Friday, January 22, 2010

Euro Skeptics: Bad Analysis or Bad Timing?

Over at Econ Journal Watch, Lars Jonung and Eoin Drea have an interesting survey article that examines how U.S. economists viewed the Euro since its inception. They find that most U.S. economists were skeptical that the Euro would last, but more than 10 years later it still exists:
By now, the euro has existed for more than a decade. The pessimistic forecasts and scenarios of the U.S. academic economists in the 1990s have not materialized...Why were U.S. economists so skeptical towards European monetary integration prior to the physical existence of the euro?
Jonung and Drea argue that U.S. economists made the wrong call based on (1) their reliance on a static view of an optimal currency area (OCA) and (2) a failure to recognize the political economy behind the EMU and the Euro. On the first point they argue that the standard OCA view that certain criteria be met--labor mobility, price and wage flexibility, cross-border fiscal transfers, similar business cycles--before a country gives up its monetary autonomy and joins a currency union ignores the possibility that these conditions may emerge over time. For example, once a currency union is formed labor mobility and similarity of business cycles could eventually appear among the various regions making up the currency union even if they are initially absent. The authors point to the long evolution of the U.S. currency union as example of such a dynamic (or "endogenous") OCA. On the second point they remind us that the EMU and the Euro are only one part of a greater European integration project that started after WWII (ostensibly to minimize the chance of further wars) for which there is much political will.

These are reasonable arguments, but given the ongoing economic problems in Greece, Ireland, Portugal, and Spain I would not dismiss the U.S. Euro skeptics so fast. Greece, in particular, appears to be imploding and according to the folks at Morgan Stanley could be the Trojan Horse that brings down the Euro. Moreover, this crisis only serves to confirm the concerns of the Euro skeptics that Eurozone is not an OCA and thus a one-size-fits-all monetary policy simply does not work. Yes, given enough time maybe the Eurozone would endogenously become an OCA but the countries in trouble may not last that long. Even if these countries survive the immediate crisis there would still be real questions as to whether they could survive the next few years as noted by Martin Wolf and Martin Feldstein. So maybe all those U.S. Euro skeptics were not wrong but merely had bad timing.

Update: Paul De Grauwe shows (ht Mark Thoma) how the Eurozone is in some ways similar to the monetary policy straitjacket that the gold standard was for Europe in the 1930s.

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