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.
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