Tuesday, July 28, 2015

Mankiw and Conventional Wisdom on Europe

Greg Mankiw wrote a week ago in the Sunday New York Times, ably explaining the  conventional view that the Euro is a bad idea, and that even countries as small as Greece (11 million people) need national currencies. Excerpt:
Monetary union works well in the United States. No economist suggests that New York, New Jersey and Connecticut should each have its own currency, and indeed it would be highly inconvenient if they did. Why can’t Europeans enjoy the conveniences of a common currency?

Two reasons. First, unlike Europe, the United States has a fiscal union in which prosperous regions of the country subsidize less prosperous ones. Second, the United States has fewer barriers to labor mobility than Europe. In the United States, when an economic downturn affects one region, residents can pack up and find jobs elsewhere. In Europe, differences in language and culture make that response less likely.

As a result, Mr. Friedman and Mr. Feldstein contended that the nations of Europe needed a policy tool to deal with national recessions. That tool was a national monetary policy coupled with flexible exchange rates. Rather than heed their counsel, however, Europe adopted a common currency for much of the Continent and threw national monetary policy into the trash bin of history.

Making matters worse, however, was the common currency. In an earlier era, 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. Mr. Friedman and Mr. Feldstein were right: The euro has turned into an economic liability that has exacerbated political tensions. For this, the European elites who pushed for the currency union bear some responsibility.
I am a big euro fan. This seems a good moment to explain why I don't accept this conventional view, despite its authority from Milton Friedman to Marty Feldstein and Greg Mankiw and even to Paul Krugman.

Short: 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.

Longer: This conventional view is deeply old-Keynesian. In this view, each region, including ones as small as Greece (11 million) or Ireland (4.6 million), less than the Los Angeles metro area (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 whose foundations are seldom examined.  (There is a "thesis topic" label here for such examination. Comparisons of US states to European countries on these dimensions seems fruitful.)

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 (LA) much "demand" comes from other cities and states, not local.

What is this "fiscal union," apparently providing countercyclical Keynesian stimulus at the right moment?  In the US, we have Federal contributions to social programs such as unemployment insurance. 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, then 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 US and Europe have some pretty large cross-subsidies. But most of these are permanent. The rest of the nation 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?

A sense in which this is a centrally old-Keynesian argument is that Greg is not making a second, common, and also wrong (in my view) case for national currencies: the view that currency union demands central bailouts of sovereign debt.  No, Greg (and the conventional wisdom he echoes) has in mind only the necessity of Keynesian countercyclical policy. Aphorisms such as "currency union demands fiscal union" are dangerous, as they have many meanings.

So, this conventional view presumes that there really are big regional "demand" shocks; that there is a big, important Keynesian fiscal multiplier, even away from the zero bound, and that our government really does a lot of recession-related fiscal transfers, larger than Europe's (agricultural subsidies, etc.) and that the US pre WWII 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.)

Consider Greece, "In an earlier era, 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." So, Greece's GDP is falling because of "tight fiscal policy?" Calamitous regulation, corruption, closed markets, and now closed banks, frozen payments are not relevant? Tight fiscal policy? Greece is still running primary deficits. After blowing through one and a half GDP's worth of what are now transfers from the rest of the EU, they've run through another half a GDPs' worth, and GDP collapses more. Really, Greece's economic problems are.... a lack of adequate borrowing and spending? And all Greece needs is one more devaluation, and suddenly will be shipping Porsches to Stuttgart in return for worthless pieces of paper rather than the other way around?

Greg passes on the labor mobility story. Here too I'm dubious and curious to see numbers. 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, that open borders leads to lots of migration.  Here again, cyclical migration, on the scale for which  monetary policy can substitute, seems unlikely. How big are business-cycle frequency migration flows across states in the US vs. 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 19th century.

Conversely, and perhaps more centrally, I  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 so reassuring. Grece and Italy's repeated devaluations and inflations did not bring great prosperity.

Joining a common currency is a pre-commitment against bad monetary policy as well as foreswearing of hypothetical good monetary policy. Political forces seldom think there's enough stimulus.  When Greece and Italy they 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.

Micro, macro 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 pre-new deal US is that prices and wages were not sticky (whatever that means) before the era of regulation. Well, that is a loss, and only very imperfectly addressed by 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 wages,  prices 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 Greg implicitly praises for fiscal stimulus tie people to location and undermine labor market flexibility.

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, and otherwise is 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 and tremendous labor immobility. It takes a year to hire faculty. But nobody thinks Stanford should have its own currency, and periodically devalue that currency. Why not? Because we are open.

So I think a lot of the conventional view seems 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 should not -- Luxemburg, say. So the question is really whether the Greece that Greece wants to be -- more open than today -- is effectively of the same size.

So, to sum up, Greg's article very nicely summarizes the conventional view. Recognize that this conventional view is deeply old-school Keynesian, both in its view of fluctuations, the need for constant "demand" management, and the success of "demand" managers to do their job. There is room for disagreement on that theory, and more productively on the underlying facts Greg passes on.


  1. "(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.)"
    -Wouldn't that be a multiplier of zero?
    Also, I suggest looking at how the dollar operates in some parts of Latin America.
    "A plausible answer to my question about pre-new deal US is that prices and wages were not sticky (whatever that means) before the era of regulation"
    -Even that's not plausible. They mostly were.

    I largely agree with this post. The drachma advocates prove too much.

