Krugman and Mankiw on Greece, OCA, US History etc

Paul Krugman writes a superb article on why Europe lacks some key features of optimal currency area:

The problem, as obvious in prospect as it is now, is that Europe lacks some of the key attributes of a successful currency area. Above all, it lacks a central government.

Consider the often-made comparison between Greece and the state of California. Both are in deep fiscal trouble, both have a history of fiscal irresponsibility. And the political deadlock in California is, if anything, worse — after all, despite the demonstrations, Greece’s Parliament has, in fact, approved harsh austerity measures.

But California’s fiscal woes just don’t matter as much, even to its own residents, as those of Greece. Why? Because much of the money spent in California comes from Washington, not Sacramento. State funding may be slashed, but Medicare reimbursements, Social Security checks, and payments to defense contractors will keep on coming.

What this means, among other things, is that California’s budget woes won’t keep the state from sharing in a broader U.S. economic recovery. Greece’s budget cuts, on the other hand, will have a strong depressing effect on an already depressed economy.

He then goes on to look at the options Greece has but none of them will work. So best bet is leave the Euro, which will be similar to Argentina crisis in 2001.

Mankiw has a post questioning Krugman’s idea of OCA:

A large part of his argument is that Europe is not an optimal currency area because it lacks a large central government enacting transfer payments among the various regions.  That argument will be familiar to students of macroeconomics.  (See, e.g., the case study on monetary union in chapter 12 of my intermediate macro textbook.)

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.

Once upon a time, one might have said that the U.S. back then had a particularly vicious business cycle.  But Christy Romer’s path-breaking research has demolished that claim. 

One might argue that the 19th century had a different set of labor institutions than we have today, and these facilitated the adjustment of wages.  That argument, suggested by the research of Chris Hanes, may have some merit.  If that is the case, then maybe that is the path forward for Greece and the rest of Europe.  As Paul suggests, increasing wage flexibility won’t be painless.  Yet it might be easier than giving up on the Euro experiment.

A final possibility is that the key difference is labor mobility: Americans were willing to move among the states, whereas Greeks have to stay in Greece because they don’t speak German.  If that is the key difference, then Paul may well be right that the Euro experiment is over.

Krugman responds to Mankiw’s question (minus the typical Krugman aggression)

Reacting to today’s column, Greg Mankiw points out another reason American makes a better currency union than Europe: high labor mobility, thanks to our cultural homogeneity. Indeed; that’s Mundell’s original optimum currency area argument. (It was actually in my first draft of today’s column, but length was a problem — I needed to cut another 200 characters — and it also doesn’t bear too directly on the current European issues.)

But Greg raises another interesting point: why did 19th-century America, with a small central government, also work as a currency area? One answer, which David Beckworth points out, is that it didn’t necessarily work all that well. When William Jennings Bryan declared that “you shall not crucify this country on a cross of gold,” he was in effect saying that the monetary policy dictated by the Bundesbank gold standard wasn’t appropriate for the farm states.

I’d add another point: the 19th-century economy had much more flexible prices and wages than later came to be the case — not, primarily, because of different institutions, but because it was still largely an economy of small, self-employed farmers. More than half of US workers were in agriculture up until the 1880s. Peter Temin has told me — I can’t find it in a quick search — that the United States didn’t start having modern recessions, with large declines in real GDP, until the Panic of 1873; Britain started having them much earlier, because it became an industrial economy earlier.

Wow. Superb stuff. Great insights from economic history.

Further, Ryan Avent adds on the debate:

As evidence for the importance of mobility, Mr Mankiw cites the example of 19th-century America, which lacked transfers but still functioned as an optimal currency area. David Beckworth has a nice response to this:

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!

He adds:

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.

Certainly rich ground for speculation. One might ask whether labour costs in Michigan, relative to other states, are the issue. Would depreciation help, in that case? Or is it better to try and force structural change onto sinking states? And are transfers between states actually adequate? It’s interesting, Americans are somewhat more comfortable with the idea that population mobility across states is perfectly wonderful, and it’s not a huge tragedy if once thriving areas depopulate. Preservation of, say, North Dakota as a functioning economic entity doesn’t get nearly the priority as would the preservation of a sovereign European state. I guess this is because of the historical and cultural legacy in European countries. American states are more like lines on maps than ancestral homelands.

Hmm. lots of food for thought. This paper by Hugh Rokoff becomes a must read.

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3 Responses to “Krugman and Mankiw on Greece, OCA, US History etc”

  1. Krugman and Mankiw on Greece, OCA, US History etc « Mostly Economics « Rubber Tyres –> Smooth Rides Says:

    [...] Krugman and Mankiw on Greece, OCA, US History etc « Mostly Economics [...]

  2. 2008 Hall of Fame class, who gets in and who doesn’t? | South Shore Retreat Says:

    [...] Krugman and Mankiw on Greece, OCA, US History etc « Mostly Economics [...]

  3. InI » Greece Daily Newslink 8 May, 2010: Greece forced to buy arms: MEP Says:

    [...] Krugman and Mankiw on Greece, OCA, US History etc “ Mostly Economics By Amol Agrawal Consider the often-made comparison between Greece and the state of California. Both are in deep fiscal trouble, both have a history of fiscal irresponsibility. And the political deadlock in California is, if anything, worse — after all, … mostlyeconomics.wordpress.com/2010/05/08/krugman-and-mankiw-on-greece-oca-us-history-etc/ [...]

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