Eurozone inevitably an Optimum Currency Area (OCA)?

I posted the following comment on Prof. Krugman's blog for the New York Times. What do you think?

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Prof. Krugman,

As you say the arguments on the shortcomings of European EMU as an OCA have been known ever since the early 1990s. If a group of economies are very open and trade in differentiated products, then as they are exposed to asymmetric shocks, they must have flexible wages and prices, high labour mobility, or alternatively, there must be some form of homogeneity and/or solidarity to ensure that transfers from one country to another balance the asymmetric shock. Otherwise one group of countries benefits from the union at the detriment of another. This is simple enough and it is what is taught in every decent manual on the economics of the EU. Moreover, it is easy to see how France and Germany might initially have benefitted from Greece's fiscal crisis. After all a cheaper € makes for more competitive exports.

What no one seems to focus a tremendous amount is on the merits of the Euro. First of all, the public and the commentators seem to have forgotten about all the exchange rate crises of the 1970s-1990s. Increased trade interdependencies expose EU member states to each other's bad governance, forcing to create arrangements to protect themselves from each other. The ERMs and the EMS were the first attempts at dealing with this issue, but proved incomplete at best, leading to the creation of the €. If the latter was to disappear, then we'd be back to the early 1990s.

Finally, speaking as a Portuguese and as a social scientist I must also admit that the euro also presents a welcomed pressure for necessary economic reform. By creating a tighter system of monitoring between the member states, it divulges more information about the quality of their performance. If for the € to work, it requires a strengthening of internal monitoring and if this increases the pressures for rationalisation of policy making and reform, then I can only conclude that the € is positive for its less efficient member states.

It seems that European integration happens through trial and error along a fairly clear integrationist path. As with any other polity, decision makers tweak and fine tune the machine. When each monetary mechanism failed after another, the argument for the € became more and more credible. Now that the consequences of the shortcomings of the Stability and Growth Pact have been brought to light, the structure will be kept with enhanced powers and institutional support, and my guess is that sooner rather than later there will be a certain amount of fiscal powers transferred to Brussels in order to fulfil the OCA.

On the USA though, by the standard of its time the country would not have been seen as any more homogenous than the Hapsburg Empire, with all its religions and languages (English, German, French). Moreover until the Civil War most Americans considered themselves first and foremost Virginians, New Yorkers, etc, and only after that Americans. Yet the dollar, fragile though it may have been, existed before the 1870s. The EU in that sense is not very different from the early USA or India, although we do not have a military threat as a catalyst for integration.

Before I conclude, I would like to add that the issue of labour mobility is limited first and foremost by language diversity. This however seems to be a decreasing problem as the vast majority of Europeans are now adopting English as their second language, thus making it the continent's "lingua Franca". This should solve the issue of labour mobility in the next 2 to 3 generations.

To conclude, just because the €zone is not an OCA, it is not automatically undesirable. Moreover just because it is now a second best option, it does not mean that it will not become a first best option in the future, as labour mobility will increase and as geographical automatic stabilizers will start to play a bigger role "

Government run Ponzi Schemes - Call the IMF!!

So, aside from the brief and recent comment posted yesterday, I haven't written much lately, which is good. It means I have a life. :) However, I think I ought to write something about this whole Greek mess, so as to at least have a reminder of these troubling times for the future. I have five comments about this mess:

First, why on earth is any country allowed to finance the payment of debt itself with more debt? Greece is (today) struggling to pay its debts, so it borrows to pay the debts. Why do markets even lend it the money, given the rather poor growth prospects that Greece is faced with?... It's likely that they have lent some money to Greece at lower interests in the past which now require more lending to get paid. Therefore the idea is that high interest yielding debts pay for low yielding debts. As long as lenders believe that Greece will pay, they keep on lending. So the risk really is to get to a point where Greece loses credibility, because then it will no longer be able to borrow. (this is a bit messy...). As a friend of mine reminded me, this cannot technically qualify as a Ponzi Scheme, because there are no asymmetries of information as the people purchasing Greek bonds are aware of the state of Greek finances and the implications. Indeed it is possible that the Greek government might be the one being defrauded…