    1. No. The multiplier would be 1.

    2. The multiplier is the ratio of the increase in aggregate demand to the size of the transfer. Here it says fore every dollar transferred from state A to state B State B's GDP increases one dollar. In regular macro every dollar taxed is assumed to be spent, so there is s transfer there too.

      A Multiplier of 0 would be if the money taxed in one state does not reach the other state, it is wasted or lost.

    3. This comment has been removed by the author.

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    5. Because the money taken from one and given to another is not going away. It's still has its original value. Wouldn't a multiplier of 0 imply the money is confiscated and then never spent by anyone as opposed to just a transfer?

    6. "Here it says fore every dollar transferred from state A to state B State B's GDP increases one dollar."
      -And State A's GDP declines one dollar. So why isn't the multiplier zero?

    7. If you multiply the money sent from NY by zero, you get 0. Right?

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  2. Thank you. Am forwarding link to this and to the previous post >>>
    >> to everyone I know in Greece.

  3. John,

    "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?"

    Most of us grew our own food, made our own clothes, and were self-sustaining through much of the 19th century.

    Money was a convenience for trade rather than a requirement for survival. The first permanent U. S. income tax did not come into effect until the 16th Amendment (ratified in 1913). Prior to that , the U. S. relied primarily on custom duties for tax revenues.

    Industrialization and the centralization of population changed all of that.

    This is what get's my craw:

    "In an earlier era, Greece could have devalued the drachma, making its exports more competitive on world markets."

    Currently Greece exports government bonds in exchange for German, or French, or other goods. How does switching to the Drachma change that? With a Drachma, Greek goods become less expensive for Germans to buy, but so do Greek government bonds.

  4. But there are options in between, right? It can both be true that a) Euro area is not an optimal currency area and that 2) Greece should not have its own currency. Maybe Euro area should split in 2,3 or 4 areas, it is not a "1 or 19" choice.

  5. The Euro is a great unit for the comparison of spot prices of the same good or tradeable service in different locations. But it is a terrible unit for use in long-term contracts, whether they are employment contracts, or loans. We have used such units for decades, in conjunction with monetary policy, as a way to manage aggregate risks and to protect balance sheets. The time is ripe for a shift to greater reliance on markets and contracts for the management of these risks, and a retirement of monetary policy. Macro markets will provide good pricing of these risks, and fewer conflicts on the fairness of fiscal transfers - conflicts of the type that Europe is mired in at this moment.

    It's great for you to offer Chile as a case where we can consider the multiple roles of monetary units, and how they can evolve. Shiller has also directed our attention to Chile to help us consider the possibilities for monetary innovation.

  6. Hello Prof Cochrane,

    I would think that being trained as a physicist you'd understand the difference between a scale free theory like economics and physical reality which has definite length scales. We all agree on the size of a Carbon atom, even if we measure it in inches or Angstroms on different sides of the world. We do not all agree on the relative value of currencies (and thus they go up and down). A meter is fundamental; a Euro is a human construct. (Unless it is a measure of information, I guess.)

    1. So the meter was around before us humans?

    2. Yes, the concept of length that is being standardized with the meter exists without us (the distance light travels in a particular number of oscillations of a Cs atom, the Bohr radius, QCD scale, string length, etc). There is no thing out there with a universal monetary value that we could use as a standard to set the value of Euro or dollar. An ounce of gold has a varying value. A liter of water has varying value.

    3. No. In your example, we arbitrarily decided the number of oscillations. Why can't Greece use 10,000 and Germany use 12,000? The unit of work that a Euro is exchanged for exists without us. If we can vary the implied energy in that unit of work why can't we vary the "oscillations" counted for a meter?

    4. @The Donk, I think I see what Jason is getting at. So at the risk of misrepresenting him, let me take a crack at it:

      Matter and electromagnetic wavelengths that measure on the order of 1 meter have different physical qualities compared to matter and wavelengths on the order of 1e-10 meters (1 angstrom). For example, does the concept of "pressure" exist for things that measure on the order of 1 angstrom? Can we invoke the ideal gas law at that scale? I don't think so, because that's on the order of the radius of a single gas atom. Single atoms don't have the quality of pressure. That's only something that makes sense to speak of at larger scales where we look at the aggregate effect of many atoms (like a meter, or more properly cubic meters). A more extreme example: the Planck length (1.616199(97)×10−35 meters): I don't think we even know what the laws of physics are at that scale.

      However, we could change to a system tomorrow where $1 = 1e35 new-dollars, and the only effect would be a lot more scientific notation on our money. There's nothing out there in the reality outside our skulls that makes some things happen at one scale of monetary value vs another.

      Jason should be along shortly to tell you where I went wrong.

    5. ... in fact, since comments here must wait for approval, I suspect Jason may have already answered you and it just hasn't been approved yet.

  7. It's a very interesting post. I'd like to see the data on labor mobility as well. I've always thought the labor mobility in the U.S. was staggering relative to Europe.

    A little completely anecdotal, introspection: I'm from Dallas, TX, though I live in Connecticut, my brother in Houston and my sister in NYC. My parents live in Dallas, but my Mom is from Michigan and my Dad is from Louisville, Kentucky. My Mom's Dad is from Pennsylvania and her Mom from West Texas, but now they live in Florida. I've lived in Virginia and D.C. and will move to who knows where in one year.

