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The optimum currency area puzzle.

Abstract The theory of optimum currency areas, suggesting the redrawing of currency areas across countries or splitting of national money into several currencies, is at odds with the one-money-one-country pattern that has dominated monetary history for 26 centuries. This paper puts forward an equilibrium approach which, by stressing the influence of the border effect on intranational adjustment, solves the puzzle and analyzes the closely related issue of the viability of monetary unions and regional specialization.

Keywords Optimum currency areas * Monetary unions * International adjustment

Optimal solutions in economics thrive as empirical evidence corroborates suggested hypotheses. Though not reaching the same standards of explanatory and predictive power as hard sciences, a large number of economic theories survive falsification and offer a reliable basis for policy design. The theory of optimum currency areas is a conspicuous exception. According to Mundell's well-known hypothesis, in the case of an asymmetric shock, internal balance can be re-established only in the regions in which labor is mobile. Hence, "the optimum currency area is the region," not the country (1961, 660). However, the circulation of one currency in an area overlapping neighboring nations has never been observed, let alone the splitting of a country's money into several currencies. It is therefore rather puzzling that the theory of optimum currency areas figures prominently in the economist's toolbox, since it is totally at odds with empirical evidence. (1)

Mundell's seminal article was no intellectual fad. It raised an important theoretical issue--"the central intellectual question of international monetary economics" (Krugman 1993a, 4)--directly bearing on the analysis of monetary unions. The literature on the topic gathered momentum, first introducing further optimality criteria (McKinnon 1963; Kenen 1969) and, after a long pause, incorporating the principles of the New Classical Macroeconomics, which provided the theoretical underpinning to the political objective of European monetary unification. The unprecedented character of this experiment, namely the adoption of a common fiat money by a large number of independent countries, attracted great attention, particularly with regard to its long-term prospects. Though critiques were initially widespread, chiefly among U.S. economists, skepticism evaporated as the project gained ground. (2)

The sudden crisis in early 2010, however, cast serious doubts on EMU's viability, exposing the unsatisfactory state of the subject. Paradoxically, before the outbreak of the crisis, the theory of optimum currency areas was blamed for failing to predict the euro's success, (3) whereas afterward it was invoked to explain the euro's bleak prospects. These glaring inconsistencies are related to the multifaceted nature of the topic. Looking at the issue from different angles brings out a variety of optimality criteria that, in some cases, appear to be in conflict with each other (Tavlas 2009). Thus, while Eichengreen (1992) and Krugman (1993c) highlight the increase in regional specialization and the reduction in income correlation under a common currency, Frankel and Rose (1998) point out greater trade integration leading to more correlated business cycles, results that speak against and for optimality respectively.

In general, the notion of optimum currency areas evokes the tension between opposing forces--the benefits of extending the currency domain and the costs of forsaking the monetary policy instrument--which should rule out extreme solutions, i.e., very large or relatively small currency areas. (4) Yet, excepting former colonies and minute nations, currency areas coincide with countries: according to the historical record, monetary union without political union proved to be short-lived (Bordo 2004). Indeed, the very idea of reshaping currency areas in order to achieve optimality is foreign to monetary evolution. No government ever thought of substituting a multiplicity of currencies for national money or designing a currency domain that included regions of other countries. The stylized fact instead is that, conditional upon political viability, national currencies are indefinitely viable.

The prevalence of the one-money-one-country pattern is a striking regularity, something like a natural law, which clashes with the implications of the theory of optimum currency areas. The lack of correspondence between the theory's variegated propositions and empirical evidence is a puzzle in international economics. The vicissitudes of the EMU provide further evidence of the puzzle because, after the initial success, the euro has been subject to centrifugal forces, a symptom of possible cracks in its construction. In this respect, a comparison with the United States is illuminating. Not only a very large economy but also a politically unified country, the United States has thrived as a currency area for centuries, even in the presence of conspicuous regional specialization. These stylized facts graphically show the resilience of the one-money-one-country pattern and, being at odds with the received view of optimum currency areas, spur the search for hypotheses that fit together the pieces of the puzzle.

