European Economic And Monetary Integration, And The Optimum Currency Area Theory

Economic Papers 302| February 2008 European Commission Directorate-General for Economic and Financial Affairs Publications B-1049 Brussels Belgium E-mail: Ecfin-Info@ec.europa.eu In May 2008, it will be ten years since the final decision to move to the third and final stage of Economic and Monetary Union (EMU), and the decision on which countries would be the first to introduce the euro. To mark this anniversary, the Commission is undertaking a strategic review of EMU. This paper constitutes part of the research that was either conducted or financed by the Commission as source material for the review. This essay follows the synergies and complementarities between European Economic and Monetary Union (EMU) and the optimum currency area (OCA) theory. Various advancements in economic theory and econometrics have made it possible to progress from the “early OCA theory” to a “new OCA theory”. The balance of judgements has shifted in favour of monetary union: it is deemed to generate fewer costs and there is more emphasis on benefits. The “endogeneity of OCA” has further strengthened this consideration. Yet there is still no simple OCA test. When EMU made the leap to the Maastricht Treaty, the OCA theory could not deliver clear policy guidance. Plans for EMU went ahead as a follow-up of the Single Market Programme (SMP) with only limited direct input from the OCA theory. The main concern was to remove the risks of destabilising exchange rate volatilities and misalignments that had disrupted the European Monetary System (EMS) on several occasions. While plans for EMU were advancing, it became apparent that several (future) euro area countries were still faring poorly under some OCA properties and concerns about “Eurosclerosis” emerged. The implications for EMU were cautionary. Over the last 10 to 15 years initiatives promoting structural reforms have been at the centre of policy-making (e.g. the Lisbon Agenda). Hence, under the surface the OCA theory was being heeded, and European countries were tackling their structural weaknesses. We can almost talk of an OCA theory in reverse. If we look at the broad governance structure of EMU there may be an “exogeneity of OCA”. So here we are: with the benefit of eight years of hindsight, what can we say about the functioning of EMU thus far? Can we also say something more about its various benefits and costs?