    My story is so common in the US, isn't it so uncommon in Europe? Paris to Munich is shorter than DFW to Louisville and less than half the distance of DFW to Detroit or NYC or Florida, but I think it's relatively extremely rare for a German family to move to Paris or vice versa.

    Is it at the right business cycle frequency? Again, I would like to see the numbers too, but I see doctors enter the scramble and go where the openings are all over the country, I see graduates go to San Fran, DC, and Atlanta. I see lots of students from other Southern states end up in Texas. There are considerable labor frictions in the US, but I think they are an order of magnitude less than in Europe.

    Even looking within the US, can the wage difference between Miami and Dallas ever be as large as between San Juan and Miami, even though they roughly the same distance apart? I think there is some staggeringly large friction there, even though it is basically not a government policy.

    1. Charlie, with all due respect one can't compare US with EURO. Long story short, their 'marginal utility' is different...and that creates completely different labor market etc. ATB

    2. I'm Portuguese and european so let me try and paint a picture of some of the troubles. labour mobility is in fact not as rigid as it might seem. In Portugal outward migration has been through the roof since the recession. Still its easiear for the younger generation that speaks english as well as plumber stories that aren't so affected by the language barriers. Still I'm convinced that without these barriers this number would be much higher. It is very hard to get a white collar job in Germany, Italy or France without speaking their languages. Sure, global firms have English speaking departments, but SMEs which are the bread and butter of the economy don't.

      But the migration issue combines with the need for fiscal integration. Sure the US got along fine without federal programs until 1930. However national social security systems combined with outward migration are a problem in Portugal for example. If an ageing population wasn't bad enough already, since the recession net migration is around -300k and counting, in a country that has a population of 10million and a workforce of 5M.

  8. "We do not have systematic, reliably countercyclical, timely, targeted, and temporary local fiscal stimulus programs."

    Yes we do. Look at what happened when the housing bubble burst. The bailouts disproportionately went to states like Florida where the bubble and subsequent crash was greatest. Look at the savings and loans fiasco. The deposit insurance was paid by all but the payout went disproportionately to Texas. Look at all manner of means tested federal assistance. If a shock hits in any state, more people automatically qualify for the assistance. The aid is temporary because a rise in income disqualifies the recipient.

    1. I totally agree with the targeted temporary fiscal stimulus. Furthermore you have federal unemployment insurance which naturally targets areas most hardly hit by unemployment which is a form of stimulus if you may. Also the fact that its a federal program creates a lower burden on the state level finances. In Europe peripheral countries have had to support their unemployed while having to balance their budget at the same time. Faced with the impossibility of solving both, unemployment benefits have beem cut and taxes have been raised, all recessionary measures amidst a recession.

  9. Great points, especially on the pre-commitment to be not irresponsible. Having experienced triple digit inflation, I think people tend to forget some of the negative aspects of having a flexible accommodating central bank.

    I have a question. You make a distinction between permanent and cyclical transfers and migration. Wouldn't the same logic apply to supply side effects? For instance, you mention:

    “So, Greece's GDP is falling because of "tight fiscal policy?" Calamitous regulation, corruption, closed markets, and now closed banks, frozen payments are not relevant?”

    Why does calamitous regulation or corruption (which presumably existed long before Greece joined the euro) cause a 30% decline in gdp and 50% youth unemployment? Do we have any good theory that suggests that corruption and regulation causes large declines once every 50 or 100 years? I can understand a level effect with Europe for instance having lower worker participation than in the US, but what explains the sudden increases?

    I find that the discussion about what to do is not very useful without first identifying the underlying problem.

  10. Great post.
    It seems to me that the central argument in this post is this paragraph:

    "Joining a common currency is a pre-commitment against bad monetary policy as well as foreswearing of hypothetical good monetary policy. Political forces seldom think there's enough stimulus. When Greece and Italy they 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."

    I think that in the case of the United States, the individual states of the Union got a taste of this precommitment when Congress refused to bail out the deeply indebted states, in the 1840s. From the early 1800s to the 1840 some states (not all) racked up a huge amount of debt, similar to Greece. And these states wanted Congress to bail them out.
    But Congress said no.
    This caused that most states nowadays have a very strict limit of how much they can borrow. And if they go on a borrowing binge (Illinois?), well, the states know they are on their own. The Feds will not bail them out. This is a very credible statement, rooted in history. And most states understand this, and live by it.

    In Europe, what was missing is something akin to Congress saying no in the 1840s. A real big fat "no". Angela Merkel is the closest to this. With one big difference - in the 1840s in America, there was no big Central Bank buying debt, and bailing out banks. Banks went bankrupt - straight bankrupt. Today, in Europe, even with Angela, the ECB buys bad debt from banks. Maybe the ECB shouldn't.

    Finally, it seems to me that European politicians got rolled into the emotion of this common currency, without explaining to the populace what it might entail if a country borrows too much. I do not think that the plumber in Naples, or the bartender in Marseille or the mechanic in Pamplona really understood what they were getting into. All was emotion of "European Unity" and all that jazz, but the politicians did not explain all of the possible consequences to the voting people. And now, some of those voting people are finding out the hard way, what it means not to be able to devalue. And they voted OXI, but they still want to be in the Eurozone - talk about cognitive dissonance...