Alternative Approaches to Optimum Currency Areas

According to Mundell's own account of the 1961 paper (1997, 29-32), he intended to criticize the case for flexible exchange rates put forward by Friedman and Meade, asking for the sake of argument whether their theory could be extended to regions. If exchange rate flexibility eased adjustment between countries, it should also ease adjustment between regions. Pursuing this line of reasoning, however, Mundell found that even between countries, exchange rate changes do not necessarily guarantee full employment and price stability. Only by redrawing borders around an area in which labor is mobile can internal balance be attained. Besides price and wage rigidity, the key assumption underlying this hypothesis is that international adjustment and intranational adjustment are equally awkward. As under the gold standard, payment imbalances put a strain on countries, the same happens to regions inside a country (1961, 658-60).

The peculiarity of this approach is that optimality depends on an exogenous characteristic of the economy, i.e., labor mobility, not, as in any economic problem, on an equilibrium process grounded in maximizing behavior. Optimal solutions, however, can hardly stem from ex ante, inbuilt features relating to just one aspect of an inherently complex problem. Moreover, the plurality of solutions poses a question of choice that has no obvious answer because each optimality criterion is specific to the issue considered. Hence, the proliferation of optimality criteria did not converge toward a generally accepted analysis, but opened a Pandora's box of variegated, even conflicting hypotheses. Since each of the exogenous criteria would supposedly yield an optimal solution, their multiplication represented a case of degenerative problem-shifts (Lakatos 1970). Like Pirandello's six characters in search of an author, optimum currency areas became a concept in search of a theory.

Given this state of affairs, it was inevitable that a rival research program should emerge, but it did not do so for several decades. The cogency of Mundell's argument stimulated the search for new optimality criteria, focusing on one of the three elements of his theory: asymmetric shocks, (in)effectiveness of interregional adjustment, and choice of policy instruments. Thus, product diversification aimed at reducing the probability of asymmetric shocks (Kenen 1969), capital mobility at enhancing interregional adjustment (Scitovsky 1957; Ingram 1959), and openness to trade at achieving price stability through the implementation of demand policies instead of exchange rate changes (McKinnon 1963). Once the lesson of the New Classical Macroeconomics was absorbed (Tavlas 1993), the end result consisted more in a refinement of the optimality criteria than in a paradigm shift. In this respect, a glaring example is the architecture of EMU that, being built on the single pillar of time-consistent monetary policy, neglects other essential elements of the construction, chiefly intra-union adjustment (see next section).

While Mundell's hypothesis underlines rigidities in the economy and the limits of economic policy so that internal balance can only be achieved by redesigning currency areas according to exogenous economic policy, classical theory posits factor mobility inside borders and is based on the frictionless setting of a pure equilibrium model. Hence, it ignores the stabilization argument and, focusing on the welfare gains generated by money, arrives at the optimal solution of a world currency. (5) These diametrically opposite views help to isolate the basic factors that affect the optimality issue. The classical assumption of absence of frictions does away with the distinction between international adjustment and intranational adjustment because both are highly effective. (6) Mundell's assumption of pervasive frictions also makes this distinction disappear, but for the opposite reason that both the domestic and the international adjustment mechanism are highly ineffective. Building upon extreme assumptions, however, these polar hypotheses have little explanatory power and, in fact, are not corroborated by empirical evidence because we observe neither a world money nor the frequent redrawing of currency areas. A more promising research strategy is to embrace an equilibrium approach and take account of frictions which, impinging on the adjustment mechanism, are essential to optimality. Equilibrium models are indeed the economist's workhorse, yet they should be thought of as a theoretical benchmark rather than ready-made hypotheses. Crucial assumptions can decisively affect the theory's results and must, therefore, be carefully considered. To give just one example, the Modigliani-Miller theorem rests on a number of assumptions that, once selectively released, lead to more robust hypotheses.

