European economic and monetary integration, and the optimum currency area theory

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? JEL classification: E42, F15, F33 and F41. Keyword: Optimum currency area, economic and monetary integration, international monetary arrangements, EMU ∗ This essay is dedicated to W. Max Corden, who posed many of the difficult questions on monetary integration. I would like to thank Manfred Kremer, Hedwig Ongena, Ivo Maes, João Nogueira Martins, Chiara Osbat, Lina Bukeviciute, Malin Andersson, Luca Onorante, Tobias Blattner and Maurizio Habib for their various contributions and Juliette Cuvry for her assistance. An earlier draft of this paper was presented at the DG ECFIN and BEPA workshop on “EMU@10: Achievements and Challenges” that was held in Brussels on 26-27 November 2007. I take full responsibility for any errors and omissions. The views expressed are mine and do not necessarily reflect those of the ECB.