    1. Well, it'll probably serve as a lesson for the future ... at least for the next generation or two (~60 years?). Perhaps nations won't be so eager to join this kind of train wreck again... ...however bad their situation is now, I think this demonstrates that things could get a whole lot worse. Hopefully that's what that bartender, mechanic and plumber learned and will dutifully pass on to their kids.

  11. By the way, Alan Blinder has a column in the Wall Street Journal a few days ago, describing the "conventional view" as well. I thought Blinder's article was (for a change) a pretty good one.

    1. Agreed. I don't agree with Blinder too often, but he's usually worth reading.

  12. 40% of Americans live in a state other than the one they were born in. That's a HUGE amount of labor mobility.

  13. You're leaving out a hugely important consideration: functionally, the US used multiple (local) currencies until the civil war. Thanks to bank-issued money before the passage of the National Banking, the US wasn't a monetary union in the same way that the EU is today. Your questions are only really valid from the late 1860's through 1930's.


  14. I enjoy the flippant attitude here, and I think that many of these questions are useful to probe our understanding, but you clearly haven't thought too carefully here...

    1. You misrepresent the conventional view. The impulse itself doesn't need to be a mysterious "demand shock"; it can just as easily be any real shock that changes the equilibrium real exchange rate. Certainly as we've seen in the recent episode, financial markets and fiscal policy (especially their intersection) can be a particularly potent source of shocks.

    2. Yes, in the past few months, Greece has probably been running a primary deficit (due to chaos and all the rest), and before that some of its relatively promising primary balance figures were the result of manipulation. Still, there's no denying that Greece experienced a *massive* increase in its primary fiscal balance, of around at least 10 percentage points of GDP. That kind of short-run hit to demand, without time for prices and wages to adjust, is exactly what Keynesian economists would expect to cause disaster, and it did.

    3. You ask what the "fiscal union" in the US is. Isn't that obvious? Combining payroll and income taxes, a typical marginal federal tax rate on labor in the US might be around one-third; by taking this money away and sending back a stream of transfers and expenditures that is much less sensitive to local fluctuations, the fiscal system dampens the cross-region volatility in after-tax receipts. This is true even if we ignore the more explicitly countercyclical components of fiscal policy like unemployment insurance. Europe doesn't have anything remotely comparable to this.

    4. Are you seriously downplaying pre-1933 US labor mobility with some homey claim about how "most" people never moved twenty miles from where they were born? I mean, you just left work in a state, Illinois, that went from 25% of the population of Massachusetts in 1830 to 175% of the population of Massachusetts in 1870, just 40 years later. The city of Chicago went from a tiny, irrelevant town of less than 5000 in 1840 to the second largest city in America, at 1.1 million, in 1890.

    Yes, you claim that this large-scale migration did not response to "business cycle frequency" shocks, but this is really an unsourced leap on your part. Have you ever looked at the time series for 19th and early-20th century immigration to the US? The Yearbook of Immigration Statistics has the data going all the way back to 1820. In response to the Long Depression of 1873-1879, the flow of new permanent residents to the US collapsed from 460,000 to 138,000 from 1873 to 1878, before recovering all the way to 789,000 a few years later in 1882. In response to the Panic of 1893 and the ensuing recession, immigration abruptly fell from 580,000 in 1892 to 259,000 in 1895, and stagnated in the gloomy 1890s before accelerating all the way up to 1.3 million in 1907 (at which point it fell again, in response to the Panic of 1907, and so on). These were large-scale, long-distance population movements, and they were *incredibly* cyclical. I realize that this isn't within-US movement (for which we don't have such high-frequency data), but surely it should cast some doubt on your presuppositions. Labor was, all in all, a lot more mobile back then than it is now.

    1. 1) nobody can know what the equilibrium real exchange rate is. Should an oil exporter receive net capital inflow or outflow? If Elon Musk discovers how to make Energy out of hot air, there should be outflow and the the eqbilibrium real exchange rate should be much lower. If we're stuck with fossil fuel the reverse is the case. Nobody knows. If someone did know he would be the perfect Planner or the promoter of a Global dominant firm setting prices for the competitive fringe.
      2) Greek aggregate demand had to go down by 25 percent to eventually yield a small Trade Surplus. Solvency was predicated on downward pressure on the Trade Balance. There is no question of Keynesian prediction here. The transmission mechanism was obvious.
      No doubt, if Greece could depreciate or put up tariffs, it could have reduced imports more quickly but there would be obvious dynamic costs to such a policy. Baumol cost disease has an exception relevant for Greece- because of its advantage in things like Tourism, Geriatric care etc- such that we can imagine how it might be prosperous while remaining Service based. But this means transferring resources out of the bureaucracy and into stuff foreigners dig. Keynesian analysis is irrelevant or misleading in this context.
      3 & 4) John wasn't writing a treatise about the U.S. He was debunking a specific argument about small countries like Greece. Suppose he had spoken of nineteenth/early twentieth century India instead- which had a common currency, the Rupee. His point was that a country can have a common currency even if there are no fiscal transfers. Surely the primary purpose of federal payroll taxes isn't to finance cross-state transfers? Even if it were, Americans speak a common language and have a strong sense of nationality. Yet, history shows that currencies can work for long periods across terrains in which this condition is not met. It is not the case that transfers are required to underpin such arrangements nor that labor mobility must be above some threshold.