The launch of European monetary unification gave the subject a new turn. Although virtually all contributions still followed the received view, a novel equilibrium approach was put forward, emphasizing the effectiveness of intranational adjustment due to the border effect. Within a country, optimality criteria result from the workings of the common currency and, thus, are endogenous (owing to the larger agents' information set, the common institutional and legal framework, and the panoply of policy instruments) (Cesarano 1997). On an empirical level, trade expansion brings more closely correlated business cycles, so that monetary union may well trigger and sustain this process (Frankel and Rose 1998). The equilibrium approach reversed the conception of optimum currency area based on exogenous characteristics, showing how market forces, institutions, and policies enhance intranational adjustment, bringing about the endogenous optimality criteria. (7)

The development of an equilibrium approach to optimum currency areas has been stimulated by the revival of classical thought, but also represents a return to the origins of the theory as developed by Abba Lemer in the 1940s and further elaborated by Friedman, Meade, and Scitovsky in the 1950s (Cesarano 2006; Boyer 2009, 2010; Dellas and Tavlas 2009). These distinguished economists contrasted the awkwardness of international adjustment with the smoothness of intranational adjustment so that inside a country, the effectiveness of equilibrium forces begets the optimality criteria. The interest of this brief digression is not just historical but theoretical. The point is the view of optimality as an equilibrium process rather than the product of inbuilt characteristics.

The Border Effect and Optimality

The classical solution of a world money, of course, sets an upper bound to the optimum. A lower bound, however, is not immediately obvious. Moving in the opposite direction away from a frictionless setting, a wide variety of obstacles to adjustment appears. Yet all of them derive from the existence of borders, conceivably the overriding source of frictions in international economics, intrinsic to the nature of the subject.

The border is not a mere physical or political boundary but an economic barrier that impinges on diverse aspects of the adjustment mechanism (Cesarano 1997, 2011). First, it entraps information inside a country, making agents' decisions less costly and, therefore, more responsive to shocks and changing economic conditions. This enhances the efficiency of markets, the reallocation of resources and, ultimately, the mobility of goods and factors, thus fostering equilibrium. Second, the border defines a uniform framework of laws, institutions, and regulations, not to mention language and cultural identity, that reduce uncertainty surrounding economic behavior, further heightening information and the effectiveness of adjustment. Third, inside a country, the availability of a wide range of policy tools can make up for inadequacies in the interregional adjustment mechanism, especially in case of major shocks. In the 1930s, fiscal policies by the federal government helped to smooth out the effects of the Depression in the hardest hit states. In normal times, regional policies as well as other measures can supplement automatic stabilizers to deal with disequilibria.

Taken together, the centripetal forces underlying the border effect create a critical mass that, by strengthening adjustment inside a country, makes the nation's money unlikely to be displaced by other types of monetary organization. Hence the prevalence of the one-money-one-country pattern throughout monetary history. That countries of greatly different economic dimension have successfully fared without needing to split into several currency areas or join a monetary union testifies to the resilience of national moneys.

Weighing the two opposite factors that bear on optimality, the welfare gains of extending the money domain and the costs of giving up the monetary policy instrument, the crucial one is the latter. In fact, welfare gains are uniform across the currency area and are strictly positive, bringing about a variety of benefits analogous to those produced by international money and its many uses. Independent monetary policy, on the other hand, can play an important role in smoothing cyclical functions (Lucas 2003) but, as noted by Mundell himself (1961, 662), stretching the stabilization argument to extremes leads to the division of the currency domain into smaller and smaller areas in order to eliminate all pockets of unemployment. Of course, this conjecture is implausible: not only does it impair the efficiency of money, it also finds a limit in the adjustment capacity of the economy that makes the pursuit of full employment in the tiniest region completely useless. Therefore, the border effect leads to a discontinuity in the design of monetary arrangements since, by heightening the self-equilibrating property of the domestic economy, it decisively bears on currency area optimality.

The foregoing analysis suggests that any country constitutes per se a lower bound because the border effect excludes the splitting of national money into several currencies. Indeed, such an event has never been observed. Considering instead currency areas larger than a country, the striking feature is the regularity of monetary unions involving city states or very tiny nations like Andorra, Liechtenstein, Monaco, etc., which usually adopt the currency of a large neighbor. Being so small, these economies can hardly suffer from interregional adjustment problems and the lack of independent monetary policy, whereas, by entering a greater currency domain, they reap the welfare gains generated by the common money, therefore obtaining a positive net benefit. This provides an indirect proof of the magnitude of the critical mass brought about by interregional adjustment and the significance of the border effect in all but the smallest countries.

