of integration. It suggests that any area can be an optimum currency area where the economic efficiency will be maximized if the region has the single currency. It therefore outlines the different conditions and variables required for the merging of the currencies as well as the creation of a single currency. Mundell (1961) outlined that it is advantageous for a country to peg the external value of its currency with a country whose business cycle most closely correlates with. Mundell outlined two important models to discuss the creation of an optimal currency area. These two models are based upon the concepts of stationary expectations as well as the International Risk Sharing.( Kenen, 1969) One of the key attribute of an optimal currency region therefore is based on the fact that it is often larger than a single country. The creation of Euro has been considered as an engineered attempt to provide a case study to test the theory of how to create an optimal currency region as individual countries in the region may not have been sufficient enough to form an optimal currency area. History of Euro Euro is the single currency in Eurozone comprising of the 17 of the 27 countries in the European Union area. Officially launched in late 1990s, over the period of time, Euro has become one of the most dominating currencies in the world. At the start of Euro as a currency, it was widely expected that the Euro will replace US Dollar as the most traded currency in the world. Backed up by the economic powers of the European economic powers in order to ensure that region is served by a single currency.( Richard; & Wyplosz, 2004.) Euro is officially administrated by the European Central Bank and the Eurosystem whereas the ECB has the sole responsibility to set the setting up the monetary policy for the region whereas the Eurosystem has the mandate of printing and minting currency notes as well as coins. Euro and Optimal Currency Area As discussed above, Euro was considered as a stable currency before the late 2000s when economic crisis started to happen. The current sovereign crisis wherein many European countries are finding it relatively difficult to pay off their obligations on time therefore has created strong doubts over the sovereign debt crisis. Greece specially faced critical challenges in terms of paying off its debts and resultantly this has created strong pressure on Euro to decline against US Dollar in international market. This has also suggested that the Euro may not be an optimal currency region if it continues to perform in its current form. Labor Mobility across the Region This suggests the absence of physical restrictions to travel and facilitate the free movement of the labor across the borders. It also requires the low cultural barriers as well as the institutional arrangements make it relatively easier for the labor to move freely. Labor mobility therefore is considered as a hedge against the adverse shocks when exchange rates are fixed or cannot be adjusted easily. It has been observed that the labor mobility within Euro area is relatively low as compared to the countries like US and Japan. (Mortished, 2010) This slow mobility of the labor therefore has created a strong dis-incentive for Euro to flourish as a strong currency besides casting doubts over the ability of euro to continue to serve as the optimal currency area. There are still restrictions on the free movement of the labor across E8 countries and therefore this may potentially discourage the development of an optimal currency region. Capital Mobility The intra-Europe trade is relatively higher as compared to the trade of EU countries with other countries. The free flow of capital however, may be considered as one of the encouraging factors to support the optimality of eurozone. It has been suggested that due to the implementation of Euro as a single currency, the overall trade between the EU countries has increased between 5 to 15%. Most EU countries also export up to 15% of their GDP to the European countries thus increasing the overall size of the trade between member states. Such an increased level of cross border trade therefore suggests that Euro might have helped the region to increase the overall level of trade between the member countries within EU Zone. Transaction costs In “One Market, One Money” the commission of the European communities suggested that there will be savings of up to 0.5% in transaction costs between the members of the EU Zone. Thus the concept of transaction cost for the single currency market outlines that as a result of the introduction of a new currency, the overall transaction costs will reduce.( Karhonen, & Fidrmuc, 2001) Since the overall intra-Europe trade between the countries is relatively lesser part of their GDP therefore the benefit of reduced transaction costs may not provide the relative benefit to the member states. Further, some of the countries are still not as advanced as other countries of the region are therefore the structural changes required to allow the economies to enjoy the full benefits of reduced transaction costs may not be entirely possible. Risk Sharing System The frequency of external shocks to the economies of EU suggests that this may not be a viable alternative to assess the impact on the single currency and its contribution on the region. Countries like France, Finland and Spain suffered larger and more frequent economic shocks however, despite this, they joined the Euro Zone. Another important disparity seen is based on the impact of asymmetric economic shocks on the prices and the GDP. Some studies suggested an irregular response of each economy to increase in interest rates thus suggesting that the response of each country within the region was relatively different. (Fidrmuc, 2002) Conclusion In order to become an optimal currency area, Euro has to fulfill four important criteria before it can form into one of the cohesive and efficient single currency areas in the world. Apart from free capital mobility all other criteria suggest that the countries in the region may not be ready and hence countries comprising of the region where Euro is the single currency may not be constituted as an optimal currency area. Conclusion De Grauwe, P 1997, ‘The Economics of Monetary Integration’, Third Edition, Oxford University Press. Fidrmuc, J 2002, The Endogeneity of the Optimum Currency Area Criteria, Intra-Industry Trade, and EMU Enlargement. Karhonen, I and Fidrmuc, J 2001, Similarity of Demand and Supply Shocks Between the Euro Area and the Accession Countries, Focus on Transition, 2/2001, pp. 26-42, National Bank of Austria, Vienna. Kenen, P 1969, The Theory of Optimum Currency Areas: An Eclectic View. In: R. Mundell and A. Swoboda (Eds.) Monetary Problems of the International Economy. Chicago, USA: University of Chicago Press. Mortished, C. 2010. Labour mobility: Europe's economic oxymoron . [ONLINE] Available at: http://www.theglobeandmail.com/report-on-business/economy/economy-lab/carl-mortished/labour-mobility-europes-economic-oxymoron/article1727275/. [Accessed 06 October 11]. Richard; B & Wyplosz, C, 2004. The Economics of European Integration.. 1st Ed. New York: McGraw Hill. Read More