  15. 5. You say that "Europe's economies are open", but of course the problem is that Greece's economy *isn't* that open, on either the product or the financial side. If the net inflow of capital to the Greek government abruptly declines, and financial markets are such that another net inflow to Greece cannot easily be found to replace it, then Greece's capital account surplus must fall. This means that its current account deficit must shrink, and without a flexible exchange rate (or flexible wages) to make this happen primarily through expenditure-switching and rising exports, in equilibrium this happens instead through a calamitous decline in Greek demand for all goods and services. This is much harder because Greece is relatively closed on the product side - you need more of a real exchange rate devaluation to accomplish any improvement in net exports, and when that fails you need more of a fall in demand to bring down imports by enough to achieve the needed current account balance.

    (A key point here is that "multipliers" when international financial markets are limited are potentially much higher than multipliers otherwise; for the sake of illustration, note that under financial autarky, a country as a whole is effectively one big Keynesian MPC=1 consumer. This is another important difference between Europe and the modern US. It's a big deal for Greece when Greece's banks are crippled, but not nearly such a big deal for Florida if its banks are crippled, since the vast majority of Florida's private borrowing and lending is not contained within the state.)

    Remember that in 2010, Greece's exports to GDP were 22%. Compare that to 25-26% in Italy, Spain, and France, 42% in Germany, 53% in Latvia, and nearly 100% in Ireland. Worse, Greece's exports mainly take the form of services with lower (short-run) elasticities of substitution, rather than highly substitutable manufactured products; Greece's already-low total for exports of goods is misleading, since much of it comes from products (like refined petroleum) for which the gross value is far higher than Greece's actual value added. From 2010 to 2014, Greece's exports to GDP rose from 22% to 33%, a big step - but too much of that is because a collapse in domestic demand has pummeled the denominator, via the process outlined above.

    (By the way, it's not clear why the openness of "the Greece that Greece wants to be" is the relevant standard here, as oppossd to the openness of Greece as it *actually is* and plausibly will be for the next couple decades.)

    6. I agree that the euro has value as a monetary discipline device for countries like Greece and Italy. But our understanding of how to ensure low inflation without cutting off all monetary flexibility with a fixed exchange rate has developed substantially since the 80s, and even the 90s (when the ERM solidifed into the euro). Inflation targeting works quite well. Today, no European countries west of Belarus/Ukraine/Moldova/Russia face any threat of secular inflation, despite the fact that many of them aren't on the euro, and a number of these aren't particularly well-governed either.

    Indeed, worldwide there isn't a single high-income economy with a persistent inflation problem, nor is there any large middle-income economy aside from two left-wing populist disasters in Latin America, Argentina and Venezuela. (And Argentina's current spell of left-wing populism is a response to the disastrous consequences of its own attempt at discipline via a fixed exchange rate!) At some point, you really have to ask whether the commitment value here exceeds the profound costs of monetary inflexibility.

    1. Why not compare Greece to Cyprus? Okay Greece is bigger, but is there really a Keynesian solution? Imagine a Greece with a depreciating drachma, the Govt. reflates because wages are sticky but the increase in capacity utilization arises from money illusion- you have galloping inflation or a prices-incomes policy that breaks down every 18 months and then capital controls and so on. What would happen? Well, just as there is a blue-dollar in Argentina, you'd have a blue-euro in Greece- i.e. a two tier economy. Those in the export sector reduce their exposure to the drachma, thus escaping tax, through on-line entities and live large while those in the 'closed sector' see their real wages eroded and their savings rendered worthless.
      You get a full blown dual economy with plenty of rent seeking opportunities.
      How is this a good thing?
      Monetary inflexibility has no cost that would not otherwise be incurred in addition to a rent-seeking & signal-extraction surcharge.
      Keynesian arguments, in this context, are misguided. There can be global agreement to reflate financed by an agreement on the equitable taxation of non-doms such that no deficit financing is required. What there can't be is Greece waving a Keynesian wand and suddenly magically jumping ahead of Cyprus and Ireland and Spain without having done antying to put its own house in order.

  16. 7. Nobody is saying that the benefit of flexible exchange rates is that central banks "wisely spot demand shocks and cleverly devalue currencies to offset them". The point is that under floating exchange rates, the needed devaluation (or revaluation) happens *automatically* under a wide variety of monetary policy regimes - a Taylor rule, (flexible) inflation targeting, etc. Friedman (1953) certainly base his case for flexible exchange rates on the omniscience of central banks...

    8. I say all this as someone who probably agrees with you, rather than Paul Krugman, on 75% of political issues. I am deeply worried that conservatives' sometimes dismissive attitude toward the importance of monetary flexibility, when it leads to disaster, will improperly lead the public to blame free-market policies rather than the true culprit (a bad monetary regime). This has happened before, in 1933, and resulted in irreparable policy changes that persist to this day. When industrial production increased by 50% in the 4 months after Roosevelt was inaugurated (amazing but true; look it up), the public didn't carefully distinguish between Roosevelt's policies; instead, they decided that what Roosevelt did seemed to be working, and elected a Democratic supermajority in both houses of Congress in the midterm. Argentina, properly or not, blamed conservative economics for its disaster in 2001; recently, Greece elected its own batch of left-wing cranks. How many times do we have to see this movie before the message hits home?

  17. Surely you are familiar with Mudell's Optimal Currency Area Theory ! Did you mean to leave Mundell out of your list of heavy hitters?

