The continuing Greek debt crisis and slow growth in other parts of Europe are leading many economists to reiterate the view that the euro is a bad idea. For example, Harvard’s Greg Mankiw wrote a July New York Times op-ed ably summarizing this view. In this conventional wisdom, the common currency prevents eurozone governments from using monetary policy to offset adverse economic shocks. States in the US, by contrast, belong in a common dollar zone because the federal government’s fiscal policy can engineer transfers across states, and labor is highly mobile across states.
I am a big euro fan. I don’t accept this conventional view, despite its authority from the late Milton Friedman to Mankiw and his colleague at Harvard Marty Feldstein, and even to the Times’ Paul Krugman.
The short explanation: I am also a big meter fan. I don’t think each country needs its own measure of length, or to shorten it when local clothiers are having trouble and would like to raise cloth prices.
The longer explanation: this conventional view is deeply old-Keynesian. In it, each region, including ones as small as Greece (population: 11 million) or Ireland (population: 4.6 million)—regions smaller than the Los Angeles metro area (population: 13 million)—suffers “demand” shocks, which governments must actively offset with fiscal stimulus or monetary policy.
This strikes me as one of those many stories that people repeat all the time until they believe it but the foundations of which are seldom examined. What are these local demand shocks for small open economies in the eurozone? Aggregate demand is, well, aggregate, not regional. Changing fortunes of local industries is more what we call supply, not demand. For small open economies (such as LA’s), much demand comes from other cities and states, not from local sources.
What fiscal union, apparently providing countercyclical Keynesian stimulus at the right moment, does the US enjoy that Europe does not? In the US, we have federal contributions to social programs such as unemployment insurance, just as Europe has the common agricultural policy and many other subsidies. We do not have systematic, reliably countercyclical, timely, targeted, and temporary local fiscal stimulus programs. Just how big is the local cyclical variation in state- or local-level government spending or transfers? And why does fiscal union matter so much anyway? If you’re a Keynesian, local borrow-and-spend fiscal stimulus should be plenty. The union matters only when countries near sovereign default and can’t borrow.
The local and cyclical qualifiers matter. Yes, both the US and Europe have some pretty large cross-subsidies. But most of these are permanent. In the US, the rest of the country subsidizes corn ethanol to Iowa year in and year out. Social-security payments come year in and year out and transfer money from states with workers to those with retirees. Monetary policy has, at best, short-run effects, so the argument for currency union has to be about local, cyclical, recession-related variation in economic fortunes, not permanent transfers.
And federal fiscal transfers only started in the 1930s. We had a currency union in 1790, and no substantial federal fiscal transfers at all until the 1930s. How did we get along all this time?
So, this conventional view presumes that there really are big regional demand shocks; that there is a big, important Keynesian fiscal multiplier, even when interest rates are not stuck at zero; that the US government really does a lot of recession-related fiscal transfers, larger than Europe’s (agricultural subsidies, etc.); and that the US prior to World War II was a disastrous, too-large currency area. I’m not convinced on any of these points.
(To be sure, I will admit a multiplier of about one for state-to-state transfers. If the federal government takes money from the citizens of New York, and sends the money to people in Florida, businesses will move from New York to Florida to follow the money, and GDP will rise in Florida and decline in New York. That fact does not mean there is much of a multiplier for the country as a whole.)
Consider Greece. “In an earlier era,” Mankiw wrote in his Times op-ed, “Greece could have devalued the drachma, making its exports more competitive on world markets. Easy monetary policy would have offset some of the pain from tight fiscal policy.” But is Greece’s GDP falling because of “tight fiscal policy”? Calamitous regulation, corruption, closed markets, closed banks, and frozen payments are not relevant? Tight fiscal policy? Greece is still running primary deficits. After blowing through one-and-a-half times its GDP in what are now transfers from the rest of the European Union, it’s run through another half a GDP’s worth, and GDP has collapsed more. Greece’s economic problems all come down to . . . a lack of adequate borrowing and spending? Really? And all Greece needs is one more currency devaluation, and suddenly it will be shipping Porsches to Stuttgart in return for worthless pieces of paper rather than the other way around?
