The EMU and optimal currency areas – it may never have been a good fit

Another core issue with Greece and the euro is whether the optimal currency area model used to drive the EMU ever fit Europe. The EMU was based on the assumption that Europe was fit as an optimal currency area. The hope of “one currency, one market” was just that, a hope not based on economic reality.[1] When we list the conditions for a common currency region, it is not surprising that euro uncertainty became reality.

The criteria for an optimal currency area are threefold:

· a high degree of trade interaction, so the area will not see asymmetric shocks that will affect one country and not others (correlated business cycles)

· a high degree of labor mobility or wage flexibility

· centralized fiscal policy that can allow for money transfers

The trade interaction across the EU is not balanced. Labor mobility across cultural lines is still not easy within the EU especially for those less educated. There is no centralized fiscal authority that can tax one set of countries and use proceeds for balancing budgets for others.

The regional uncertainty and instability now more than ever will place an overhang on the euro which will be hard to model. While we can easily measure the sovereign risks of any one part, the integration of these parts or the solution to any problem with one country member creates market uncertainty without a change in the political structure.

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[1] The gravity model of trade suggests that bilateral trade is a function of distance, similar preference, and income as well as culture. The pull between some countries in the EU may be weaker than would be expected by just geographic distance. The politics of the EMU were driven by the view that one currency would lead to one market. This assumption or at least the speed of integration was not fast enough relative the chance of a fiscal shock.