Optimum currency area (OCA) theory: Testing OCA Theory

Optimum currency area (OCA) theory

Optimum currency area (OCA) theory: Variants of OCA Theory

The OCA literature has dominated the theoretical explanation of currency areas for almost a half century. There have, however, been few systematic tests of OCA theory and little positive support for OCA theory as a useful way of explaining the composition of existing currency areas or of predicting changes in currency domains. One empirical challenge was the rarity of changes in currency areas during the 1970s and 1980s. In the early 1990s it was argued that the stability of actual currency arrangements may be explained by switching costs (Dowd and Greenaway 1993), but the many changes in currency arrangements in Eastern Europe in the 1990s and the introduction of the euro in Western Europe suggest that the mechanics of changing currency arrangements are neither difficult nor especially costly.

With multiple OCA criteria, the theory becomes difficult to test: a small open economy has the biggest potential gain from joining a larger currency area in order to reduce transactions costs, but it may also be most vulnerable to external shocks and hence has the most to lose from giving up the exchange rate as a macropolicy instrument. The economists Kreinin and Heller (1974) synthesized the various criteria into the single question of whether a country could better deal with external imbalance through devaluation or through adjustment of domestic demand. Their conclusion was that Italy, Sweden, and Switzerland were the three Organisation for Economic Co-operation and Development countries most likely to abandon their national currencies. Thirty years later only one of the three had done so, while ten of the ‘‘less likely’’ countries had abandoned their national currencies.

If currency areas become ‘‘optimal’’ ex post, then OCAtheorymay be untestable.Acommon currency might promote closer trade links and more synchronized cycles, both of which are OCA criteria; closer trade ties increase the benefit from a common currency, and synchronized cycles reduce the cost of giving up independent currencies. This is not a theoretical result but a hypothesis to be tested empirically because more bilateral trade could promote interindustry specialization and less synchronized cycles. Using various measures of bilateral trade intensity and cycle synchronization for 21 developed economies, Frankel and Rose (1998) find a robust relationship between the two variables, which they interpret as evidence that as a common currency promotes bilateral trade it also increases cycle synchronization. Thus actual currency areas fit OCA criteria better thanpotential currency unions, and the OCA criteria are endogenous.

The impact of currency union on bilateral trade flows has been the subject of a burgeoning literature initiated by the economist Rose (2000). Using a gravitymodel, Rose found that currency union has a large effect on bilateral trade, which he interpreted as evidence that a common currency substantially reduces transactions costs. Although it is plausible that a common currency reduces transactions costs and stimulates trade, the magnitude of the common currency effect is hotly debated. In Rose’s study the countries in currency unions are not from a randomdraw; several authors have shown that currency unionmembers are smaller andmore open than their natural comparators and that history (usually in the form of colonial background) matters.

The debate has been conducted with analysis of currency area changes over time. Analyzing timeseriesdatafor correlationsbetweenchangingcurrency union status and bilateral trade flows,Glick andRose (2002) estimated thatdissolutionof a currency union halves bilateral trade. Currency union breakup is, however, usually associated with other events that disrupt trade; out of some 60 cases of post-1947 currency union dissolutions in the Glick-Rose data set,more than two-thirds broke upwithin a decade of the end of a colonial relationship, and the end of the ruble zone, which is not in the data set, would increase the percentage still further. In tranquil currency union changes, notably Ireland’s secession from its currency union with the United Kingdom in 1979 and subsequent participation in the process leading to the euro, the impact on bilateral trade is unclear.Theweaker the link between currency union and bilateral trade, the less convincing is the claim thatOCA criteria become self-fulfilling ex post.

In practice, irrespective of whether the criteria may become endogenous, most of the literature on currency domains treats OCA theory as having predictive capability. Yet, the general track record of OCA theory in explaining the monetary history of the post-1945 international economic order has been miserable. Despite the increasing openness of national economies and increasing capital mobility, both unambiguous pressures for larger currency areas according to OCA theory, the number of currencies has increased substantially and the geographical size of currency domains has shrunk correspondingly. The sole significant exception is the introduction of the euro, but in Europe and the former SovietUnion as a whole there weremore currencies in 2002 than a decade earlier.Globally, over the last half century, the exogenous increase in the number of countries drove the number and size of currency areas, and theOCA criteria were irrelevant to explaining this pattern. In sum, although OCA theory has dominated the analysis of currency domains, the empirical support for the theory is weak.