Secondly, it is interesting to see the aggressive comments coming out of Greece, about German WWII reparation payments and about Anglo-Saxon media and financial conspiracies... It’s evident that the first two are political manoeuvres to confuse the electorate and shift the blame from the present government to other people. Nonetheless, I must say that the financial conspiracy does carry some weight. I’m not saying that there was any wrong doing. I’m just saying that there is enough evidence to make me believe that it would have been interesting to investigate whether there was collusion between the major lenders to Greece, the last time that it issued its debt. This idea is motivated by the fact that someone recently brought to my attention the fact that although the German bund spreads on Greek debt went up massively the last time they issued debt, the demand for it was massive. This would imply that lenders had estimated an increase in the risk of Greek defaults, but still found them to be attractive enough to want to purchase them. Because the Greek government really needed the money, its demand was rather flat, and inelastic. If there was collusion between the major financial players, then in real terms they would have behaved like a monopolist, supplying cash at an interest equal to their marginal revenue, not their marginal cost. So to go back to the beginning of this paragraph, I’m not saying that there was any wrong doing. I just think its natural to investigate whether the collusion that seems to have taken place was natural, tacit and logical or whether there was some type of explicit agreement between some of the financial actors. Both situations are possible, but only the first is legal.

Thirdly, it was interesting to read Eichengreen's article about why the Euro will not collapse, due to market arbitrage (ie: if Greece was to leave the Eurozone, firms would know that it would devalue its currency, and as such would move their assets abroad before this, so as to not have them devalued) and to practical concerns of paying machines and cash dispensers, as well as the cost and time of producing the new currency itself.

Fourthly, one thing that is becoming more talked about is the consequence of the default for other EU member states as the interdependencies in the EU financial sectors might mean that Greece defaulting on its debt would destroy the assets of some other member states financial institutions. (As illustrated in that article: This in turn would freeze lending in EU markets as markets once more become unable to distinguish between good assets and bad ones, as they did when Lehman fell. This might cause companies to go bankrupt, because they are dependent on some type of lending from the financial sector, and to consequently fire more people. Depending on the size of these interdependencies, we could either have a little glitch or another financial crisis on our hands. Lovely...

I must say that in light of all this, and particularly in light of the stupidity of some greek politicians it might actually be better to bring in the IMF. At least that way the Greeks will stop blaming other Europeans. Moreover I don't think Germany is in the mood to help a country where a government official says something like what the Greek deputy prime minister said and the government does nothing. (Actually I wouldn't be surprised if on the eve of a German led bail out, he would be fired or retire for “personal reasons”, that most political of euphemisms…) "Let the IMF let loose the Washington consensus dogs of war"

A less interesting situation, but one which takes me back to my Varieties of Capitalism days, is the understanding of why people are protesting in the streets of Athens. On this issue, there are two interesting paths to explore here. The first one is that Greece probably lacks a substantial export sector other than its shipyards (which is not little, but probably not overwhelming). This in relation to other insights on labour force reactions to economic policy and industrial relations makes me feel that the default position for labour is protest, not refrain. If it was, then Greek workers from exporting industries would protest against the protestors (for that sake the same would apply to Danish workers when Denmark joined the Deutschmark area). The other thing is that myopic self interest really is a strong force. I mean, Greece is really in a mess. If it does not tighten its belt, it will really have to default on interest payments of its debt. This would bring about a number of painful consequences, where the little business existing in Greece would leave, thus increasing unemployment, and decreasing wages, which is basically what the EU is asking Greece to do. The difference is that business would not leave if Greece did it without defaulting on its debt. However, public functionaries don't really seem to care much about that... I may sound cruel and cold, but the truth is that Greece has no alternative. One way or another it will have to decrease wages. The choice is between the process, ie whether it wants to be coerced into doing that by basic economic mechanisms or whether it decides to do so voluntarily.