Optimising the Eurozone
RBS's Economics department has released this pair of charts on Twitter:
The accompanying tweet said "One of these is an Optimum Currency Area. And the other isn't." It's easy to tell which is which, yes?
Not so fast. It's not that simple.
Robert Mundell, the inventor of the Optimum Currency Area (OCA) concept, defined the essential requirement for an OCA as free factor mobility. Since his rather vague definition, though, the concept has been developed further. Economists now generally agree that four criteria must be met for a group of regions or countries to qualify as an OCA:
- regions/countries should be exposed to similar sources of economic disturbance (common shocks);
- the relative importance of these shocks across regions/countries should be similar (symmetric shocks);
- regions/countries should have similar responses to common shocks (common responses)
- if regions/countries are subject to local economic disturbances (idiosyncratic shocks), they must be able to adjust to them quickly.
In practice, this means that regions/countries need a high degree of economic, political and cultural similarity to qualify as an OCA.
It is now generally understood that the Eurozone does not qualify as an OCA. The member states are culturally, politically and economically divergent, there are enormous trade and financial imbalances between them, and although free movement of both labour and capital is enshrined in EU treaties, movement of labour is decidedly sticky. An OCA should not experience a severe balance-of-payments crisis such as the Eurozone crisis of 2010-12: any economic divergences between the countries should be minor and transient. It seems likely, therefore, that the Eurozone is the area that RBS does not consider to be an OCA.
So, presumably the USA is the OCA. But wait.....is that really true? There are large cultural and economic differences between American states too.
In this paper, Michael Kouparitsas of the Chicago Federal Reserve considers whether the USA meets the criteria for an OCA. He divides the USA into eight groups of states, which he calls "regions". Five of these are broadly similar in the kinds of shocks that they experience and their response to them, but the remaining three differ significantly from the other five. Kouparitsas therefore concludes that the USA is not an OCA.
So neither of these charts depicts an OCA. RBS's tweet was incorrect. In fact I have serious doubts that anything close to an OCA ever exists in reality, at least not for long. Nation states are by nature dynamic and changeable: it seems to me that convergence between dynamic, changeable states is about as permanent as a contrapuntal dissonance in a Bach fugue. If they stay convergent, it is because they are forced to do so - and forced convergence eventually fails.
And yet, there is evidently far greater convergence of unemployment rates in the USA than there is in the Eurozone. So if neither is an OCA, why would this be? There are a number of reasons.
- Firstly, the USA is a federation. Each state has its own government, but there is also a fully functional fiscal authority at federal level with tax and spending powers. Automatic fiscal stabilisers - unemployment benefit and income taxes - are harmonised across the federation (states have their own unemployment insurance programmes, but these must comply with federal guidelines). There are also federal-level programmes for other major government expenditures such as pensions, education, healthcare and defence.
In contrast, the Eurozone has no federal fiscal authority with tax and spending powers. Automatic stabilisers operate at state, not federal, level and there is little attempt to harmonise them - indeed attempts to harmonise tax rates are met with fierce resistance from member states. Similarly, budgets for pensions, education, healthcare and defence are set by the individual states without reference to each other, although Brussels now supervises member state budgets to ensure compliance with fiscal rules.
- Secondly, the USA is a transfer union. Richer states support poorer ones by means of federal fiscal transfers. States can borrow on their own account, and they can - and do - go bankrupt. But because of federal programmes and fiscal transfers, living standards tend to be maintained even in states that completely foul up their budgets.
In contrast, the Eurozone has little in the way of fiscal transfers: there is development aid to poorer regions, and systematic help for farmers in the Common Agricultural Policy, but that's about all. The lack of federal programmes and fiscal transfers means that living standards can fall catastrophically when states make a mess of their finances (see Greece) or suffer local economic shocks (see Cyprus), while lack of fiscal harmonisation coupled with free movement of capital means that states are vulnerable to "sudden stops" even if they are fiscally responsible (see Spain).
- Thirdly, the USA has a monetary authority with a dual mandate. The Fed is responsible for maintaining both price stability and full employment. Consequently, high unemployment can be fought with monetary stimulus as well as fiscal measures.
In contrast, the ECB is only responsible for price stability. Provided that inflation is under control, the ECB has no reason to do anything at all about high unemployment. Consequently, the ECB has maintained far tighter monetary conditions than the USA over the last few years despite considerably higher unemployment. This has seriously hampered the efforts of member states, particularly in the distressed periphery, to reduce unemployment.
- Finally, the USA - although not an OCA - has a common language and free movement of people both in theory and practice (though parts of the USA can be unfriendly to migrants, as anyone who has read Steinbeck will know). The ease with which people can migrate within the US to find work is a primary cause of the convergent unemployment rates evident in the chart.
In contrast, the Eurozone has multiple languages and widely divergent cultures, which inhibit movement of people. There remains a lack of common identity in the Eurozone, and there is widespread suspicion of migrants, not least because the lack of fiscal harmonisation is thought to encourage "benefits migration" from poorer countries to richer ones. People in the Eurozone simply don't move around as much as they do in the US, so unemployment rates do not adjust: German unemployment remains very low while Greek unemployment remains over 25%.
The US generally has a more flexible labour market than the Eurozone and a much more entrepreneurial culture. This also tends to encourage people to move around.
If the Eurozone really wants to end the scourge of unemployment, it must become more like the US, with a federal fiscal authority that has tax-raising and spending powers, federal programmes, and a monetary authority with a mandate to target full employment.
The most urgent need is to put in place a federal fiscal authority and common programmes, particularly for automatic stabilisers. In parallel with this, the ECB should adopt a dual mandate like the Fed's. These two measures would go a long way towards stabilising the Eurozone's wobbly economy and reducing its awful unemployment levels.
There have been calls for fiscal transfers within the Eurozone to ease the plight of distressed periphery countries, but this is fiercely resisted and in my view is not the most critical need. Fiscal transfers may become possible later on when member states have accepted a common federal fiscal authority. In the longer term, consideration could be given to adopting a Eurozone-wide common language, compulsorily taught in all schools.
But if I am perfectly honest, my heart is not in this. I call for completion of the currency union, but I don't believe it. I just don't see that the political will to create a workable union exists: all I see is a lot of countries pursuing their own narrow interests and refusing to support, or even cooperate with, each other. While such attitudes prevail, the union cannot be completed and will eventually fail. Sadly, I still think it would be better to unwind the Euro before it falls apart.
The black hole theory of the Eurozone
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