2 - It seemed like a good idea at the time

Summary

The starting point for the creation of a currency union is establishing the requirements for it to work – in other words, the circumstances under which it makes sense for countries to undergo the complicated process of abandoning their national currency to create and share a common one. Intuitively, adopting a single currency makes sense when doing so improves the efficiency and functioning of national economies and, more importantly, offers increased resilience to external shocks, compared to going it alone.

A number of economic arguments make the case for adopting a single currency. Among the most important are the elimination of exchangerate risk and transaction costs, the convergence of prices, increased trade and investment, lower interest rates and macroeconomic stability. However, the litmus test has been the resilience to shocks: can an economy in a system of fixed exchange rates deal with economic shocks as well as, or better, than one operating under floating exchange rates? To answer this question and judge when circumstances are propitious for a common currency to succeed, most economists turn to Mundell’s “optimal currency area” theory (Mundell 1961).

The optimal currency area that wasn’t

For an “optimal currency area” to exist, the theory requires certain conditions to be present. The first is free movement of people; in cases of economic shocks, workers should be able to move from high-to low-unemployment areas. The second is capital mobility and flexible wages and prices; resources (both money and goods) should be able to flow freely from areas and activities where they are least to where they are most productive. The third is sufficient economic integration so that the economic cycles of countries in the common currency area are pretty much synchronized. The fourth condition is some kind of a risk-sharing system that makes fiscal transfers possible when needed to cushion the cost of an economic shock.

At the inception of the euro, many critics pointed out that the eurozone did not, in fact, satisfy Mundell’s requirements. Of the four conditions above, it could be argued that the first, labour mobility, while theoretically part of the framework as established in the Treaty for the EU, was in practice limited, for both cultural and historical reasons.