In 1961, economist Robert Mundell introduced a theory which stated that a common currency in certain monetary unions, or “Optimum Currency Areas” as he called them, could maximize economic efficiency. He developed several criteria that were required for a region to qualify as an optimum currency area, such as a high level of labor and capital mobility, flexible labor markets and wages, openness of economies and decentralized monetary and fiscal policy. Mundell saw flexible labor and capital factors as an essential ingredient for a currency union to properly function in a fixed exchange rate mechanism. The higher the factor mobility, the more effective a centralized monetary and fiscal policy would be, he posited. In the absence of floating currencies, high factor contribution to economic growth was, in Mundell’s view, the only effective adjustment mechanism during demand or supply shocks.
Ronald McKinnon advanced Mundell’s work in 1963 by empirically looking at the openness of trade across economies. McKinnon’s work became a cornerstone of the optimum currency area theory: postulating that the more open economies are in trade with one another, the less asynchronous output fluctuations will be between countries resulting from demand or supply shocks. Like Mundell, McKinnon concluded that the higher the factor mobility, the more synchronized business cycles would become, which is a key ingredient in optimum currency areas.
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U.S. Versus Europe Three developments allowed the U.S. to become a full-fledged monetary union: the drafting of the U.S. Constitution, which gave Congress the power to coin and regulate money; the establishment of the Federal Reserve and the Fed’s issuing of Federal Reserve Notes in 1914; and the introduction of the Banking Act of 1935.
Similarly, the European Monetary Union (EMU) was founded on “convergence criteria” established by the Maastricht Treaty in 1991. These criteria were aimed at converging inflation, budgets and interest rates. On the other hand, optimum currency criteria were not officially adopted for currency union membership. As a result, “rigidities” like labor union bargaining, high minimum wages and unemployment insurance benefits (among other factors) have become the focus of further economic integration, specifically in Europe.
In a speech at Jackson Hole in August 2011, former ECB President Jean-Claude Trichet discussed the economic differences between the U.S. and Europe. His presentation showed that aggregate inflation and growth differences are not too dissimilar. In fact, since 1995, U.S. average real GDP has been only half a percent higher than Europe’s real GDP. The unemployment rate saw a distinct difference, however, as the European unemployment rate was three percent higher than the U.S.’s over the same period. Economic integration has progressed materially since the inception of the EMU, but the difference between the U.S. and Euro labor markets can be attributed to specific factor contribution to real GDP growth. Trichet’s Jackson Hole presentation revealed this difference, whereas the U.S. scored much higher in terms of labor productivity, labor mobility and wage flexibility, as depicted in Figure 1.
Several academics such as Paul Krugman have researched factor contribution further by looking at “factor specialization.” This is defined as the production of different goods in coherence with degree of trade openness. Krugman developed a factor specialization index which measures the extent to which a country's production pattern differs from those of a comparison group of countries. The index runs from zero to two, where zero means countries produce the same goods in the same proportions while an index at two says countries produce totally different goods. A low degree of specialization displays a value close to zero, a very high degree closer to two.
Building upon McKinnon’s work on trade openness, Krugman’s research showed that the higher the degree of specialization, the more synchronized business cycles could become between countries. Interestingly, ECB research (De Grauwe and Mongelli) shows that business cycle synchronization has increased over the last two decades following more pronounced economic integration, mainly in some of the business services sectors. The historical series in Figure 2, however, displays a relatively low factor specialization for the EU relative to the U.S. since early 2000. A general explanation has been that, in certain segments of labor and product markets, integration in the EMU is still behind the U.S. Because factor growth contribution and factor specialization are underlying elements to optimum currency area criteria, they are more visible for the U.S. than for the eurozone economy.
In his speech, Trichet noted that there was a similar dispersion in Unit Labor Costs (ULC) in areas with both high and low wage costs, a reflection of differences in economic diversity and competitiveness. However, when looking closer at labor markets in both regions, there is a distinct difference in “labor market wage rigidity” measured through variables such as wage indexing schemes and bargaining systems. ECB studies (see 2006 paper entitled
How Wages Change: Micro Evidence from the International Wage Flexibility Project, for example) have shown that U.S. wage rigidity declined during the 1980s and 1990s as pattern bargaining among labor unions diminished. The presence of eurozone unions, on the other hand, remains very strong in collective wage bargaining.
The 2006 paper shows that average real wage rigidity, defined as wage freezes or wage cuts as a fraction of total workers in the labor force, is very low for the U.S. at ten percent, but much higher for the eurozone at an average of 25 percent. The density of labor unions when measured as a percentage of workers who are members of a labor union, remains low for the U.S. at 20 percent versus an average for the eurozone of 45 percent. When we plot wage rigidity against labor union density, as shown in Figure 3, it is clear that the U.S. is the least rigid in wages, while the eurozone experiences far greater rigidity. In optimum currency area terms, the U.S. seems to have greater labor factor flexibility.
The eurozone has lacked mobility of labor for some time. In an Economic Survey of the European Union, the OECD concluded that only four percent of the European workforce has lived and worked in a different member state. The OECD measures labor mobility as number of people commuting cross border as a percentage of the working-age population. Since 2000, the average cross-state migration of labor has been highest in the U.S. and lowest in the European Union, as depicted in Figure 4. Once again, the U.S. stands out because of its more effective adjustment mechanism.
Conclusion: Crisis Spurs ReformsAccording to Mundell, there are two different ways the pace of employment within countries with a current account deficit is set: In currency areas made up of different countries with different national currencies, the pace of employment within deficit countries is set by the willingness of the surplus countries to generate inflation. But in a currency area comprising many regions and a single currency, the pace of inflation is set by the willingness of central monetary authorities to allow unemployment in the deficit regions. To combine both currency areas into an “optimum” one, there has to be coordination among central banks to avoid unemployment and inflation whereby surplus countries help to adjust deficit countries. In reality, such balance is delicate -- and Mundell saw, therefore, the concept of optimum currency areas having only direct practical applicability in areas where the political spectrum is in a state of flux.
A political state of flux is a form of decentralized policy. When there are no free-floating currencies, optimum currency area theory says its criteria should hold for economies to have an effective adjustment mechanism to absorb shocks. What the qualitative data analysis shows in Figures 1, 2 and 3 is that the U.S. has more optimum currency area features than the eurozone. But U.S. average annual real GDP has been only half a percent higher than Europe’s real GDP since 1995, while average headline inflation was lower in Europe during the same period. Hence, even though the U.S. is (presumably) closer to an optimum currency area than the EMU, it does not necessarily mean higher and more sustainable economic growth. Key for the EMU is to eliminate labor market rigidities.
Underlying this difference is the so-called “structural reform” that has been very modestly implemented in the eurozone. These reforms are aimed at facilitating more effective entry of firms and workers into the product and labor markets. For that to happen, oligopolistic market structures have to merge into competitive market structures, which entails greater wage flexibility and labor mobility. As the optimum currency area theory argues, without such factors in place there is no effective adjustment mechanism.
However, the eurozone debt crisis has one “advantage” -- negotiations between the different countries on debt sustainability are now forcing a more effective labor market adjustment mechanism. Albeit painful, the intensity of the debt crisis may force a quicker progress of reform implementation that could be a competitive and comparative advantage for the EMU in the future. As Krugman and others have argued, such reforms generally increase factor specialization and should better synchronize the business cycles between the European surplus and deficit countries. For now, the U.S. has the advantage, which also explains the relative growth and unemployment differences between the two economies.