Wednesday, July 22, 2015

The Big Lesson of the Eurozone Crisis

Paul Krugman notes that Eurozone crisis is a vindication of that optimum currency area (OCA) theory. I agree but would note the crisis also sheds light on the specialization versus endogeneity debate surrounding the OCA criteria. Interestingly, Krugman himself wrote some of the literature in this debate back in the early-to-mid 1990s.

So what is the specialization versus endogeneity debate? To answer this question, first recall that the OCA theory says members of a currency union should share similar business cycles, have economic shock absorbers (fiscal transfers, labor mobility, and price flexibility) in place, or some combination of both. Similar business cycles among the members of a currency union mean a common monetary policy will be stabilizing for all regions. If, however, there are dissimilar business cycles among them a common monetary policy will be destabilizing unless these regions have in place economic shock absorbers. This understanding can be graphically represented as follows:

Regional economies in this figure need to be outside the OCA boundary to be a viable part of a currency union. There they have a sufficient combination of business cycle correlation with the rest of currency union and economic shock absorbers. Inside the OCA boundary they do not.  In terms of the Eurozone, Greece would be inside the boundary and Germany outside of it.

Okay, those are the basics of the OCA theory. A question that emerged from this theory is whether a country like Greece that did not originally meet the OCA criteria could eventually do so. There were two answers to this question which led to the specialization versus endogeneity debate in  the OCA literature as noted by Mongelli (2002):
[W]hat type of forces might monetary unification unleash? Looking ahead, we may be confronted with two distinct paradigms -- specialisation versus “endogeneity of OCA” -- which have different implications on the benefits and costs from a single currency... 
The first paradigm is the “Krugman specialisation hypothesis” that is based upon the “Lessons of Massachusetts” i.e., the economic developments experienced by the US over the last century (Krugman (1993) and Krugman and Venables (1996)). This hypothesis is rooted in trade theory and increasing returns to scale as the single currency removes some obstacles to trade and encourages economies of scale. It postulates that as countries become more integrated (and their reciprocal openness rises) they will also specialise in the production of those goods and services for which they have a comparative advantage... Members of a currency area would become less diversified and more vulnerable to supply shocks. Correspondingly their incomes will become less correlated...An increase in integration would move a country away from the OCA line... 
The second paradigm is the “endogeneity of OCA” hypothesis... The basic intuition behind this hypothesis is that... [if] countries join together and form a “union,” such as the European Union (EU), both trade integration and income correlation within the group will rise: i.e., they will gradually move to... the right of the OCA line. This point carries important implications. A country’s suitability for entry into a currency union may have to be reconsidered if satisfaction of OCA properties is endogenous or “countries which join EMU, no matter what their motivation may be, may satisfy OCA properties ex-post even if they do not ex-ante!” (Frankel and Rose 1997).
In terms of the above figure, these two competing views can be drawn as pushing Greece either toward the OCA boundary or away from it.

The endogenous view of the OCA criteria fed right into what Lars Christensen calls the fatal conceit of Eurozone planners. It provided an ex-ante justification for believing all would work out well in this grand monetary experiment. The specialization view, on the other hand, was par for course with the tendency among American economists to be pessimistic about its success.

We all know now which view was right. Greece did not over time become better suited to be a part of the Eurozone.  And relative to Germany, many of the periphery countries, including Greece, became more specialized as seen in the figure below. This figure is constructed by looking at the agricultural, industry, manufacturing, and service shares of Eurozone economies relative to Germany and seeing how this ratio change over time. 

More sophisticated evidence suggests that at a minimum the periphery economies failed to further diversify after joining the Eurozone. So the great hope of Eurozone countries like Greece endogenously conforming to OCA criteria never happened. If anything, joining the Eurozone pushed Greece and the periphery further away from the OCA boundary. So probably the biggest lesson of the Eurozone crisis is to take the OCA criteria seriously before joining a currency union.

Thursday, July 16, 2015

Who Predicted the Eurozone Crisis?

According to a recent Bloomberg article, nine people saw the Eurozone crisis coming years before anyone else. Wow, only nine people saw it coming? That is remarkable, these folks must be truly prescient if only they foresaw the crisis. 

Except that this claim is terribly wrong. There were many economists who saw the problems of a European monetary union before it formed. One prominent economist not on the Bloomberg list is Martin Feldstein who wrote a famous 1997 Foreign Affairs article that began as follows;
Monnet was mistaken... If EMU does come into existence, as now seems increasingly likely, it will change the political character of Europe in ways that could lead to conflicts in Europe...What are the reasons for such conflicts? In the beginning there would be important disagreements among the EMU member countries about the goals and methods of monetary policy. These would be exacerbated whenever the business cycle raised unemployment in a particular country or group of countries. These economic disagreements could contribute to a more general distrust among the European nations.
Feldstein was one among many American economists who doubted a currency union in Europe would work. In fact, an entire article in Econ Journal Watch provides a survey of the skeptical tendencies of most American economists over the Euro prior to its inception. The authors, both Europeans, went on to claim these skeptical Americans had been proved wrong by history:
The main finding of our survey is that US academic economists were mostly skeptical of the single currency in the 1990s. 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. The euro is well established. It has not created political turmoil in Europe, and it has fostered integration of financial, labor and commodity markets within the euro area. Trade within the euro area has increased, and so has business cycle synchronization. Inflation differentials within the euro area are presently of the same order of magnitude as in the United States.
Why were U.S. economists so skeptical towards European monetary integration prior to the physical existence of the euro? 
Ironically, the article was published in early 2010 just as the Eurozone crisis was unfolding. For our purposes the most interesting thing about this article is not its incredibly wrong Euro triumphalism, but its documentation of the many American economists who were skeptical of the Euro. The article looks at American economists in the 1990s both at the Federal Reserve and in academia. Below is the list of academics covered in this paper. 

