When I travelled to Spain several years ago, I talked with man who lived there.  He explained how it was difficult for Spain to export their goods because the Euro was too expensive.  This is because countries like Germany were doing economically well, causing the Euro to do well.  However, Germany was not able to import the goods the wanted, because the Euro was valued to low.  This is because countries like Spain were causing the Euro to do poorly.  Essentially, the Euro was valued too highly for some countries, and too low for others.  This problem could be fixed if the countries had different currencies that would be allowed to fluctuate.

Optimal currency areas were not researched until an economist named Abba Lerner began to work in this area.  Robert Mundell popularized it in 1961 when he published an article titled “A Theory of Optimum Currency Areas.”  One argument made for optimal currency areas is the problem with shocks to economies.  If there is a large currency area, the shock can be distributed across areas.  There is also easier mobility in the area, which encourages trade and better adjustment to shocks.  His vision was realized in 2002, when the euro replaced many currencies in Europe.  This created a new optimal currency area.

Mundell asked the question, “What is the appropriate domain of a currency area?”  The common understanding is to allow each country to have one currency and to let it adjust to other currencies.  However, inside a specific country, the currency is essentially fixed.  Shocks to one part of the country do not force an adequate adjustment to the national currency.

Mundell wondered what would happen if currency areas weren’t limited to countries.  His idea was that it might be beneficial for a currency to possible cover portion of countries, or even multiple countries.  He thought that the currency covers areas that are economically similar.  This allows for the shock to be absorbed properly.  Multiple country optimal currency areas had other beneficial aspects to them.  Trade, factor mobility between the countries, and confidence in the currency would increase.

Mundell had four criteria for a successful currency area.  1) Labor mobility throughout the area, 2) price and wage flexibility across the area, 3) fiscal transformation of funds to more economically distressed parts of the area, and 4) a similar business cycle across the area.  While some of these might be difficult to implement, Mundell believed that a currency area would not be successful unless these four criteria are met.

In 2002, Mundell’s ideas were first tested.  Many of the countries in the Eurozone adopted a common currency.  They believed that the Eurozone was an optimal currency area.  Since its inception, many countries have begun using the Euro.  However, several Eurozone countries have maintained their original currency.  Most notably, Denmark and United Kingdom have retained their currency.

The Euro has had its ups and downs.  It has provided stability in Europe.  In addition, it has allowed many other countries to peg their currency to the Euro, providing stability to those currencies.  It has also prevented inflation in Eurozone countries.  There have also been positive effects on trade and investment.  We have also seen a decrease in interest rates, allowing for more effective fiscal policy in participating countries.

However, it has not been perfect.  One major issue is that exports have been too expensive.  This because countries that rely on exports might require a cheaper currency to maintain their exports.  Due to the price of their currencies, it is more difficult for them to export.  In recent years, we have also observed the European Union beginning to show its cracks.  Greece has recently run into problems with its irresponsible fiscal policy, causing concerns over the Euro.  The United Kingdom’s recent “Brexit” vote caused more worries.  France is also showing more nationalistic tendencies.

Recently, fears have increased over the possible collapse of the EU and the Euro.  While some complaints about the EU might be well-founded, there are some good things that have resulted from the EU.  The question must be asked, “Should we fix the EU and how should it be fixed?”

Perhaps one way to fix the EU is to fix the Euro.  Economists are beginning to wonder if the Eurozone is an optimal currency area.  There is little mobility between the countries, there are multiple languages spoken, and there are multiple cultures around the Eurozone.  This violates Mundell’s first criteria for an optimal currency area.  However, the Eurozone does fulfill some of Mundell’s criteria.  Perhaps the Eurozone is not an optimal currency area, but actually several optimal currency areas.

For example, what if Spain and Portugal had a different currency than German and Austria?  This would allow the currencies to fluctuate in relation to each other.  It would also have the benefits that the optimal currency areas would provide, without the drawbacks of a single currency.  Theoretically, the Eurozone could be separated into four or five optimal currency areas.

How would the optimal currency areas be drawn up?  There would be five things to look at.  First, it is important to look at the industries in the countries.  Also, it would important to understand the cultures and languages in the different areas in Europe.  Additionally, a simple analysis of the geography of Europe could put certain countries into certain optimal currency areas.  Another option would be to look at how the country’s net exports move in relation to each other.  If they are highly correlated, they might be in an optimal currency area.  Finally, an analysis into the migration patterns would be effective.  If there is a high amount of migration from one country to another, this might indicate an optimal currency area.

These five indicators of the optimal currency area are based off Mundell’s four criteria for an optimal currency area.  There were several issues with measuring these five indicators.  First, data since 2000 might not be best to use because the Euro might have affected net exports.  In addition, there is not a good measurement to determine the industrial similarities between economies.  Finally, determining similarities between cultures can be a very daunting task.  I generated a simple map of how currency areas might look.

 

 

To create this map, I generated a correlation matrix of each country’s net exports.  If two countries have a correlation of greater than .85, I placed them in the same currency area.  This assumes that the countries are in a similar geographic area.  I then looked at the migration patterns between countries.  Countries with high amounts of migration between each other were also placed in a similar currency area.  After this, I placed countries in similar geographic areas in the same currency area.

There are several benefits to this.  It will allow for better trade among countries than if each country had its own currency.  It would also promote create greater financial stability in those areas.  Several optimal currency areas would have the same beneficial effects of the Euro, but perhaps to a lesser degree.  However, several optimal currency areas would not have the major drawback of the Euro, which is the inability to allow for the currency to adjust to shocks.

With the advent of cashless currencies in Europe, an even more radical idea is possible.  Currencies would not be limited to national boundaries.  For example, the southern half of France could be part of an optimal currency area that includes Spain and Portugal.  The northern half of France could be included in an optimal currency area that includes Germany.  With this possibility, it allows for greater freedom in Europe to create better optimal currency areas.

There are even more implications of multiple currency areas in Europe.  In order for countries to establish an optimal currency area, they will be forced to develop monetary and fiscal rules.  However, the monetary and fiscal rules do not have to be the same.  This would force great experimentation in monetary policy, which is something that is sorely needed in political, financial, and economic studies.

While Mundell’s ideas for optimal currency areas are unlikely to occur anytime soon, a collapse of the Euro and the Eurozone could force countries to become creative in how they deal with it.  Perhaps the optimal currency areas could save the Eurozone and the Euro, not replace it.

 

 

 

Saving The Euro