Critical evaluation of the Euro-based currency union

Abstract

An optimum currency area is a geographical region such that it would maximize economicefficiency to have the entire region share a single currency. Robert A. Mundell, the economistwho is widely accepted as the pioneer of the theory of optimum currency areas, based hispremise on the fact that fixed exchange rates and rigid wage and price levels prevent the termsof trade from fulfilling a natural role in the adjustment process. He also pointed out thedownsides of a system of national currencies connected by flexible exchange rates. Although asystem of flexible exchange rates is a device whereby depreciation can take the place ofunemployment when the external balance is in deficit, and appreciation can replace inflationwhen it is in surplus, the question then arises should these countries allow each nationalcurrency to fluctuate, or would a single currency area be preferable?1Mundell defined a currency area as a domain within which exchange rates are fixed. Throughhis paper1, he tried to address the question of what the appropriate domain of a currency areais.A single currency implies a single central bank (with note-issuing powers) and therefore apotentially elastic supply of interregional means of payments.Full employment imparts an inflationary bias to the multiregional economy or (more generally)to a currency area with common currency. In a currency area comprising different countrieswith national currencies the pace of employment in deficit countries is set by the willingness ofsurplus countries to inflate, while in a currency area comprising many regions and a singlecurrency, the pace of inflation is set by the willingness of central authorities to allowunemployment in deficit regions. But a currency area of either type cannot prevent bothunemployment and inflation among its members. The fault lies not with the type of currencyarea, but with the domain of the currency area. The optimum currency area is not the world.The flexible exchange rate system does not serve to correct the balance-of-payments situationbetween two regions (which is the essential problem) although it will do so between the twocountries; it is therefore not necessarily preferable to a common currency or nationalcurrencies connected by fixed exchange rates.If the case for flexible exchange rates is a strong one, it is, in logic, a case for flexible exchangerates based on regional currencies, not on national currencies. The optimum currency area isthe region.Meade vs. Tibor: Mundell cites the well-known position of J. E. Meade, who argued that theconditions for a common currency in Western Europe did not exist, and that, especially because of the lack of labour mobility, a system of flexible exchange rates would be more effective inpromoting balance-of-payments equilibrium and internal stability; and the apparently oppositeview of Tibor Scitovsky who favored a common currency because he believed that it wouldinduce a greater degree of capital mobility, but further added that steps must be taken tomake labour more mobile and to facilitate supranational employment policies. In terms of thelanguage of this paper Meade favored national currency areas while Scitovsky gave qualifiedapproval to the idea of a single currency area in Western Europe. In both cases it is implied thatan essential ingredient of a common currency, or a single currency area, is a high degree offactor mobility; but Meade believed that the necessary factor mobility does not exist, whileScitovsky argued that labour mobility must be improved and that the creation of a commoncurrency would itself stimulate capital mobility.The concluding argument of Mundell’s paper states: If the world can be divided into regionswithin each of which there is factor mobility and between which there is factor immobility, theneach of these regions should have a separate currency which fluctuates relative to all othercurrencies (i.e. flexible external exchange rate).But a region is an economic unit while a currency domain is partly an expression of nationalsovereignty. Except in areas where national sovereignty is being given up it is not feasible tosuggest that currencies should be reorganized; the validity of the argument for flexibleexchange rates therefore hinges on the closeness with which nations correspond to regions.