Paul Krugman has an interesting column today where explains the Greece and Eurozone crisis from the optimal currency area (OCA) framework. Greg Mankiw also likes the OCA framework, but takes issue with Krugman's emphasis on the lack of a centralized fiscal authority as the key reason why the Eurozone is a mess:
Using this framework I showed that Greece lies inside the OCA boundary. That is, there is not enough of either business cycle similarity or shock absorbers in Greece to justify the cost of its membership in the Eurozone. This is the point Mankiw is making--a number of factors not just lack of meaningful fiscal transfers is why Greece and other countries in the Eurozone may abandon the Euro.
Mankiw's claim, however, that the U.S. currency was an optimal currency area in the 19th century is less convincing. In terms of labor mobility, Gavin Wright has shown that South was an almost entirely separate labor market up until the 1930s-1940s. There was very little labor movement going into and out of the South up until New Deal programs and World War II spending opened up the region. Thus, the cost of the South's membership in the U.S. currency union may have exceeded the benefit up until the latter half of the 20th century. Interestingly, Hugh Rockoff makes the case the U.S. economy did not become an OCA until the 1930s!
I will go one further in this debate. It is not clear to me even now that all of the United States is an OCA. Do we really think Michigan and Texas over the past decade or so benefited from the same monetary policy? And do we think both states had an adequate amount of economic shock absorbers? Given the vast differences between these two states in their business cycles, diversification of industry, union influence, and wage stickiness it easy to wonder whether these states should belong to the same currency union. Yes, they have access to fiscal transfers, labor mobility is great (I myself left a job in Michigan for this one in Texas), culturally they are similar, and politically there is will for the dollar union. Still, given the disparate impact of U.S. monetary policy on different regions of the country one does wonder whether all the United States is truly an OCA.
Update: See Ryan Avent, Paul Krugman, JJ Rosa, and Urbanomics for replies to this post.
A large part of [Krugman's] argument is that Europe is not an optimal currency area because it lacks a large central government enacting transfer payments among the various regions... Is that right? I am not so sure. The United States in the 19th century had a common currency, but it did not have a large, centralized fiscal authority. The federal government was much smaller than it is today. In some ways, the U.S. then looks like Europe today. Yet the common currency among the states worked out fine.Mankiw attributes the success of the U.S. currency union in the 19th century to wage flexibility and labor mobility. He notes, though, that Greece and much of the Eurozone lack these and thus the Euro experiment may be doomed. I agree with Mankiw that the Eurozone problems are more than just the lack of a centralized fiscal authority. As I have shown before, members of a currency union should (1) share similar business cycles or (2) have in place some combination of economic shock absorbers including flexible wages and prices, factor mobility, fiscal transfers, and diversified economies. Having similar business cycles among the members of a currency union means a common monetary policy, which targets the aggregate business cycle, will be stabilizing for all regions. If, however, there are dissimilar business cycles among the regions then a common monetary policy will be destabilizing—it will be either too stimulative or too tight—for regions unless they have in place some of the economic shock absorbers. Here is how I represented this understanding graphically:
Using this framework I showed that Greece lies inside the OCA boundary. That is, there is not enough of either business cycle similarity or shock absorbers in Greece to justify the cost of its membership in the Eurozone. This is the point Mankiw is making--a number of factors not just lack of meaningful fiscal transfers is why Greece and other countries in the Eurozone may abandon the Euro.Mankiw's claim, however, that the U.S. currency was an optimal currency area in the 19th century is less convincing. In terms of labor mobility, Gavin Wright has shown that South was an almost entirely separate labor market up until the 1930s-1940s. There was very little labor movement going into and out of the South up until New Deal programs and World War II spending opened up the region. Thus, the cost of the South's membership in the U.S. currency union may have exceeded the benefit up until the latter half of the 20th century. Interestingly, Hugh Rockoff makes the case the U.S. economy did not become an OCA until the 1930s!