These stylized facts shed light on the viability of monetary unions. The border effect tampers with intra-union adjustment so that, for the less competitive members, adjustment costs may, at some critical point, rise above the welfare gains from the common currency, thus involving a net loss. If wide-ranging reforms did not reduce frictions and adjustment costs below the critical point, monetary union would not be viable. The historical evidence points in this direction. Even at the heyday of commodity standards when both theory and institutions were most consonant with equilibrium models, the main experiments in monetary union like the Latin Monetary Union soon came under severe strains, usually after public finance imbalances, and stopped functioning according to the rules.

Upon the establishment of a common currency, the maintenance of borders significantly hinders intra-union adjustment, but at the same time, the effects of money flows are inescapable. This potentially fatal conflict has its roots in the coexistence of a supranational monetary authority with a plurality of governments. In general, the less the power of monetary authorities, the more automatic adjustment. In a monetary union, the abolition of national central banks eliminates balance-of-payment problems and makes adjustment fully automatic, as in an undiluted gold specie standard in which central banks have virtually no role to play and money flows are unstoppable. However, while the effects of money flows cannot be halted, the border effect tampers with intra-union adjustment, putting increasing pressure on the common currency. Hence, excepting a frictionless setting in which borders are irrelevant, monetary union sans political union may well run into trouble.

The analysis of the adjustment mechanism, then, is central to the theory of optimum currency areas and clarifies some puzzling issues. First, the dominance of the one-money-one-country pattern stems from the effectiveness of intranational adjustment which, as mentioned above, brings about a critical mass that makes the country's money hard to supplant. Actually, even among the largest countries, no national money has ever been replaced with several currencies. Furthermore, the frequent adoption of the currency of a neighbor on the part of small countries is indicative of the significance of the border effect just above a rather limited dimension of the economy. For instance, Luxembourg formed a successful monetary union with Belgium as early as 1921, yet the Netherlands had little incentive to adopt such a solution because it was large enough to make the border effect significant. In this respect, the fact that currency unions were mostly limited to tiny countries or former colonies makes the experiment of the euro all the more peculiar and farfetched.

Second, the contrast of the euro's success in the first decade with the sudden crisis in early 2010 can also be accounted for by the nature of the intra-union adjustment mechanism. Since money flows operate automatically in a monetary union, as inside a country, their effects are gradual and span a long time. This is similar to the operation of the gold standard, often compared to a large lake with small inflows and outflows, thus making adjustment in either the level of water or the intensity of the flows very gradual and lengthy (Fisher 1920, 95; Niehans 1978, 147 n. 5). An important consequence is that, in the presence of frictions due to the border effect, disequilibria accumulate before erupting into a major crisis. Actually, currency union may be looked at as an extreme form of hard peg which, being far more rigid than currency board and dollarization, does not allow members to opt out easily. This leads to growing imbalances.

Third, the notion of endogeneity of optimum currency area criteria depends on the border effect in an essential way. Only if adjustment forces can operate to their full extent in a monetary union as they do inside a country can the optimality criteria emerge from the establishment of a common currency. Monetary unification, therefore, must be accompanied by political unification, otherwise the maintenance of borders hampers adjustment and builds up disequilibria. Indeed, the presence of borders and the different speeds of adjustment to various types of imbalances explain the scanty integration of EMU's economies and the lack of empirical evidence about the emergence of the optimality criteria. (8)

As envisaged by its supporters, the introduction of the euro provided for time consistent monetary policy and would be followed by reforms aimed at integrating markets and institutions. Yet no such reform, however comprehensive, could have the same efficacy as political unification on the elimination of institutional barriers and information failure in order to arrive at full-fledged economic integration. Thus, looking only at the benefits of time-consistent monetary policy while neglecting the adjustment problem in a monetary union sans political union would be like playing Hamlet without the prince. (9) Hailed as a project enhancing monetary stability and economic growth soon to be imitated in other parts of the world, the EMU seems to be heading toward mounting difficulties that may well discourage similar plans. Definitely, this unique exemplar of monetary organization was not set up on solid foundations, but was like venturing into uncharted territory without the compass of sound theory.

