Posted by: Dirk | December 23, 2013

The puzzling ignorance of optimum currency area theory

Robert Mundell received The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 1999 ‘for his analysis of monetary and fiscal policy under different exchange rate regimes and his analysis of optimum currency areas’. In 1973 wrote the following paragraph in connection with his theory (Uncommon arguments for common currencies, p. 115):

A harvest failure, strikes, or war, in one of the countries causes a loss of real income, but the use of a common currency (or foreign exchange reserves) allows the country to run down its currency holdings and cushion the impact of the loss, drawing on the resources of the other country until the cost of the adjustment has been efficiently spread over the future. If, on the other hand, the two countries use separate monies with flexible exchange rates, the whole loss has to be borne alone; the common currency cannot serve as a shock absorber for the nation as a whole except insofar as the dumping of inconvertible currencies on foreign markets attracts a speculative capital inflow in favor of the depreciating currency.

So, how did that play out in reality? A real estate bubble that burst in Ireland and Spain caused a loss of real income, ‘but the use of a common currency (or foreign exchange reserves) allows the country to run down its currency holdings and cushion the impact of the loss, drawing on the resources of the other country until the cost of the adjustment has been efficiently spread over the future.’ Come again?

Ireland and Spain have shown that reality is very far removed from optimum currency area (OCA) theory. There is more to OCA, to be fair, with ideas about labour mobility and fiscal issues. I don’t have time to go into this, but only the insistence on fiscal issues proved to be correct. The point of this should be to acknowledge that economists have a hard time developing models that later stand up. Therefore, one should allow more than one model. Nevertheless, there must be some method to determine which model is ok to use and which is not. I suggest to examine the model’s main assumptions and mechanics closely, always with an eye to reality. For Spain and Ireland, in the case of OCA, what would be the equivalent of ‘allows the country to run down its currency holdings’? I think that one should look into the Target2 payment system for an answer, but the idea of Spanish ‘currency holdings’ in the Target2 system is very far removed from what Mundell wrote about. Personally, OCA theory confuses me more than it helps me think clearly. Charles Goodhart’s paper on the two concepts of money, on the other side, I find more helpful every time I re-read it.


Responses

  1. How different is Robert Mundell’s understanding of asymmetric shocks in a currency union from that of Wynne Godley as quoted by Rob Parenteau:

    “First of all, if a government stops having its own currency, it doesn’t just give up ‘control over monetary policy’…If a government does not have its own central bank on which it can draw cheques freely, its expenditures can be financed only by borrowing in the open market, in competition with businesses, and this may prove excessively expensive or even impossible, particularly under ‘conditions of extreme urgency’…The danger then is that the budgetary restraint to which governments are individually committed will impart a disinflationary bias that locks Europe as a whole into a depression it is powerless to lift.”

    http://www.nakedcapitalism.com/2013/12/rob-parenteau-how-to-exit-austerity-without-exiting-the-euro.html

  2. OCA can exist only with adequate fiscal transfers, that is the only thing that make OCA possible. There is no OCA within any city, let alone between states if not for fiscal transfers.
    Deficits are everywhere you look and if not for fiscal transfers from surplus toward deficit areas without interest costs, there will be only families left as OCA where nobody looks at how much deficits kids represent.
    Fiscal transfers as retierment, health, disability, education, military, roads, infrastructure, governing that make fiscal transfers possible are making an OCA visible as a succes.
    Fiscal transfers enable shocks be absorbed by the whole country or currency area instead of only by a region where shock occurs. Larger the area taking the shock the less it is being felt due to spreading or watering down.


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