Add to this list another 43 surveyed from the Federal Reserve. So yes, there were a few more than nine people who expressed some level of doubt and worry about the viability of the Eurozone. So next time you hear someone touting the few who saw the Eurozone crisis coming, understand there were actually many who foresaw it.

Update: Presumably most of the UK residents who were against the Maastricht Treaty in 1992 did so because they understood the problems of a European currency union. After all, they had just gone through the Exchange Rate Mechanism crisis. So add these folks to the list of people who saw the Eurozone crisis coming.

Monday, July 13, 2015

Did Monetary Policy Really Offset Fiscal Austerity in Canada?

The blogosphere is once again talking about Canada's successful fiscal austerity in the mid-to-late 1990s. Paul Krugman rekindled the conversation with this statement:
[L]ook at everyone's favorite example of successful austerity, Canada in the 1990s. Canada came in with gross debt of roughly 100 percent of GDP, roughly comparable to Greece on the eve of the financial crisis. It then proceeded to do a pretty big fiscal adjustment -- 6 percent of GDP according to the IMF's measure of the structural balance, which is about a third of what Greece has done but comparable to other European debtors. But unemployment fell steadily. What was Canada's secret?
Ramesh Ponnuru and I have argued numerous times that Canada's secret was a monetary policy offset. That is, monetary policy eased to offset the drag of fiscal tightening. Paul Krugman agrees in the above post. The evidence that we and others have pointed to in support of this view is the Bank of Canada cutting its target interest rate more than 500 basis points between 1995 and 1997.  

Some of our conservative and libertarian friends, however, are not convinced by this evidence. David Henderson and Robert Murphy, in particular, have pushed back against this view. They contend there was no monetary offset. Henderson questions how much influence the Bank of Canada actually has over interests rates. Murphy goes further and provides a list of data points that he claims show the Canadian success story did not rely on loose money. So are Henderson and Murphy's skepticism of the monetary offset warranted?

The answer is no. Let us start with the Henderson's claim, echoed by Murphy, that the Bank of Canada has little control over interest rates. This point is generally true for long-term interest rates, but not for short-term interest rates. Central banks intervene in money markets and peg short-term interest rates all the time. It is true that if a central bank cares about price stability its short-run interest rate adjustments will conform over time to an interest rate path determined by the fundamentals. For example, Canada being a small open economy has its interest rates determined in part by capital flows from large economies like the United States. But this is a long-run tendency that still leaves a lot of wiggle room in the short run for central banks to tinker with interest rates. 

But do not take my word for it. See the figure below. It plots the target interest rates for both the Bank of Canada and the Federal Reserve over the period in question. The 500 basis point cut by the Bank of Canada is evident and occurs against a relatively stable federal funds rate. If the Bank of Canada has no control over its short-term interest rates then why was it able to create such large deviations around the federal funds rate? If the Henderson-Murphy view were correct this should not be possible.

Again, over the long-run the fundamentals will kick in and cause these two interest rates to follow a similar path. Henderson and Murphy assume this long-run relationship will also hold in the short-run. But it does not as shown above. The evidence, then, points to the Bank of Canada exogenously lowering short-term interest rates during the period of fiscal tightening.

I must say I was surprised to see an Austrian like Murphy makes this argument. Any Austrian worth his salt believes central banks can and do manipulate short-term interest rates. To go from this traditional Austrian position to one above is hard to reconcile. Put it this way: Murphy's reasoning, if consistently applied, would lead one to accept Bernanke's saving glut theory for the low interest rates during the housing boom. But Murphy does not accept this view. So it is hard to understand why he would suddenly embrace this emasculated view of central banks.

Murphy does attempt to provide other evidence to support his view on the Canadian austerity experience. It is impossible, though, to draw conclusions from his evidence because he does not provide the proper context for evaluating it. For example, one cannot simply look at the growth rates over a few years of the monetary base and nominal GDP as Murphy does and conclude with certainty whether monetary policy was tight or loose. Instead, one has to evaluate them against what was expected by the public and or desired by the central bank. 

So let us do that for the monetary base and nominal GDP. Consider first the monetary base (excluding required reserves) as seen below. This figure shows both the monetary base and its pre-1995 trend. Note the one-time permanent increase in it that occurs in the mid-to-late 1990s. A permanent increase in the monetary base is a sure way to raise aggregate demand and offset fiscal austerity. The above trend growth strongly suggests explicit monetary easing during this time.

Next, let us look at nominal GDP in the figure below. It shows the nominal GDP relative to its trend path. 

Note that nominal GDP follows its trend path rather closely during the period of fiscal austerity. The Bank of Canada, in other words, did what was necessary to keep aggregate demand on a stable growth path during this time. Given the evidence shown above, the Bank of Canada offset the fiscal tightening via lower interest rates and a permanently higher monetary base path. This story is completely missed by Murphy's cursory look at nominal GDP growth rates over a few years. So yes, monetary policy did offset fiscal austerity in Canada in the mid-to-late 1990s. 

The policy implications from this experience are clear. Economies undertaking fiscal austerity are best served by expansionary monetary policy. It provides a viable path to obtaining a more sustainable debt level. The ECB, however, tightened monetary policy twice during the Eurozone crisis. Given the one-size-fits-all approach problems, this tightening proved excessive for the periphery countries and helped spawn the soveriegn debt crisis. Just imagine how different the Eurozone would be today had the ECB began its QE program back in 2008.