Asymmetric Shocks and Adjustment

Economies are continuously subject to shocks and changes of various kinds. Even in the most tranquil environment, an economy does not remain on a steady path but is affected by ever-mutating forces. The ultimate adjustment to changes in external conditions involves a reallocation of resources that varies widely in both magnitude and timing. While minor shifts in, say, the demand for consumption goods are quickly solved by price changes, the restructuring of a productive sector may take years if not decades. In any case, these problems cannot be tackled by episodic theorizing, or molding specific situations into different hypotheses. They must be handled by analyzing the adjustment process.

In this regard, the search for particular characteristics that would prevent the occurrence of shocks is misleading because it pretends to answer the adjustment problem by designing the economy according to those characteristics. This research strategy turns economic logic upside down. The analysis should instead focus on the way the economy reacts to shocks, or the nature of the equilibrating process. To give an example, the goal of market stability can hardly be pursued by looking for some peculiar, contingent feature that forestalls imbalances rather than investigating the dynamics of prices and quantities in response to shocks. These principles especially apply to optimum currency areas. Clearly, if change is connatural to economic evolution, it makes little sense to consider regions as immune from disequilibria because they possess a specific characteristic at a given time. What is at issue, instead, is the effectiveness of the adjustment mechanism.

Regional specialization is a case in point. Inasmuch as a common currency fosters specialization, regions are more vulnerable to adverse shocks whose impact may well be worsened by high capital mobility because booms attract capital in the region, heightening expansion, whereas slumps trigger capital outflows, deepening recession. Exchange rate variations could mitigate these disruptive disequilibria (Krugman 1993b, c). Notwithstanding the clarity of this argument, however, it is odd that, though regional specialization is greater in the United States than in the EMU area, the euro suffers from serious imbalances while the dollar has been thriving for more than two centuries. The empirical evidence vividly exposes the weakness of the received view, which selects single exogenous criteria to solve a multifaceted problem instead of focusing on intranational adjustment. In the United States, owing to the border effect, equilibrium forces heighten interregional adjustment, which gradually absorbs shocks and does away with the need for independent monetary policy by single regions.

Looking at the issue from an equilibrium perspective, regional specialization is the natural result of long-run real adjustment, reflecting the deep integration of the economy inside the border. The adjustment of domestic payment imbalances proceeds together with the necessary changes in resource allocation, though with different timing, both being the outcome of equilibrium mechanisms. As Krugman has showed (1991), the spatial distribution of economic activity is determined by Marshallian external economies, triggered by the reduction in a variety of transaction costs like transportation, tariffs, different regulations, etc. The concentration of certain industries in particular areas, then, is the result of a market process that brings about significant productivity and efficiency gains. Regions may be prone to demand or supply shocks, yet the significant integration of the economy within the border strengthens the effectiveness of intranational adjustment that sees to their absorption.

Alternatively, shocks could be tackled by exchange rate variations, splitting the money domain into diverse currency areas according to regional specialization. However, this is no ordinary policy measure but a major reform of monetary arrangements that cannot be implemented frequently. More importantly, after the reform is realized, the issue of adjustment pops up again. Inside each newly created currency area, real factors would push resource reallocation, fostering productivity and efficiency gains as well as specialization. Certainly, regions can be hit by shocks, but at the same time the effectiveness of intranational adjustment will see to their absorption. The point is the border, once defined, has momentous implications for agents' behavior, institutions, and economic policy that heighten both real and monetary adjustment, ensuring the viability of the nation's money.

These issues essentially depend on the flexibility of the economic system and, of course, do not emerge in a frictionless setting. In a monetary union, borders are the main source of frictions, leading to the conflicting combination of automatic money flows and fettered intra-union adjustment. If structural differences between members are considerable, adjustment costs will put monetary union under strain. The maintenance of sovereignty gives rise to a hybrid form of monetary organization that has all the disadvantages of every alternative because countries lose the exchange rate instrument and incur the adjustment costs brought about by the border effect.

