Wednesday, January 27, 2010

Transatlantic Debate on the Euro

I often chided in this blog European economists for their uncritical endorsement of the euro and the centralization of monetary policy in the European Union. Now two European economists, Lars Jonung (Research Adviser, Directorate General for Economic and Financial Affairs of the European Commission, Brussels) and Eoin Drea (Senior Economist, Tom Phillips and Associates, Dublin) publish, in Econ Journal Watch, a survey of the U.S. economists’ analyses of the EMU and the euro. In it, they take in particular U.S. economists to task for being excessively pessimistic about the euro:

“In short, by adopting the optimum currency area theory as their main engine of analysis, U.S. academic economists became biased against the euro” they conclude, and they add that:

“it is surprising that (…) living in a large monetary union and enjoying the benefits from monetary integration, (they) were - and still remain - skeptical toward the euro. To our knowledge no U.S. economist, inspired by the optimum currency area approach, has proposed to break up the United States into smaller regional currency areas.”

On this point they are wrong since a few U.S. economists did raise the question of the non optimality of the dollar area, and suggested that substituting several “regional dollars” for the current federal one could be an economically superior solution. More recently David Beckworth did answer that criticism in his blog, Macro and Other Market Musings.

Read “The Optimal Eurozone and the Optimal Dollar zone” (January 12), and “Euro Skeptics: Bad Analysis or Bad Timing?” (January 22), as well as his complete analysis "One Nation under the Fed? The Asymmetric Effects of U.S. Monetary Policy and Its Implications for the United States as an Optimal Currency Area”.

Beckworth reply is that the current crisis “only serves to confirm the concerns of the Euro skeptics that Eurozone is not an OCA and thus one-size-fits-all monetary policy simply does not work. (…) Even if these countries (Greece, Ireland, Portugal, and Spain) 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.”

I would like to add that past experience also proved that European governments and monetary authorities were perfectly able to pursue unrealistic policies for quite a long period, as they did with the “Growth and stability pact” supposed to constrain national budget deficits even when facing recessions. It amounted to suppressing the only shock absorber that was left to national governments to dampen business cycles. That regulation was much criticized by economists (foreign ones, that is, because European economists were forbidden by the authorities to even discuss the Pact) and, despite censorship, was swiftly abandoned as soon as difficulties with monetary management and economic growth became serious.

The lesson is that governments can indeed adopt non optimal policies and institutions if they wish, but then the constraints of reality are to be felt more strongly with the passage of time. I personally did not doubt at all that the euro could be put in place in 1999, even though it was an economic mistake (see my 1998 book). Maybe the U.S. economists had a more optimistic view of the political process and thought that rational governments would not do so, and in that they were wrong when they wrote that “it could not happen”.

It was clearly a bad policy move in economic terms (an even Jacques Delors later recognized that, while another former President of the European Commission, Romano Prodi, publicly said that the Growth and Stability Pact was “an absurdity”) but such a consideration would not deter any politician to enact it if he could envision a political profit from it. Indeed politicians maximize political profit, not always congruent with economic wellbeing, just as bankers maximize banks’ - and their own - profit, not necessarily to the aggregate economic advantage. And economists too are often players in that game.

Richard Posner writes in “A Failure of Capitalism” (p.259):

“Business economists – consultants, and employees of business firms or trade associations – emphasize economic forecasting, and often have industry-specific knowledge and data, but many are compromised by their business status. One does not expect economists employed by real estate companies or by banks to be talking about housing and credit bubbles.”

Nor should one expect economists employed by central banks or federal institutions to be talking about the drawbacks of centralizing currencies and monetary management.

Just as finance professors entwined with the finance industry, they cannot criticize the industry for hubris, or they may become black sheep and lose lucrative consultantships and/or positions. In Europe where most economists are government employees and where the main demand for their work comes from governments and central banks, this is a real risk.

But returning to fundamentals, there is also an economic reason for U.S. economists to disregard the possibility of breaking up the dollar zone: the U.S. is in a much better position regarding the OCA criteria than Europe is. The mobility of labor and capital is higher on the other side of the Atlantic, and the federal tax system is working as a shock absorber for unequally distributed negative shocks among states, where Europe has no such compensating device.

And, last but not least, central banking, the Federal Reserve System, has been created a long time ago (1913), in a period of general centralization (the “Schumpeter and Chandler era”), while the euro and the ECB have been created in a period of general decentralization (the late XXth century), against the organizational trend of the time.

Given the established existence of a political unity in the U.S. (which was obtained at the enormous price of the civil war), given the characteristics of the economy which are much closer to those of an OCA, and the existence of a compensating shock absorbers in the federal fiscal system, the opportunity cost of a non optimal monetary zone is much lower in the U.S. than in Europe, while the political opportunity cost of getting out of it is probably much higher in terms of the disruption of long established institutions. The cost/benefit ratio of exit is quite different on both sides of the Atlantic and this can explain why few U.S. economists considered the option.

If a break up of currency unions happens, it will more likely happen in Europe first and maybe in the US too, but later, or never (in terms of usual human forecasting horizon, that is).

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