Two years ago to this day I co-wrote an essay as part of my undergraduate degree which discussed optimal currency areas and questioned the future role of the euro. Today I will look at those hypotheses and with the added benefit of hindsight discuss where Europe is two years on.
Robert Mundell is an (in)famous economist when discussing optimal currency areas; he was originally opposed to the European Monetary Unification (EMU) but paradoxically, since 1970, he has been a strong supporter. For the purposes of this article I will call pre-1970 ‘Mundell I’ and post-1970 ‘Mundell II’.
In the early 1960s there was a strong Keynesian mindset – the belief that national monetary and fiscal policies could be used on aggregate demand in order to offset any private sector shocks.
Mundell I assumed stationary expectations – the assumption that people took the current interest rate, domestic price level, and exchange rate as the long run levels – as well as the assumption that labour mobility was restricted to fairly small national or regional domains and as a result stated these ‘regions’ would be affected by shocks (e.g. financial, oil prices etc) asymmetrically.
Assume there are two countries which hold a common currency. Under normal conditions (i.e. different currencies) if country A suffers a demand shock then the currency would depreciate. However with a common currency the central bank may decide to help country A thus harming country B because their demand outstrips their supply creating inflationary pressures.
Conversely in 1970, Mundell presented two papers in Madrid in favour of Optimal Currency Areas. Mundell II shows how a common currency area can mitigate shocks by reserve pooling and portfolio diversification. As two or more countries hold each other’s output in a common currency, a loss from shock affecting one country can be shared among many.
We should also look at interest-bearing bonds which can lead to currency risk and speculative attacks. An interesting situation is where interest rates, in those countries on the periphery increase relative to those in a centre country e.g. Spain, Portugal and Italy before the Euro against Germany. As a result, these countries may have to devalue if hit by a speculative attack. A common currency would share this risk premia in interest rates.
A difference in the two Mundell models is highlighted by Paul De Grauwe;
“Mundell I implicitly assumed an efficient foreign exchange market when exchange rates were flexible, whereas Mundell II implicitly assumed an efficient international capital (financial) market once exchange rates were convincingly fixed.”
The foreign exchange markets could lead to a situation where central banks buy more foreign currency than they could afford. One way to counter this is to give the central bank one clear inflation objective – this curtails Keynesian economics and shows the move towards monetarism.
Moreover in an environment where there is free mobility of capital, exchange rates may become the problem with respect to speculative attacks. As a result “the view of Mundell I implying that the exchange rate could be used to stabilize the economy after an asymmetric shock should be abandoned.” Therefore Mundell II calls for a decrease in flexibility of exchange rates as well as closer integration.
In this essay written in 2008 we predicted that the future for the euro becoming the world standard was not a fanciful idea. The euro arrived at a time of general weakness of the dollar; Kuwait depegging away from the dollar; oil rich states feeling insecure at the value of the dollar; vicious cycle of the lack of investment further decreases value of dollar. The relative ‘stability’ the euro could bring – as can be seen by the government bond yields converging and becoming less volatile in Europe between 1992-2002 – as well as the debt deflation spiral of the yen meant the euro was at the forefront of becoming a new world standard.
Two years on and after suffering the ‘worst’ recession for decades the euro is no longer competing to become the world standard; rather it is fighting for survival.
The Greek debt situation is well reported (see other blog post) with a budget deficit of 8.7% of GDP. Spanish, Portugese and Irish levels are 10%, 8.3% and 11.7% respectively. This is far beyond the ‘Growth and Stability Pact’ level of 3%. Without a global credibility of being able to manage this debt there will be no investors and the European Central Bank will have serious decisions to make. While it is true that the Irish have a strong credibility in their debt reducing measures, Greece have been ‘massaging’ their output statistics for years leading to increased scepticism from potential investors; so much so in fact that bond yields are at a similar level to those of Hungary which is an IMF supported emerging market.
Greek debt now amounts to 254 billion euros – Russia had debt of 51 billion euros when it had to default in 1998 (although this could have been under heavy influence of the IMF).
The Yen is still caught up in a debt-deflation spiral with lacklustre quantitative easing package and extremely low interest rates. With the US having reported a 5.7% growth rate for the last quarter of 2009 could this further indicate that the dollar is here to stay?
The ECB has some tough decisions to make. Is the euro strong enough to withhold a Greek default? Do they bail out Greece which could promote a more relaxed attitude from the Greek socialist government towards public spending cuts and potential inflationary pressure elsewhere? The dollar looks like the standard if not because of the most recent figures but moreover as there isn’t a viable alternative. Could this be not only the final nail in the coffin for the euro as a world standard, but the end of the euro altogether?
 McKinnon, R. Optimum Currency Areas and Key Currencies: Mundell I versus Mundell II JCMS 2004 Volume 42. Number 4 pp. 689–715 Blackwell Publishing Ltd page 696 (brackets added by myself)
 ibid page 714
 The Financial Times January 30/31 2010