Everybody now is calling for a higher degree of integration of economic policy in the Eurozone. The recent events prove that an integrated monetary policy doesn't suffice to ensure sustainability, if the fundamentals of the member countries diverge sharply. Hence, politicians and journalists are keen on demanding harmonisations of tax rates, coordinated wage setting and - maybe most prominently - fiscal federalism.
Do these proposals capture the spirit of the theory of optimal currency areas? At least the latter one does not.
What is ment by fiscal federalism these days? Basically a transfer union. The core countries are supposed to support the periphery. Explicitily by direct transfers or implicitly by e.g. guarantees on their governtment debt and by providing cheap funding via the EFSF.
What is ment by fiscal federalism in OCA theory? Well, pretty much the opposite. Areas within a currency area facing excess demand and inflationary pressure transfer parts of their budget to areas where growth is sluggish. If this would have been the case in the Eurozone, Ireland and Spain should have transferred funds to Germany and France in the years before the financial crisis, where everybody used to call Germany "der kranke Mann Europas". Mike Wickens wrote an insightful paper dealing with the stability of currency unions. The stability is at risk, if the nominal interest rate is set for the currency area as a whole. However, country-specific inflation rates then yield to country-specific real rates and inflationary pressure is somehow self-reinforcing via the further decrease of the real rate. This could create a positively sloped demand curve and therefore an unstable development away from equilibrium. Nevertheless, there are some mechanisms which could still ensure stability. First of all, a positive inflation differential in a currency union automatically a real appreciation which might bring down AD. Wickens additionally introduces the possibility of fiscal transfers from "overheaters" to "low-performers", which further promote stability.
But at least concerning this issue, the model - and OCA theory in general - is way too stylized and remains wtihin an unrealisitc two-country setup. The most striking argument against such mechanisms is the heterogenity of the Eurozone members. Just consider their size. Ireland could pass over its whole budget to Germany, but this would yield only a small stimulus. Moreover, such transfers don't seem politically feasible, as we still witness large differences in GDP per capita between core and periphery countries. Admittedly, transfers from Germany to the periphery would be in line with Wicken's proposal for today, since Germany benefits from strong export-driven demand and the periphery suffers from weak AD right now. But if this constellation inverts again, then we are back at the problem I sketched out. OCA theory is silent on these issues.
Politicans are looking for support for the currently discussed measures by talking about OCAs just like if it was their daily bread. This is dishonest. OCA theory doesn't support systematic transfers.
