Closer to OCA Criteria: Eurozone or Dollarzone?

This is a quick follow-up to my recent article on the Eurozone. There I argued for more integration or separation in the Eurozone since ECB monetary policy is pushing regional economies further apart rather than together. I showed a version of the below chart in the article to illustrate this point:

ECB policy--and its response to the various shocks hitting the Eurozone--has effectively kept nominal demand growth in the core economies fairly stable while pulling it down in the periphery. This divergence suggest the Eurozone is quite far from being an optimal currency area (OCA). 

Someone asked on twitter what the chart would look like for the United States. So I made a similar chart that compares the top twenty states (ranked in terms of GDP per capita) to the bottom twenty:

While both regions are below their pre-crisis trend paths, Fed policy has at least been consistent in how it has affected nominal income growth in both rich and poor states. So the Fed beats the ECB on consistency, at least! 

Moreover, this outcome suggests there are more effective regional shocks absorbers in the United States that make the dollar zone more of an OCA than the Eurozone. That is, even if Fed policy is not optimal for all regions of the United States this is less of a problem than in Europe because the regions can better handle bad monetary policy via fiscal transfers, labor mobility, safer retail banking system, flexible prices, etc. For more on these shock absorbers see my other recent post on this topic.

Will Australia Be the First Country to Try NGDPLT?

There is a new Brookings paper by Warwick J. McKibbin and Augustus J. Panton titled Twenty-five Years of InflationTargeting in Australia: Are There Better Alternatives for the Next 25Years? Here is how they answer the question in their title:

This paper surveys alternative monetary frameworks and evaluates whether the current inflation targeting framework followed by the RBA for the past 25 years is likely to be the most appropriate framework for the next 25 years. While flexible inflation targeting has appeared to work well in Australia in the past decades, the nature of future shocks suggests that some form of nominal income targeting is worth considering as an evolutionary change in Australia’s framework for monetary policy.

Put differently, this Brookings paper argues that inflation targeting is a monetary regime whose time has come and gone. I completely agree. 

What is interesting, though, is that they are making this case for Australia whose economy has had a remarkable 27-year expansion. This is attributable, in part, to the Reserve Bank of Australia (RBA) who has successfully navigated through numerous shocks including the bursting of the tech bubble, the global financial crisis, commodity price collapse, and periodic bouts of China panic. The last time there was a recession in Australia it was in the early 1990s.

Along these lines, it is worth highlighting again that Australia, if any country, should have experienced a so-called 'balance sheet' recession in 2008-2009. It had a housing boom and a surge in household debt that exceeded the United States as seen below. It also faced a large negative commodity price shock in late 2008-early 2009. And yet there was no Great Recession in Australia. 

Australia, in short, was the balance sheet recession that never happened. The reason the Australian economy faired so well is because is because the RBA never hit the ZLB and, in so doing, kept aggregate nominal income on it trend growth path. Thus, there was less financial stress created for nominal debt contracts holders. So, unlike the Fed and the ECB, the RBA saw its nominal GDP stay roughly on course during and right after the global financial crisis. And that made all the difference in the world.

This gets us back to the new Brookings paper. So why do the authors argue for an explicit nominal GDP level target (NGDPLT) when the RBA's inflation target has been implicitly doing the same? The authors argue that going forward the biggest shocks likely to hit the Australian economy will be large supply shocks:

There are three main areas where future shocks can be anticipated. The first is climate change and climate policy responses. The second is the emergence of a fourth industrial revolution or a new Renaissance due to the rapid adoption of new technologies such as artificial intelligence. The third is the growth of larger emerging economies into the world economy following the experience of China.

The authors note an explicit NGDPLT is better suited to handle such shocks and thus their call for the RBA to adopt it. I agree completely on the supply shock motivation. I would, however, submit another reason for the RBA to explicitly adopt a NGDPLT in Australia. 

The RBA in the past has done a great job keeping nominal income on its trend growth path. However, in recent years it has actually slipped a bit and now it is now below trend. An flexible inflation target, apparently, is not enough to always keep aggregate demand growth stable. Moving to an explicit NGDPLT would put the focus on this emerging gap and force the RBA to take corrective actions. 

New Zealand was the first country to adopt inflation targeting. It was the avant-garde of this new monetary regime in the early 1990s. So maybe a smaller economy like Australia needs to do  same with NGDPLT before other larger economies try it. Here is hoping the RBA is willing to try it. 

The Future of the Eurozone

So we are live at NRO discussing the future of the Eurozone:

Albert Einstein is rumored to have quipped that doing the same thing over and over again and expecting different results is the definition of insanity. If he were alive today, Einstein might say this is the definition of some key euro-zone policymakers.

There I argue hard choices have to made in the Eurozone: further integrate or separate.

So where does this leave the euro zone? For now, euro-zone officials are still kicking the can down the road, but at some point they will face a fork. One path will force further integration upon the euro zone, along the lines of Emmanuel Macron’s proposal and better ECB monetary policy. The other path will lead to the separation of the euro zone. As Ashoka Mody shows in his new book, the 20-year history of the euro zone suggests the latter path is more likely. Breaking up the euro zone, though, need not end the EU. As suggested by Ambrose Evans-Pritchard and Ramesh Ponnuru, the periphery could keep using the euro while the core could exit and adopt their own currency: Call it the Deutschmark 2.0. This approach would minimize the financial stress from the breakup of the currency union.

One chart that did not make it into the final article is below showing the OCA theory. It shows that if a region’s business cycle is similar to the currency union or if there are sufficient shock absorbers in place, or some combination of the two exists, then it makes sense for the region to be in the currency union. If a regional economy does not meet these criteria, like Italy, then it would be inside the OCA frontier curve in the figure and should not join the currency union. 

My conclusion in the article effectively says that Eurozone officials are not willing or able to make the changes needed to push countries like Italy beyond the OCA frontier. Ashoka Mody makes a convincing case in his book that, if anything, the Eurozone is pushing countries like Italy farther inside, away from the OCA frontier. Better to address the inherent tensions of the Eurozone now than to keep kicking the can down the road.