The Puzzling Ignorance of Optimum Currency Area Theory

by Dirk Ehnts, Econoblog101

Robert Mundell received The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 1999 ‘for his analysis of monetary and fiscal policy under different exchange rate regimes and his analysis of optimum currency areas’.

In 1973 Mundell wrote the following paragraph in connection with his theory (Uncommon arguments for common currencies, p.115):

A harvest failure, strikes, or war, in one of the countries causes a loss of real income, but the use of a common currency (or foreign exchange reserves) allows the country to run down its currency holdings and cushion the impact of the loss, drawing on the resources of the other country until the cost of the adjustment has been efficiently spread over the future. If, on the other hand, the two countries use separate monies with flexible exchange rates, the whole loss has to be borne alone; the common currency cannot serve as a shock absorber for the nation as a whole except insofar as the dumping of inconvertible currencies on foreign markets attracts a speculative capital inflow in favor of the depreciating currency.

So, how did that play out in reality? A real estate bubble that burst in Ireland and Spain caused a loss of real income, ‘but the use of a common currency (or foreign exchange reserves) allows the country to run down its currency holdings and cushion the impact of the loss, drawing on the resources of the other country until the cost of the adjustment has been efficiently spread over the future.’ Come again?

Ireland and Spain have shown that reality is very far removed from optimum currency area (OCA) theory. There is more to OCA, to be fair, with ideas about labour mobility and fiscal issues. I don’t have time to go into this, but only the insistence on fiscal issues proved to be correct. The point of this should be to acknowledge that economists have a hard time developing models that later stand up. Therefore, one should allow more than one model. Nevertheless, there must be some method to determine which model is ok to use and which is not. I suggest to examine the model’s main assumptions and mechanics closely, always with an eye to reality. For Spain and Ireland, in the case of OCA, what would be the equivalent of ‘allows the country to run down its currency holdings’? I think that one should look into the Target2 payment system for an answer, but the idea of Spanish ‘currency holdings’ in the Target2 system is very far removed from what Mundell wrote about. Personally, OCA theory confuses me more than it helps me think clearly. Charles Goodhart’s paper on the two concepts of money, on the other side, I find more helpful every time I re-read it.