IN A new paper*, Kevin O’Rourke and Alan Taylor compare the American and euro-area currency zones. Optimists argue that if a big, diverse economy like America manages to have a single currency, Europe should too. Optimists, if not already disillusioned, will find more to dislike in this new analysis.

The trouble with a large currency area is that economic conditions can very widely within. A central bank struggling to accommodate all regions with just a single policy may find that some places inevitably run hot, experiencing tight labour markets and inflation, while others are nearer a slump. For a currency area to survive, then, one has to hope that individual regions never diverge too much in their economic fortunes. 

Mssrs O'Rourke and Taylor compare European and American performance on this score. They first calculate the “desired” policy rate for each area over time. To do this, inflation and unemployment are taken into consideration. They then compare the desired policy rate to the actual policy rate that was implemented at that time.

For the sample of American regions, the difference between the desired and the actual policy rates was usually between 0 and 200 basis points. In other words, many areas received an interest rate that was perfect for their economy, and almost none received one that was more than two percentage points off.

The euro area is a different story. The desired interest rate for peripheral countries (such as Greece and Portugal) was usually 300 basis points above the actual rate—before the crisis. After the crisis, the target was a massive 500-700 basis points below the actual rate. Shocks in the euro zone do not happen uniformly—some areas tend to get hit much harder than others. The authors calculate that the average correlation between GDP growth in the euro zone countries and GDP growth across the whole euro zone is about 0.5. The comparable figure for America is 0.78. No matter how the ECB sets policy, many of its regions are confronting an inappropriate policy rate.

Labour mobility is often stressed as a pressure-release valve for a currency area with diverging economic cycles. Migration can help clear labour markets when demand conditions are wildly different, as the unemployed in one region up stakes and move to another. Free labour movement is enshrined in EU laws.

But America does better than the euro zone. on average, 42% of the people in an American state were born outside that state. In the euro area, the comparable figure is 14%. Barriers like language and culture reduce labour flows relative to American levels (as do pension and tax rules, and differences in professional certifications). This means that in the euro zone, economic imbalances can build up more easily and persist for longer, making a single monetary policy even less effective.

Even without labour mobility, uneven booms and busts can be mitigated by a central fiscal authority. America has one. The currency zone as a whole is exposed to national fiscal taxes and transfers that vary with the local business cycle. At the state level, a loss of $1 is offset by 28 cents due to fiscal transfers. These taxes and transfers operate as automatic stabilisers within America—often preventing areas in a downturn from turning into areas in a depression. No such luck for the euro zone. The authors calculate that there is almost zero offsetting.

The euro zone is (to no one's surprise) a less developed currency zone than America. In economic jargon, America:

“...is more likely than the eurozone to satisfy the three Mundell-style optimal currency area criteria regarding the integration of product markets, symmetry of shocks, and labor mobility, as well as [the] criterion regarding the ability of a central fiscal authority to smooth shocks across regions.”

Perhaps the euro zone would be in a better position if it allowed countries to default—like American states have been expected to do, if need be, for hundreds of years. Defaulting means that federal taxpayers are not supposed to be liable for big bail-outs. It also provides some flexibility to debt-laden states.

The authors point out that America took a long time to develop its economic structure. The euro zone has only been around for a few years. But time is not on the euro’s side, and there seems little political will to take the American way. 

The Economist_Different rates and different fates.pdf






* O’Rourke, K. H., & Taylor, A. M. (2013). Cross of Euros. Journal of Economic Perspectives, 27(3), 167-92.