    1. Yes, this is the basic framework. Did Mundell offer opinions on whether Europe was too big to be a currency area? I don't like to mischaracterize opinions, and I don't know what Mundell's were.

    2. Mundell wrote the linked paper in 1968 when Bretton Woods still held, so he didn't comment on Europe per se. Mundell didn't list size as the limitting factor, though he did say not the whole world and not so small that a single speculator can affect the exchange rate. Mundell gave general guidelines, which Europe fails.

      First, the central bank has to be willing to pursue full employment policies - which necessarily means that Germany will suffer inflation so Greece and Spain will not suffer as much unemployment.

      Second, the optimal currency area must allow factor mobility. Labor is one critical factor, but not the only one. Tourism is a big factor in Greece, but it isn't likely that the acropolis will move to Germany. As far as this goes, even a single country might need 2 currencies. Mundell gives Canada as an example. You can't transplant the forests of British Columbia to Quebec. If a shock of some sort makes lumber from BC uncompetitive on the world market, the unemployment in BC could be severe. Quebec will have to suffer substantial inflation to make BC more competitive. For this reason, he thought Canada might do better with 2 currencies that could float against each other (though he considered this an empirical question that would only be determined by evidence he didn't have). That way BC could regain competitiveness without requiring either inflation in Quebec or reassigning all the capital and labor in BC lumber to new industries.

      In short, Europe isn't too big, but its cross-country differences are.

    3. I think Mundell was and is very pro-Euro.

    4. Yes, but he is adamantly oposed to the low inflation target - and the reason he gives for maintaining the Euro is the massive damage from trying to leave.

    5. even Nobel Laureates make mistakes. Mundell was an advocate of a world currency... crazy!

      Greece is bearing the costs of its folly, but that will happen even if it defaults in some way, or exits the euro. That's water under the bridge, the question now is what is the best way forward economically, as well as the impact on sovereignty, democracy, etc. As others have mentioned, trade/GDP is tiny for Greece, as opposed to Luxembourg. Geographically, it is not adjacent to any other EZ countries: it borders Turkey, Bulgaria, Albania. But most importantly, a devaluation is not a mere redenomination (like decimalization in England, or a stock split) -- those unit conversions are irrelevant. But a deval, while nominal, has real effect too, since inflation doesn't match 1-1. In theory you can decrease prices and wages to have the same effect, but in practice, the necessary conditions to cause those are massive unemployment. Balance sheet effect (debts being stuck in nominal terms, and so increasing) will occur in either scenario.

    6. "Did Mundell offer opinions on whether Europe was too big to be a currency area?"

      Yes, he did. He was, and I suspect still is, very much in favour of the Euro. I think you find that Mundell is less enamoured to a lot of his own gadgets than people who are religiously devoted to them like Krugman actually is. A lot of his later work was very historical, largely model-free. He seems to be in favour of commodity money a la the gold standard, so obviously the Eurozone would not be too big as a currency area.

      Having said that, Mundell is not beyond criticism - a bit of a Donald Trump figure in his adopted Tuscany - with garish dyed hairstyle to match.


    7. Well, in fact Mundell now thinks that the whole world is one big optimal currency area. He lately advocates a new global gold standard.

  18. "You're leaving out a hugely important consideration: functionally, the US used multiple (local) currencies until the civil war. Thanks to bank-issued money before the passage of the National Banking, the US wasn't a monetary union in the same way that the EU is today."

    This isn't really true in the sense that matters. The US has had a common unit of account, the US dollar (originally specified as a silver dollar coin, and legally defined by the federal government), for essentially its entire history.

    The only thing that the US didn't have before the National Banking Act (and, slightly before that, the issuance of greenbacks) was uniform *paper* money. Different banks' paper issues could trade at discounts to each other and to specie, depending on the expected probability of redemption.

    But to my knowledge, prices and wages generally weren't specified in terms of particular paper issues of fluctuating value. Instead, the unit of account was specie - and if a Vermont store charged $1 for an item and you happened to try and pay with a bill from the Sketchy Bank of Northwest Arkansas (or even the Known Sketchy Bank of Vermont), they would make you fork over bills with face value greater than $1, not take whatever bill of dubious creditworthiness you gave them.

    The importance of the unit of account (which has always been the US dollar), of course, is premised on the view that nominal rigidity is the central reason why monetary arrangements matter. Our host here probably wouldn't agree with that (mainstream) view - but if you do, then the US has been in a currency union in the most relevant sense for its full history.

  19. No Nobel for you

  20. US mobility is greater than Europe's by an order of magnitude.

    "In 2011, 2.7% of Americans had lived a year earlier in another of the 50 states. By contrast, only 0.2% of Europeans had migrated since a year before."


    The article also discusses Mundell`s work.

    IMHO the take home message of the American fiscal union is that it does not eliminate transfers. As I mentioned on another post Americans are either unaware of or complacent about it. If Europe has this fantasy that fiscal union will solve their problems I suggest they take a look at the strife between northern and southern Italy or Madrid vs Barcelona.

    If Germany wants to eject Greece and maintain a current account surplus someone else has to pick up the deficit. Or is there some form of German poker where at the end of the night there is one winner and four break-evens?