I’m dubious about the labor-mobility story as well. The story is also told that there is less and less labor mobility in the US, especially of people leaving dying regions. And there are lots of Polish-plumber stories from Europe suggesting that open borders lead to lots of migration. Here again, cyclical migration, on a scale for which monetary policy can substitute, seems unlikely. How big are business-cycle-frequency migration flows across states in the US versus Europe?
Again, the US until 1933 poses an interesting challenge. Your school stories of westward migration were not a business-cycle-frequency response to demand shocks. And when people traveled by horse or foot, the vast majority of Americans never moved more than 20 miles from where they were born. The costs of labor mobility in Europe today are vastly smaller than the costs of labor mobility in the US of the 19th century. Yet we had a currency union all that time.
Conversely, and perhaps more centrally, I am less trusting of the stabilizing influence of central banks. Dispassionate omniscient central banks can, in theory, wisely spot demand shocks and cleverly devalue currencies to offset them, while not responding to supply shocks, political demands, and so forth. The same technocrats could quietly redefine the meter as needed to let tailors respond to shocks without changing prices.
But the history of small-country central banks is not reassuring. Greece’s and Italy’s repeated devaluations and inflations did not bring great prosperity.
Joining a common currency is a precommitment against bad monetary policy as well as a commitment to hypothetical good monetary policy. Political forces seldom think there’s enough stimulus. When Greece and Italy joined the euro, they basically said defaulting and inflating now will be extremely costly. They were rewarded for the precommitment with very low interest rates. They blew the money and are now facing the high costs they signed up for. But that just shows how real the precommitment was.
Microeconomics, macroeconomics, and politics interconnect. The case for separate currencies is to protect the economy from sticky wages, sticky prices, and sticky people. But none of these stickinesses are written in stone. A plausible answer to my question about the pre–New Deal US is that prices and wages were not sticky (whatever that means) before the era of regulation. Well, the loss of flexibility in prices and wages is a loss, and only very imperfectly addressed by central banks’ artful devaluation of the currency. Not every block can have its own currency, so local and industry variation within a country remains hobbled by sticky prices, wages, and people. If sticky prices, wages, and people are the central economic problem, we ought to have a lot of policies to unstick them. We do the opposite, and Europe even more so. The very social programs that the conventional view prizes for fiscal stimulus tie people to location and undermine labor-market flexibility. Our labor laws and economic regulation are full of incentives not to move and especially not to reduce prices and wages.
The strongest case for a separate currency might come from a small economy like Chile, which sells one product (copper) subject to big price fluctuations, is otherwise pretty closed, and has institutions with sticky nominal wages that it doesn’t want to fix. When the price of copper declines, price times marginal product of labor declines, so real wages should decline, and the value of haircuts provided to copper miners should decline as well. Chile may prefer to keep nominal wages steady and let the exchange rate rather than wage rate discourage imports.
But even Chile exports a lot more than copper these days. Texas is still booming despite a large decline in oil prices. The same argument does not hold for company towns within the US, which do not use their own currency. Stanford has extremely sticky wages (tenure) and suffers demand shocks (positive lately) without offsetting fiscal stimulus. Stanford has very little labor mobility. It takes a year to hire faculty. But nobody thinks Stanford should have its own currency, and periodically devalue that currency. Why not? Because it is open.
Proponents of the conventional view seem to think implicitly of fairly closed economies, operating in parallel. But Europe’s economies are open. Moreover, the whole point of the eurozone is to open them further. Small open economies are much worse candidates for their own currency.
Surely each block should not have its own currency, nor each city. We’d probably all agree that very small countries—Luxembourg, say—should not have their own currencies as well. So the question is really whether the Greece that Greece wants to be—more open than today—is effectively of the same size it is now.
Mine is not the conventional view. But recognize that this conventional view is deeply old-school Keynesian in its notion of fluctuations and the need for constant demand management by each government. This conventional view has a very rosy outlook on the abilities of national central banks and other demand managers to diagnose and artfully offset shocks without overdoing it. If you don’t agree with these underlying presumptions, you can, like me, think the euro is a great idea for an open and growing Europe. Europe’s continuing problems do not stem from its money.
John H. Cochrane is distinguished senior fellow at Chicago Booth and a senior fellow of the Hoover Institution at Stanford University.