The scenario is totally reversed if monetary unification is accompanied by political unification. Bringing back the conspicuous regional specialization in the U.S., the long-standing viability of so big a currency area might appear a singular phenomenon, analogous to the paradox of hornet flight. It appears surprising that such a huge and regionally specialized economy did not break into several currency areas but has thrived for centuries, overcoming the most serious imbalances. However, this is just the result of the effectiveness of adjustment inside a nation that endogenously fosters the optimality criteria. Just as hornets can fly thanks to elastic thorax structures that save kinetic energy, large countries can fly high because the flexibility of the fully integrated economy reduces intranational adjustment costs. On the contrary, the establishment of a common currency in a group of countries postulates, implicitly or explicitly, a smooth intra-union adjustment. If this condition did not exist, as it were, the noose of the common money would very gradually yet inexorably tighten around the neck of feebler members, slowly suffocating them.

The focus on asymmetric shocks in the analysis of optimum currency areas has been a source of confusion. It is connatural to the traditional approach that arrives at a static solution of a problem which, by its very nature, is essentially dynamic. The many types of shocks instead suggest an equilibrium approach that probes into the properties of intranational adjustment. Asymmetric shocks do occur in large, regionally specialized economies which, however, do not divide into several currency areas but thrive on possible sluggishness in attaining a new equilibrium. The effectiveness of interregional adjustment inside the border, therefore, accounts for the optimum currency area puzzle. Nations of unequal economic size and most variegated characteristics, say China and Cambodia, are all viable currency areas because the large agents' information set, the common legal and institutional framework, and the panoply of policy instruments heighten the internal adjustment mechanism, thus smoothing eventual disequilibria. Hence the dominance of the one-money-one-country pattern.

The equilibrium hypothesis also explains the difficulty of successfully establishing monetary union unless it is accompanied by political union. If borders are maintained, many kinds of frictions meddle with intra-union adjustment, imposing significant costs on less competitive members. The automaticity of monetary adjustment puts real factors--efficiency, productivity, growth--in the foreground, so that differences in competitiveness are of critical importance. This was clear to the leading exponents of the classical theory of the balance of payments, Antonio Serra (1613) and David Hume (1752), who emphasized the role of real variables and economic growth in the distribution of the world money stock through the specie-flow mechanism. (10)

Conclusions

Obstfeld and Rogoff (2001) have accounted for the six major puzzles of international economics by a single hypothesis based on the friction of trade costs. Optimum currency areas constitute a seventh puzzle: even though the theory implies the redesigning of currency areas among regions of different countries or the splitting of a nation's money into several currencies, the one-money-one-country pattern has dominated through 26 centuries of monetary history. This puzzle too is closely related to a key friction, the border effect, which hinders international adjustment and heightens intranational adjustment.

Central to the theory of optimum currency areas is the effectiveness of the adjustment mechanism in relation to the goal of internal balance. The assumptions underlying Mundell's disequilibrium view, chiefly price and wage rigidity as well as lack of domestic factor mobility, suppress all adjusting factors, thus making optimally depend on exogenous characteristics. From an equilibrium perspective, the centripetal forces stemming from the border effect create a critical mass that intensifies the effectiveness of interregional adjustment and the emergence of the optimality criteria, which are, therefore, endogenous. The equilibrium approach turns the conception of currency area optimality on its head, shifting the focus from a static problem solved by redrawing currency areas to the dynamic problem of absorbing shocks through the domestic adjustment mechanism.

In a world of continuous change, tailoring currency areas to one inbuilt characteristic, as the received view prescribes, would at best answer just one type of imbalance. Likewise, redesigning currency areas in order to avoid asymmetric shocks would not do because the adjustment problem would emerge again in the new setting: under ever-mutating circumstances, a once-and-for-all policy is illusory. On the other hand, looking at optimality from an equilibrium viewpoint brings out the nature and properties of intranational adjustment that see to the absorption of all kinds of shocks. The border effect, by heightening domestic adjustment, brings about a discontinuity in the range of monetary arrangements because, to displace national money, alternative monetary organizations must match its adjustment properties, which is implausible. The equilibrium approach, then, explains the optimum currency area puzzle.

