The World As Optimum Currency Area?

I was a little surprised to read in the Christmas edition of the Frankfurter Allgemeine Sonntagszeitung (not yet online, subscription wall, in German) that Robert Mundell seems to have changed his mind. In his seminal 1961 paper about monetary integration, he famously stated that “the optimum currency area is not the world”. Now it appears he favors a sort-of worldwide currency union, initially comprising Dollar, Euro, and Yen (apparently, he’s also made that point earlier this year in Lib?ration (subscription wall, in French)).

Mundell’s theory of optimum currency areas deals mainly with ‘asymmetric real shocks’, that is a demand shift of the assumed only product of region A to the only only good produced in region B. He also assumes that price level and wages are downward inflexible and that labor is completely immobile between the two regions. In a currency union such a demand shock has the effect of causing unemployment in region A and inflation in region B because a common monetary policy can only accommodate either the macroeconomic needs of region A (monetary expansion) or region B (monetary contraction). This leads to the first central result that “the optimum currency area is not the world“, because by changing the exchange rate between region A and B the demand shock can be absorbed without creating unemployment in region A and causing inflation in region B.

But Mundell himself noted that these assumptions are limiting the usefulness of the model for practical reasons, as money is – the second central result usually disregarded by opponents of integration in the pre-Euro discussion – also a “convenience”, and that currency unions can be a tool to greatly reduce the transaction costs of economic exchange if their creation is at all viable given the structural characteristics of the economies involved – particularly with respect to the diversity of production structures and labor market flexibility. I think, among others, the eminent US economist and NY Times columnist Paul Krugman once remarked that, with respect ot production structures, the 12 US federal districts may be less suitable for a currency union than the current Eurozone.

Thus, while it is inherently difficult to determine an optimum, any currency area is a trade-off of regional macroeconomic policy independence and gains from reduced transaction costs made possible by a single currency – the more tightly two economies are intertwined, the higher the gains from monetary integration. Consequently, even proponents of regional monetary integration usually believe, despite the rapidly increasing international division of labor, that Mundell’s first point is still valid with respect to the current global economy: the optimum currency area still is not the world. But now it seems Mundell doesn’t believe that anymore.

The interview in the Frankfurter Allgemeine is not too detailed, unfortunately. But my interpretation of Mundell’s proposal to create a sort-of currency union of Dollar, Euro, and Yen (to begin with) is that he must have come to the conclusion that the transaction costs of flexible exchange rates are so high (now?) that he believes the savings would offset the loss of regulatory independence even given a degree of economic integration far below that of, say, the Eurozone.

I’m sure there must be reactions to such a challenge from “flexible rate”-proponents that go beyond regulatory inertia and pure lobbying. Suggestions very welcome.

8 thoughts on “The World As Optimum Currency Area?

  1. I attended (indeed, helped organise) a lecture by Mundell in brussels in November 2001 in which he put this view forward; the summary of the meeting reports that “the three main world currencies – the dollar, the euro and the yen – should be fixed in preparation for a world currency. Five conditions would have to be fulfilled for this: a common inflation rate and a common measure of inflation would have to be agreed on, exchange rates should be fixed, a common monetary policy would have to be designed and executed by a common monetary policy committee, and an agreement on the distribution of seignorage would have to be reached. This could be the basis for an international currency (? a global economy needs a global currency ?).”

    So it’s not especially new for him to be saying this. What his response to your questions would be, of course, is a different matter – but why not email him directly via his website?

  2. Interesting article.

    To add to Nicholas’s comments I helped arrange a conference in 2000 in Rome when Mundell made a similar argument. IIRC his point was that currency markets are too instable. At the time he wanted 100 yen to equal 1 dollar to equal 1 euro. This would obviously require a much lower euro today.

    On whether he’s changed his mind on OCA, I remember him saying that he always thought he had been slightly misinterpreted. I’m afraid I do not remember why.

    [Actually this article helps to explain this thinking a bit

    Of course there’s no political (and I think Mundell acknowledges this) chance of this happening. I personally think some weak commitment to keeping the exchange rates around these levels would be a good idea, but even that seems unlikely on the US side.

  3. Naturally, the insuperable political hurdles over instituting a world super currency, bringing with it irrevocably fixed exchange rates forever more, a consensual international monetary policy and a uniform international inflation rate, render it an especially attractive policy option for solving the otherwise daunting economic problems of the Eurozone.

    It is the perfect excuse for not dealing with the sclerotic markets of the major Eurozone economies or for addressing fiscal imbalances in the Eurozone as prescribed by the Stability and Growth Pact of 1997. What more can we expect? World government?

  4. @ Bob:

    “It is the perfect excuse for not dealing with the sclerotic markets of the major Eurozone economies”

    Au contraire.
    Flexible factor markets (e.g. a flexible labor market) get much more important in fixed exchange rate schemes: Because external shocks can no longer be absorbed by exchange rate fluctuation, they must be absorbed by changing factor prices or by increased unemployment.
    (As the “sclerotic markets of the major Eurozone economies” presently find out at heavy cost.)

  5. Florian,

    Exactly so, which is why irrevocably fixing exchange rates between Eurozone currencies was not a good idea with sclerotic markets in Europe and the barriers to labour mobility from prevailing national differences in languages, cultures, and social security systems.

    The only surprising factor is that the wise advice in February 1998 from 155 German economists about postponing launch of the Euro because a currency union was premature sadly went unheeded:

    The predictable and predicted outcome is the sluggish growth performance and persisting high unemployment of the major Eurozone economies. The tragedy is that priorities in launching the European currency union were driven by political imperatives with little regard for the economic realities.

  6. In Germany in 1998, the discussion about monetary union was almost entirely political and not economical.
    In general, anyone who was against the new currency was labelled as conservative, anti-business and probably nationalistic.
    Put another way: Those _for_ the Euro were credited in the media with being rational, those _against_ it, with being emotional.

    I remember that back than I was once questioned for a poll which was designed as to reveal the people’s attitude to the Euro.
    The questions all ran along the line “Are you in favour of introducing the Euro, or do you believe the Euro will be a weak currency?”
    I tried to tell the interviewer that I didn’t believe the Euro would be weak but that I was nonetheless against introducing the Euro (for the reasons stated in above post).
    But that was just not possible.

    Even today, I am still waiting for any serious media attention to the problem formulated by Bob (namely: German unemployment is high because of the mix of fixed exchange rates and unflexible labor market – any one of them we could handle, both togetether are devastating).

  7. Florian,

    During the run-up to the launch of the Euro in January 1999, I was much embroiled in trying to debate online with fellow Brits the merits of European monetary union.

    Sadly, it was mostly a complete waste of time and my computer was much hacked as a result. The wisest insight came from a Dutchman posting from the Netherlands. I needed to realise, he suggested, that some had a commitment to European monetary union like a fundamentalist religion. He was absolutely right about that. Rational discussion was impossible. The issues you and I have raised here were regarded as completely irrelevant. Anyone criticising the start of monetary union was painted as a narrow-minded xenophobe or as verging on senile.

    In retrospect, the really fascinating thing is that Delors, the EU Commission President at the time of the Maastricht Treaty in 1992, has said that he understands Britain’s decision to stay out of the Euro:

  8. Germany itself is not an optimal currency area. The Neue Bundesl?nder would require completely different monetary policy than, e.g., Bavaria. The DDR Mark conversion to DEM back in 1990 in the ratio 1 : 1 was absolutely insane.

    Other solution – making markets flexible – is impossible for political reasons.

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