Directorate-General for Research
Working Paper

Economic Affairs Series







I. Optimum Currency Areas


II. Mechanisms of Adjustment


III. The shortcomings of OCA theory


IV. Is EMU viable?


V. The measures required



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  • Will EMU make the EU more or less vulnerable to external shocks?

The fact of monetary union means that over 60% of Member States' external trade will automatically become domestic transactions. By comparison with the individual countries making it up, therefore, the euro area will be an autarkic economy, with external trade accounting for only between 10%-15% of GDP, (depending largely upon whether all 15 Member States eventually participate). This means that

the euro area's vulnerability to external shocks will be low compared to the past vulnerability of the separate EU countries. It will be on a par with that of the United States;

the relative unimportance of external trade will make possible a policy of "benign neglect" with regard to the euro's external value, similar to that practised by the US in recent years with regard to the dollar.

  • Will the shocks likely to be faced by the EMU area be symmetric or asymmetric?

Most research finds that only a minority of the shocks actually experienced by EU countries have been country-specific; and that even country-specific asymmetric shocks have often had similar outcomes. Some of the shocks have been sector-specific, having no special consequences for exchange rate or monetary policy.

However, a high proportion of shocks have been regionally asymmetric, a situation which has continued over time, and is likely to continue within the euro area. The conclusions are that:

the ability to alter national exchange rates, or to conduct a country-specific monetary policy, can be of little value in meeting such asymmetric shocks; but that

mechanisms will still be needed within the euro area to deal with the consequences of asymmetric shocks for relative regional incomes, employment and growth.

  • What have been the main causes of asymmetry?

Both at a national and regional level, a variety of structural differences have accounted for the asymmetric effects of shocks. To these may be added cyclical factors at national level, though the relative importance of these is not agreed. A high proportion of the asymmetries, however, can be attributed to factors under the direct influence or control of governments and political systems: legal differences, the "political cycle", public purchasing, fiscal policies, etc.; and to lack of international coordination between them. The conclusions are that:

many of the asymmetries might be removed by the coordination within EMU of economic policies, the alignment of legislation (e.g. in the area of financial services or labour law) and by the fact of monetary union itself; and

other asymmetries may be removed because private economic agents will change their behaviour in the light of the new economic circumstances (e.g. the expectation of low inflation rates).

  • Will differences in financial structure mean that monetary policy has asymmetric effects?

Existing research tends to show that the effects upon output of interest rate changes does vary between countries, both in timing and magnitude. It also indicates that these asymmetries are due to differences in financial systems: the role of banks, the extent of consumer debt, whether borrowing is at fixed or variable interest rates, etc.

Both deregulation at national level and the removal of barriers at EU level, however, are already beginning to produce a convergence of systems. Continuing low inflation, and the fact of monetary union itself, should speed up the process of change. The conclusions are that

whether the ECB will be able to conduct a single monetary policy for the whole euro area will depend to a considerable extent on these changes: for example, the extent to which the corporate bond market and equity finance develop as an alternative to bank lending;

certain legal and tax changes could speed up this process.

  • How flexible are real wage and price levels in the EU?

Evidence suggests that real wages and prices have been relatively inflexible in the short and medium terms, both between EU countries and between regions within them. This has been particularly true in a downward direction.

Flexibility between regions has been less than between countries, in part because the ability to devalue has disguised real wage reductions, at least while the "money illusion" has lasted; and in part because large economic disparities between different parts of the same country have been politically unacceptable, leading to mechanisms for substantial income transfers (e.g. from the Western to Eastern German Länder). The conclusion is that

after EMU, short and medium-term wage and price flexibility may prove even less significant as a mechanism of adjustment to asymmetric shocks than before, particularly since the existence of a single currency will make direct comparisons between regional price levels and wage rates easier.

  • How mobile is labour in the EU?

Comparisons with the Unites States show that labour is relatively immobile in Europe. However, this is almost as true between regions in the same Member State as between the Member States themselves, indicating that linguistic, cultural, legal and other differences play only a modest role. A more plausible explanation is that the costs of large-scale labour movement in Europe generally outweigh the advantages, both for the regions of net immigration and of net emigration, and for the workers themselves. The consequences are that

labour mobility might be marginally increased by the removal of artificial barriers caused by differences in tax and social security systems, residence restrictions, nationality limitations on recruitment in the public sector, inflexible housing markets, etc.; but that

labour mobility - that is, geographical mobility - is unlikely to form a major mechanism of adjustment to asymmetric shocks within the euro area.

  • How mobile is capital in the EU?

Stages 1 and 2 of EMU, together with the Single Market programme, have resulted in a high degree of capital mobility within the EU, though obstacles still remain. Capital flows have both the short-term role of facilitating temporary payments adjustments between countries and regions, and the longer-term role of providing investment in less prosperous areas. The integration of capital markets throughout a currency area is also required for the uniform transmission of monetary policy measures.

Whether such positive effects will outweigh possible negative consequences - the concentration of investment in richer areas to take account of economies of scale, etc. - is the subject of controversy. So is the suggestion that capital mobility and the free movement of goods will increase regional specialisation, leading to an increased vulnerability to asymmetric shocks. Recent empirical evidence suggests that positive factors will prevail, though it is difficult to disentangle the effects of capital mobility from the those of special tax incentives, regional aid, etc.

The consequences are that:

the euro area's vulnerability to asymmetric shocks could be further reduced by removing the remaining obstacles to capital mobility and to markets in financial services. This would both improve inter-regional adjustment, and remove distortions in monetary policy transmission mechanisms; and

efforts should also continue to bring order to national systems of regional and sectoral aid, including those implemented through tax systems, so that any adverse effects of capital mobility within the euro area can be identified and met on an agreed basis (see also final conclusion).