  21. I think Mankiw, etc. is correct to point out the importance of fiscal union in the U.S. Fiscal "rebalancing" allows the "poor" states to maintain roughly balanced budgets without having to resort to austerity. For example, Mississipi receives $2 in federal spending for every $1 they pay in taxes. Hence, the Feds run a large "Mississippi deficit" which keeps Mississippi afloat. In contrast, New Jersey ships $1 in taxes off to Washington for every $0.60 they get back. But we are all Americans and no one complains. (Ironic to note that the "rich" states are mostly "blue" while it is the "red" states who are generally the beneficiaries of government largesse - called the "moocher's paradox" in the economic literature). Without this rebalancing mechanism, Mississippi would eventually be like Greece in many respects . We would then tell Mississippi to "get its house in order" by increasing taxes or reducing state spending. Such reductions in private sector income ( a demand shock) would just make matters worse - as we have seen in Greece, Spain, Portugal, etc. (and then deficits don't decline because of "automatic stabilizers" from a weaker economy - sort of like a dog chasing its tail).

    True, this mechanism was not very significant in, for example, the nineteenth century. But I think that's one reason there were so many depressions (six I believe) in that century..
    Thus, this "silent stabilizer" probably should get more recognition than it does.

  22. "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?"

    Well, it went something like the following philosophical declaration by Grover Cleveland, which I don't think many people would agree with today:

    "I return without my approval House bill No. 10203, entitled “An act to enable the Commissioner of Agriculture to make a special distribution of seeds in the drought-stricken counties of Texas, and making an appropriation of $10,000 therefore.”

    I feel obligated to withhold my approval of the plan, as proposed by this bill, to indulge a benevolent and charitable sentiment through the appropriation of public funds for that purpose.

    I can find no warrant for such an appropriation in the Constitution, and I do not believe that the power and duty of the General Government ought to be extended to the relief of individual suffering that is in no manner properly related to the public service or benefit. A prevalent tendency to disregard the limited mission of this power and duty should, I think, be steadfastly resisted, to the end the lesson should be constantly enforced that though the people support the government the Government should not support the people.

    The friendliness and charity of our countrymen can always be relied upon to relieve their fellow-citizens in misfortune. This has been repeatedly and quite lately demonstrated. Federal aid in such cases encourages the expectation of paternal care on the part of the Government and weakens the sturdiness of our national character, while it prevents the indulgence among our people of that kindly sentiment and conduct which strengthens the bonds of a common brotherhood."

  23. John Cochrane says “When Greece and Italy they joined the euro, they basically said, defaulting and inflating now will be extremely costly.” Correct.
    Between 2000 and 2010 Germans paid themselves and extra 16% in terms of Euros while Greeks paid themselves an extra 53%. Source:


    Did Greeks really think that “generosity” towards themselves wouldn’t come at a price?

    1. The question is which Greeks reaped the benefits, and which will bear the costs.

  24. In the 1800s, the fact that bank notes traded at exchange rates with each other and that there was not one interest rate only, would be a moderation on capital flows making the situation very much unlike a single currency in the context for comparison with the euro.

  25. Excellent set of arguments, I suppose if you argue from the real business cycle Prospective that most of the business cycle is from productivity shocks, the ability of monetary policy to make a positive contribution is rather small.

  26. I'm more modest about how well we understand money, and exchange rates in particular. But the evidence is that economic stress is often associated with *massive* changes in currency values. Look at the Korean won during the Asian crisis, or the Swedish kronor over the last 30 years, or the Swiss Franc in recent times. It's not something we find easy to explain -- they're not Chile, for example -- but that's what we see.

    Now what do we think would happen if we took exchange rate movements off the table? The right answer, I believe, is we don't know. But it's not much of a stretch to think that the stresses often reflected in currency prices might come out in some other way. That's my take anyway.


  27. I read the post twice, and the comments once, and I must conclude there is a common thread of thought behind both which I need to have already internalized in order to follow the argument. If this makes sense, a link to some kind of prior summary would help.

  28. I think the real problems with the Euro arise from (1) its poor design and (2) its political development rather than labour mobility, transfers etc. The latter are really a debate about fixed vs flexible exchange rate systems and not unique to the Euro. The ERM, which was basically a fixed exchange rate system prior to the Euro also had these flaws. There were no fiscal transfers then... whatever the Bundesbank did, everyone else would have to follow and countries either had to adjust or exit if that proved to be too politically difficult.

    What changed with the Euro was that exiting is far more difficult. So countries such as greece need an internal adjustment, lower nominal wages etc. relative to Germany but of course this causes a debt deflation spiral which an already too high debt load to become unbearable.

    What is then needed is some mechanism for the gov't to default. But the sovereign - bank loop makes this very devastating. Greek banks hold mainly Greek gov't bonds as collateral so as the sovereign credit deteriorates, banks get weaker and credit dries up, economy slows even further and so on.

    So this is one of the main problems with the design of the Euro. The banking system remained fragmented along national lines. An extension of this are pension funds, insurance companies etc. There are no real pan Euro area financial institutions. Its as if JP Morgan held mostly Municipal debt from Chicago and if it ever went bankrupt the banking system would collapse. In theory there are no reasons why Greek banks should predominately hold Greek gov't bonds but there are regulatory reasons (EU sovereigns having zero risk weighting for Basel so why not grab the highest yield) and political reasons. Also I guess since the banks are regulated by the national govt's they don't have a real incentive to be "healthier" credits than the sovereign. If some greek bank held only German Bunds, and the greek gov't was about to go bust, they could just nationalize the bank.