In this connection, the widespread use of an international money throughout monetary history, normally the currency of the dominant power (Mundell 1972), never replaced national currencies. The adjustment costs incurred by countries would have probably more than offset the welfare gains of extending money's domain to the world. Thus, in the half century before World War I, notwithstanding the widely shared ideal of unifying the monetary system under the gold standard, only a few core countries were able to play by the rules of the game. This stylized fact corroborates the significance of the border effect. With regard to monetary union, therefore, the conflict between unescapable money flows and hindrances to adjustment due to borders, inherent in the design of monetary union sans political union, accounts for the ephemeral success of the euro. On the contrary, because economies are greatly integrated inside the border, the currencies of countries of very unequal size and conspicuous regional specialization coexist and exhibit everlasting resilience to multifarious shocks.

Acknowledgments I would like to thank Michael Bordo, Benjamin Friedman, David Laidler, and an anonymous referee for their useful comments. This paper was presented to the 73rd International Atlantic Economic Conference in Istanbul in March 2012. I am grateful to the discussant, Manfred Gartner, and to other participants for their helpful suggestions. The usual caveat applies. The views expressed in this paper are the author's own and not necessarily those of the Banca d'Italia.

Published online: 9 May 2013

[c] International Atlantic Economic Society 2013

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Serra, A. (1613). Breve trattato delle cause che possono far abbondare li regni d'oro e d'argento dove non sono miniere. In P. Custodi (Ed.), Scrittori Classici Italiani di Economia Politica, volume 1. Milano: Destefanis, 1803. A short treatise on the wealth and poverty of nations. Ed. by S. A. Reinert; transl. by J. Hunt. London: Anthem Press, 2011.

Tavlas, G. S. (1993). The 'new' theory of optimum currency areas. The World Economy, 16(6), 663-685.

Tavlas, G. S. (2009). Optimum currency area paradoxes. Review of International Economics, 17(3), 536-551.

Willett, T. D., Permpoon, O., & Wihlborg, C. (2010). Endogenous OCA analysis and the early Euro experience. The World Economy, 33(7), 851-872.

(1.) This point has been made by Goodhart and Mussa: "The evidence ... suggests that the theory of optimum currency areas has relatively little predictive power. Virtually all independent sovereign states have separate currencies, and changes in sovereign status lead rapidly to accompanying adjustments in monetary autonomy. The boundaries of states rarely coincide exactly with optimum currency areas, and changes in boundaries causing changes in currency domains rarely reflect shifts in optimum currency areas" (Goodhart 1995, 452); "When we look at the factors that actually determinate the domains of different monies, we find that they are not the economic considerations suggested by the theory of optimum currency areas, as first discussed by Mundell, Kenen, and McKinnon 30 years ago. They are, rather, political. In particular, virtually all of the world's nations assert and express their sovereign authority by maintaining a distinct national money and protecting its use within their respective jurisdictions. Money is like a flag; each country has to have its own" (Mussa 1995, 98).

(2.) In their thorough survey, Jonung and Drea (2010) found various shades of criticism of the euro before its launch by Dornbusch, Feldstcin, Friedman. Krugman, Obstfeld, and Tobin, among others. These critiques dimmed after the successful establishment of the common currency. Thus Otmar Issing remarked: "The change in the attitude of economists, especially in the United States, could be observed ... at ... the annual meetings of the American Economic Association. After very critical reactions before the start of EMU, the panelists and the audience became more and more positive about the future of EMU as the years passed " (2010, 70).

(3.) In particular, several discussants of the Jonung and Drea article (2010, 59-77) stress the limits of the theory in capturing the weight of political factors on the euro's achievements in the first decade.

(4.) As Jeffrey Frankel remarked: "An optimum currency area can thus be defined as a region that is neither so small and open that it would be better off pegging its currency to a neighbor, nor so large that it would be better off splitting into subregions with different currencies. The principle of the interior solution crops up again. Even to the extent that corner solutions are appropriate for given countries, the optimal geographic coverage for a common currency is likely to be intermediate in size: larger than a city and smaller than the entire planet" (1999, 11).