I will go one further in this debate. It is not clear to me even now that all of the United States is an OCA. Do we really think Michigan and Texas over the past decade or so benefited from the same monetary policy? And do we think both states had an adequate amount of economic shock absorbers? Given the vast differences between these two states in their business cycles, diversification of industry, union influence, and wage stickiness it easy to wonder whether these states should belong to the same currency union. Yes, they have access to fiscal transfers, labor mobility is great (I myself left a job in Michigan for this one in Texas), culturally they are similar, and politically there is will for the dollar union. Still, given the disparate impact of U.S. monetary policy on different regions of the country one does wonder whether all the United States is truly an OCA.
Update: See Ryan Avent, Paul Krugman, JJ Rosa, and Urbanomics for replies to this post.
I'm less sure that we can say that the US had a common currency in the (early, anyway) 19th century. Bank notes were local and, the further one got from the issuing bank, the greater a discount they were generally acepted at. In effect, banknotes from Georgia were treated in New York as more like currency from another country. Under somewhat tighter conditions governing isse, commercial banks still issued bank notes in the 1920s (I have one, from the Farmers and Merchants Bank of Terre haute, Indiana, with my grandfather's signature--he was the secretary of the bank). The movement to a uniform national currency did in fact accompany the development of a larger, more important central government.
ReplyDeleteAn addendum. The fact that all these currencies in the US were called "dollars" does not suffice to make them a common currency.
ReplyDeleteThere can be no such thing as a perfect OCA but the US probably comes closest to it. If the US carves out monetary unions there will be a price to pay (since each state now needs a central bank and so on) that could very well outweigh the flexibility of having different currencies. Africa is another interesting case: because it has multiple currencies, the flexibility has resulted in relatively prosperous countries like Botswana, Namibia and South Africa while at the same time a few countries are on the other end of the spectrum. If Africa adopted a common currency, the living standards in the prosperous countries would tend to go lower because there would always be a transfer of wealth from the richer countries to poorer countries to maintain the common currency (exactly what Germany is being forced to do for Greece).
ReplyDeleteIndia is probably the best example of a country that roughly has a US like system but is worse off with a single currency because underneath it is more Europe like in terms of heterogeneity. The more developed economies of Bangalore, Mumbai subsidize the poorer economies of much of the rest of the regions in the country.
Isn't solidarity a part of what a common currency zone is about. Richer states helping develope poorer states makes everyone better off in the long run. This is particularly true when trade barriers amoung states have been removed.
ReplyDeleteHowever solidarity takes a hit when international tariffs outside the common market countries are removed. Not only do they end up competing with countries that have different political economies but also with countries that use currency manipulation as unofficial tariffs.
The EU has a tariff free zone so there is no reason they shouldn't have a common currency if solidarity is their goal. In which case richer states have to be willing to help poorer ones.
Making Greece suffer for following it's interests by getting around EU rules isn't the way to solidarity. The way to solidarity is greater power over members given to the EU.
That brings the problem of solidarity down to the problem of legitimacy. The EU needs more democratic backing. It won't get it by punishing its members but by having more power vesting in it as a central government.
That may be too much for the European states to bear right now but it doesn't make it less true if unity is what they are aiming for.
Germany as the most economically powerful state in the EU could help by showing leadership toward that goal.
So David, we put this post of yours and the penultimate one together and we add them together to find the potential for monetary mischief to derail economic progress to a profound degree. But look a little deeper....and what shines through both euro madness and Fed dereliction is Neal Ferguson's dictum that politics trumps economics every time. Monetary mischief is always and everywhere a political phenomenon.
ReplyDeleteYou can rail all you want about technocratic fixes like nominal GDP targeting or optimal currency areas but we both know that this is irrelevant noise until and unless there is a configuration of political forces that finds them to be the convenience du jour - like Margaret Thatcher found Milton Friedman and the monetarists to be "useful idiots" in pursuit of class war against the unions in the 1980s.
The question is not whether the US is an OCA or not -it clearly is not, but what are the reasons why it has not disappeared.
ReplyDelete