The Endogeneity of OCA Conditions and Macroeconomic Imbalances in EMU

Abstract

When assessing the benefits of monetary union in Europe, an important debate over the direction of causality of effects emerged. On one side of the argument, the theory of optimum currency areas (OCA) recommended some a priori conditions necessary to ensure the gains from monetary integration. Underlying such conditions was the objective of either ensuring the availability of alternative mechanisms to allow adjustment to idiosyncratic shocks or reducing the probability of occurrence of such events. On the other side, advocates of the endogenous properties of currency unions suggested an inverse direction of causality, a position based on the assumption that monetary integration, by itself, promotes a quick process of real convergence, rendering domestic adjustment mechanisms irrelevant. Almost two decades after the birth of the euro, and in the midst of a prolonged financial, economic and political crisis in the European Union, for which many blame the single currency, there is now sufficient data to contrast both sides of the argument. In this paper, we use OCA indices to investigate the endogeneity hypothesis in the euro area, and to observe whether the dissimilar paths help explain current macroeconomic disequilibria, exposed in mounting internal and external imbalances.