  • Is the EU labour market sufficiently flexible?

Developments such as the growth of information technology have made the geographical mobility of labour of decreasing importance compared to occupational mobility.

In this context, both approving and disapproving comparisons have been made between Europe's apparently inflexible labour markets and the "hire and fire" culture of the United States. Criticisms have focused, in particular, on labour market legislation which protects those in employment at the expense of the unemployed; and the effects of tax and social security systems on incentives to offer, and to take up, employment.

However, there is evidence that "labour markets across Europe are significantly more flexible than they were 10 years ago, even though the continent still lags behind the US and the UK" (1).

High job mobility also has important implications for the education and vocational training systems, a field to which all Member States and the EU itself have paid increasing attention in recent years. The conclusions are that

the improvements to labour markets and training systems necessary to meet asymmetric shocks may already be under way. But further progress, including the spread between countries of "best practices", is almost certainly needed.

  • Does the EU have a mechanism for autonomous fiscal adjustments?

Given that the EU Budget amounts to under 1.5% of GDP, compared to 33% for the US Federal Budget, the answer is clearly: no. In the US the existence of a "fiscal pump" results in 40% of any fall in income in a particular state being automatically offset by lower federal taxes and higher federal payments. On the other hand, national budgets in the EU account for between 43% (the UK) and 66% (Sweden) of GDP, allowing a high degree of fiscal redistribution between regions within each Member State. It can be concluded that

whether monetary union requires an increased element of "fiscal federalism" is a matter of debate. Given that, in response to shocks, asymmetry between regions within the same Member State is greater than between Member States, adjustment through national fiscal mechanisms may be sufficient. However,

country-specific shocks may still occur, to meet which an EU-level mechanism may be needed; and

the provisions of the Stability and Growth Pact may circumscribe the degree of inter-regional insurance through national budgets.

  • Does the EU have mechanisms for discretionary adjustments?

The EU has at its disposal a considerable number of financial instruments for directing funds to areas affected asymmetrically by shocks. These include budgetary instruments (e.g. the Structural and Cohesion Funds) and loan instruments (e.g. the European Investment Bank and the funds administered by it).

Certain possibilities in both cases remain unexploited: for example, a reformulation of the Treaty provisions for mutual assistance in the event of balance of payments disequilibria; or the use of the EU's credit rating to raise capital on world markets at advantageous rates of interest (the "Delors bonds" proposal).

The 33 billion ECU available throught the Structural and Cohesion Funds, and the 27 billion ECU available through EIB and other loans, are nevertheless modest sums by comparison with the volume of regional and industrial aid available from national budgets, which probably amounts to over 100 billion ECU a year in total direct payments.

A distinction, however, must be made between the need for rapid, short-term stabilisation in the event of asymmetric shocks; income transfers to reduce the social and other costs of shocks; and long-term investment to reduce asymmetry: i.e. to reduce the vulnerability to shocks of particular regions.

It can be concluded that

all existing and potential instruments of adjustment will need to be re-examined in the context of EMU, and in particular in the context of the mechanisms for economic policy coordination established by the Treaty; and

the application of competition policy to state aids has to be fully reconciled with the role of national public expenditure in reducing potential asymmetry.

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Ever since Economic and Monetary Union (EMU) became a serious prospect for the European Union, there have been people arguing that it will not happen - or if it does, that it can't work. Such views are held by politicians and journalists on both the left and right, but also by serious academic economists.

Their reasons for scepticism are expressed differently depending upon the source. For some it reflects a fear of sharing the euro with countries that have a past record of monetary laxity, for others the opposite fear of imprisonment in a "deflationary straight-jacket". The economists have maintained that, in the absence of the ability to alter exchange rates, and given that there will be a single monetary policy for the whole euro area, no credible mechanism will exist to combat "asymmetric shocks": that is, events that may have varying economic effects on different parts of the area. They have observed that possible alternative mechanisms - a substantial federal budget, or labour mobility - do not exist in Europe to the extent that they do in, for example, the United States.

All these fears and arguments may perhaps be summed up in a single proposition: that the European Union does not constitute an "optimum currency area". In such circumstances, it is maintained, the gains from EMU in terms of reduced transaction charges, increased price transparency, etc. will be more than offset by losses in production and employment.

This critique of EMU raises a number of serious questions. What does constitute an "optimum currency area"? What kind of shocks have asymmetric effects? Will any misalignment of business cycles within a single currency area automatically and eventually disappear? Is the ability to alter exchange rates any longer a credible adjustment mechanism? Can devolved fiscal policies compensate for the centralisation of monetary policy, or is an element of "fiscal federalism" inevitable? And are the other adjustment mechanisms available within the EU in fact so inferior to those in the United States? If not, what should be done?

The object of this working paper is to examine these questions, and also some of the answers that have been advanced. The move towards EMU has given rise to a large number of relevant studies, both popular and academic - though "definitive conclusions remain elusive" in key areas (Obstfeld and Peri 1998). Much of the tone has been adversarial rather than dispassionate, perhaps inevitably given the past political debate about whether EMU should go ahead and, if so, when and with whom.

But EMU is going ahead. Contrary to many predictions, the 1999 start-date is being met, and with the participation of all but four EU Member States. Whether this will prove evidence of courage and clear-sighted vision, or of "cock-eyed optimism" (2), time will tell.

Meanwhile, the creation of the euro is going to provide a unique test bed for a considerable body of economic theory.

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1. Münchau, W. "Europe's fragile recovery" in the Financial Times, 29 th July 1998.

2. Editorial in The Times of Tuesday June 2, 1998

© European Parliament: September 1998