Robert Mundell's Work on Optimum Currency Areas
Don Roper
The 1999 Nobel Prize in Economics was given to Robert Mundell, in part for his work, Optimum Currency Areas, which is often credited with the development of the Euro. The history of this classic article is found in a 1997 speech by Mundell. Having set out a theory of optimum currency areas in the early 'sixties, he concluded by the late 'sixties from further emprical observation that the optimum currecny area is the world.While Mundell is often cited as the (god)father of the Euro, his notion of a currency area was developed before more recent literature that recognizes that multiple currencies can circulate in parallel in the same area. Mundell almost entitled his article "Optimum Currency Units" which would have shifted attention from the size of geographical areas to the number of currencies. In my opinion a revolutionary part of his work is in the title itself which immediately suggests that an ideal currency area is not coincident with the nation-state. A political-economy of currency areas is not the same as the pure economic theory of currency areas. Despite the fact that Mundell focused on currency areas, his work was perhaps the first in what might be called multi-currency monetary theory simply because he separated currency areas from the nation-state.
Since the development of the Euro in 1999, countries in the southern cone of South American and countries in the ASEAN group have considered the adoption of a common currency. If countries adopt a common currency they obviously give up their independent monetary policies. A theory of optimum currency areas must identify the tradeoffs. The larger the currency area the fewer transactions costs from dealing in multiple currencies. The centerpiece of Mundell's theory is greater clarity around the cost to a country of giving up their central bank and monetary policy. The trust of his argument is that the cost to a country of losing its monetary policy may be less than imagined.
With perfectly fixed rates a central bank loses control of monetary policy -- base money must be created and destroyed in quantities necessary to fix the exchange rate. Mundell consequently contrasted (perfectly) fixed rates (or a common currency) with the case for floating or flexible rates in which the full benefits of discretionary monetary policy should be most evident.
Wage rigidity has been a topic of extensive discussion since Keynes' General Theory (1936), but Mundell did more than anyone else to bring this discussion into the theory of exchange rate policy by arguing that monetary expansion and devaluation may do nothing to resolve an unfavorable current account unless labor can be fooled into accepting a real wage cut. If labor will work just as hard with lower real wages then a country can indeed generate more exports w/o generating more imports and, thereby, strengthen the current account via currency depreciation.
Having identified a key assumption of the floating rate argument Mundell subsequently expressed doubts that labor can be fooled; hence, the floating rates looses its potency, the optimum currency area is larger than otherwise and the case for fixed exchange rates is strengthened.
It is important to note that the assumption of "money illusion" on the part of labor was used by Mundell to cover what many others refer to as sticky money wages. It also covers, from Mundell's perspective, what Keynes ("Economic Consequences of Mr. Churchill" 1925) referred to as the "me first" problem. When Britian returned to gold at the pre-war parity in 1926, Keynes warned that, even if labor were willing to lower money wages if general prices fell, they would not be willing to go first. What followed Britian's return to gold at an overvalued rate was the General Strike. The argument for floating rates requires, according to Mundell, that such real consequences to different values of a nominal variables (like the pound price of gold and foreign exchange) could have been avoided.
If, however, labor is mobile, they do not need to be fooled into taking real wage cuts via a devaluation in order for an economy with a BOP deficit to avoid an economic slump. If, following real trade theory, one defines a 'region' as an area within which labor is mobile and outside of which labor is immobile, then it is clear that a shift of demand from the goods of region A to the goods of region B can not, by definition of "region," be solved by the movement of labor from A to B. On the other hand, a shift of demand within a region can be addressed by labor mobility. If the argument for floating rates is to solve a current account imbalance, then it is hopefully most useful in solving that problem between regions. But, it doesn't work, according to Mundell, unless labor can be fooled into taking real pay cuts via devaluation. Thus, the Mundellian case for the Euro is the empirical argument that the individual central banks of Italy, France, ... can do little to solve intercountry shifts in demand with monetary policy; ergo, the case for individual currencies is weak.
So why would indebted countries resort to the printing press and devaluation if labor does not have money illusion? Answer: the hope that such illusion exists.
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