(5.) Mundell incisively illustrates the classical position: "Money is a convenience and this restricts the optimum number of currencies. In terms of this argument alone the optimum currency area is the world, regardless of the number of regions of which it is composed" (1961, 662). It is ironic that Mundell, who strongly criticized the classical hypothesis, later became a staunch supporter of a world money (see his Nobel lecture, Mundell 2000) owing to his long-standing aversion to exchange rate flexibility motivated by the quest for anchoring economic policies. In a fiat money standard, however, this objective may prove hard to realize.

(6.) In his celebrated essay, David Hume elaborates on this proposition, stressing the role of growth in the specie-flow mechanism both inside a country and between countries. "How is the balance kept in the provinces of every kingdom among themselves, but by the force of this principle, which makes it impossible for money to lose its level, and either to rise or sink beyond the proportion of the labour and commodities which are in each province? ... [A]ny man who travels over Europe at this day, may see, by the prices of commodities, that money, in spite of the absurd jealousy of princes and states, has brought itself nearly to a level; and that the difference between one kingdom and another is not greater in this respect, than it is often between different provinces of the same kingdom. Men naturally flock to capital cities, sea-ports, and navigable rivers. There we find more men, more industry, more commodities, and consequently more money; but still the latter difference holds proportion with the former, and the level is preserved" (1752, 65-66).

(7.) The conclusions of Mundell's article graphically show the clash between his approach and the equilibrium approach. Acknowledging the case for flexible exchange rates, he considers internal factor mobility a given, or an exogenous characteristic, not the product of an equilibrium mechanism. "[The] validity of the argument for flexible exchange rates ... hinges on the closeness with which nations correspond to regions. The argument works best if each nation (and currency) has internal factor mobility and external factor immobility. But if labor and capital are insufficiently mobile within a country then flexibility of the external price of the national currency cannot be expected to perform the stabilization function attributed to it, and one could expect varying rates of unemployment or inflation in the different regions. Similarly, if factors are mobile across national boundaries then a flexible exchange system becomes unnecessary, and may even be positively harmful, as I have suggested elsewhere" (1961, 664).

(8.) For an extensive discussion of these empirical findings, see Willett et al. (2010). In this connection, Barry Eichengreen, recalling how the decision to form political union put an end to the circulation of separate monies in the U.S., rightly ridicules the reverse hypothesis that, by the way, is exactly what the founders of the EMU had in mind: using the lever of the euro to lift up Europe's political unification. "Arthur Rolnick, Bruce Smith, and Warren Weber (1993) ... suggest that the inefficiencies of separate currencies created pressure for the creation of a single currency and that this required political unification. By implication, the U.S. Constitution was the product of floating exchange rates!" (1996, 12, n. 12).

(9.) On the limits of the New Classical Macroeconomics for modeling a monetary economy, see Friedman (1979) and Laidler (2010).

(10.) Thus Schumpeter remarks: "The really important point is not that [Serra] explained the outflow of gold and silver from the Neapolitan Kingdom by the state of its balance of trade, but that he did not stop at this but went on the explain both the outflow and the balance of trade by the economic conditions of the country. Essentially, the whole treatise is about the factors on which depends the abundance of commodities--natural resources, the quality of the people, the development of industry and trade, the efficiency of the government--the implication being that if the economic process as a whole functions properly, the balance of trade will take care of itself and not require any specific. In this schema monetary phenomena are consequences rather than causes, and symptomatic rather than important in themselves. And the author (in his discussion of the case of Venice, ch. X, Part I) brushes against, though he docs not explicitly state, the proposition that a prosperous country--that is to say, a country whose economic process is not disintegrating--can have all the gold and silver money it may require. From this, however, the way should not have been very far to Hume" (1954, 354-55). About Hume, see footnote 6 above.

F. Cesarano

Banca d'Italia, Via Nazionale, 91, 00184 Roma, Italy

e-mail: filippo.cesarano@gmail.com

F. Cesarano

e-mail: filippo.cesarano@bancaditalia.it
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