Regions in an `optimum currency area' (OCA) are affected symmetrically by disturbances, so there is no obvious gain from altering inter-regional relative prices, and labour and other factors of production flow freely among them, which eliminates localized unemployment. Hence an OCA may optimally dispense with exchange rate changes traditionally used to effect relative price adjustments and reap the convenience and efficiency benefits of a common currency. The OCA literature provides no formal test of the hypothesis, and can only compare the suitability of different areas as OCAs.

In Discussion Paper No. 478, Research Fellow Barry Eichengreen assesses whether the European Community satisfies Mundell's criteria free mobility of labour within the area and stability of relative prices to a greater or lesser extent than the US or Canada. The asymmetry of disturbances may be measured by the variability of real exchange rates, which has been greater within the Community than in the US, typically by a factor of three or four. Also, a comparison of the co-movements of securities prices on the Paris and Düsseldorf stock exchanges with that of prices of shares traded in Toronto and Montréal points to a much higher correlation of shocks in Canada than in Europe. Finally, there is direct evidence that mobility is significantly lower in Europe than in the US. While the removal of legal restrictions in conjunction with the 1992 programme will probably increase labour mobility significantly, this is only a necessary, not a sufficient, condition for high labour mobility.

Eichengreen concludes that the establishment of a European currency union will lead to non-negligible regional problems, so the political and economic institutions necessary to its smooth operation must be developed. The ability of the US and Canada to tolerate region-specific shocks is commonly attributed to the provision of regional insurance by their federal fiscal systems, which attenuate the impact of regional shocks on inter-regional income differentials. To the extent that the locus of regional shocks shifts over time, all regions are rendered better off by the risk-sharing achieved.

Eichengreen maintains that fiscal federalism will be beneficial to a monetary union if private markets and individual member states are unable to provide comparable insurance. Moral hazard and adverse selection may prevent individuals from diversifying their human capital, liquidity constraints may prevent them from using financial assets to diversify region-specific risk, and a state government may be unable to borrow on their behalf if factors of production are highly mobile between it and neighbouring members of the federal union. On the other hand, income transfers into a depressed region may discourage adjustment and create incentives for unions to intensify wage demands. But a case study of fiscal federalism in the US highlights the institutional mechanisms that reduce such distortions.

Is Europe an Optimum Currency Area?
Barry Eichengreen

Discussion Paper No. 478, November 1990 (IM)