    The second flaw with the Euro is how the "rules" were developed. Because a sovereign default would be a huge disaster due to the sovereign/bank loop, rules were made (Maastricht Criteria) to ensure default was extremely unlikely. Debt/GDP under 60% and deficit/GDP under 3%. These were almost universally ignored for political expediency so the result was debt levels just too high and growing too quickly in southern europe when the downturn hit. Yes there are the Spanish and Irish exceptions, which had to do with the real estate bubble, but in general you have a system where (1) there is no effective control on the level of debt and (2) no effective way for a sovereign to default without causing massive collateral damage.

    To compound all this, we now have EFSF, ESM, OMT, and numerous other bailouts which entangle countries and the central bank with each other and politicize the entire process. We've moved from a rules based approach (where none of the rules were ever followed) to one where politicians are more or less just making it up as they go along.

    This is obviously an incomplete analysis but I think this is a taste of what is really wrong with the Euro. Not labour mobility or fiscal transfers. If we had more people moving from greece to Germany or more transfers the other way around, we would still be in the mess we are today.

  29. Not bad sniffo, but don't catcha snivo! That's what everyone had to say in Europa

  30. Milton Friedman was an Old Keynesian. Who knew?

    1. Friedman wrote in an article called "Freidman on Keynes" that he said Keynes' methodology was right, but not his conclusions".

      But remember he is talking about Keynes, not Samuelson or Hicks.

      The truth is, however, Friedman would most likely not be happy with what Sargent and Lucas did to the discipline.

  31. "So, Greece's GDP is falling because of "tight fiscal policy?""

    No. Greek GDP is falling primarily due to a local demand shock that wasn't at all offset by EU monetary policy or Greek fiscal policy.

    Other than loquaciously declaring "It's not true", I don't think you've rebutted the conventional view. We can debate whether monetary or fiscal policy is most effective to offset demand shocks, but to claim that 1) neither could, or 2) neither should, or 3) Greece hasn't suffered a demand shock requires more than hand waving.

  32. This piece is rather long by blog standards, but has only words and no data. Maybe Cochrane does not have the time to go into those pesky numbers of all these small european economies (I know, they are so many you get lost, that is why is so nice to study the US economy...)

    Germany had NO cumulative current account surplus in the 10 years leading into the Euro, whereas Italy had a surplus on average. After 15 years of the Euro Germany has a 7% of GDP surplus, and has accumulated 700 billions of Target2 credits toward other euro members. Italy joining the Euro went straight into deficit and only a violent contraction of -9% of GDP for consumption (...retail sales) brought by austerity has led now to a 1,5% surplus. Why was austerity (taxes) imposed ? Because Target2 credits had gone to 1,000 billions in 2002 (from zero basically before 2008) and Germany demanded it, using the public debt/GDP of 120% of GDP as an excuse. Why do I say an excuse ? Because as a result of austerity public debt/GDP went up to 135%. But italian yields were at 6% in 2012 with 120% debt/GDP and are now 1,8% with 135% debt/GDP. The Germans only wanted to avoid the external deficit of the southern countries through Target2

    But without the Euro, Germany would have an exchange rate of 1,8$ and instead thanks to the Euro has enjoyed of 1,3$ on average. So the Euro means basically an artificially low exchange rate for Germany....which creates a huge trade surplus...and a chain of consequence none of which enter in JC writings..

    You know, New Zeland and Australia, Canada, Switzerland, Sweden, Japan, Korea, Israel, UK, Turkey, Hungary, India, Cina all managed indirectly their exchange rates or simply had them to adjust. Maybe they are all wrong and they all shoud join a currency union... Japan, Korea, China, India, Taiwan all together in a single nice currency call the YenYuanRupia...
    and New Zeland and Australia are simpy utterly crazy not to join together... and so Israel and
    Turkey, it is also strange that the Israeli do not ask to join the Euro don't you think ?

  33. "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? "

    we didn't. We had a civil war, remember? Now imagine what would have happened had we not shared a common language/culture

  34. "In an earlier era, Greece could have devalued the drachma, making its exports more competitive on world markets."

    This stuff has been repeated ad nauseam by Krugman and others for years. A lot of the points you have made, commentators on your's, Wren Lewis's and other blogs for ages now as well. As you point out, labour mobility in Europe is very high - so high in fact it was the major political issue facing Cameron before the election and, ironically, one of the biggest political challenges to the European project. Greece's problems relate to its trade and industrial structure and institutional weaknesses, which as you point out were not solved by devaluations in the past. These were related the to the reasons these countries were keen on joining (and still despite everything, keen on staying in) the Euro. Another big reason was trade finance reasons - difficulties in earning the foreign exchange needed to pay for essential imports.

    So your post is a refreshing change.

    A lot of the discussion I have seen where people just repeat what is in conventional models shows the problems in economics education. There seems to be a terrible lack of critical engagement and a lot of a-historicism - eg. a lot of reticence in trying to to understand how these economies work and a fear of thinking outside Model.

    My only quibble with your post is that these mistakes are not old Keynesian. Thinking only in terms of open-economy ISLM and optimal currency areas is much more Samuelson/Hicks "Keynesian". Real Keynesian approaches are much more literary based, with much more questioning - and much more engaged with history and data. Marshall-Lerner, for example, would be closer to old Keynesian.

  35. If the common Euro currency is such a wonderful thing why is it that Europe is tearing itself apart after little more than a decade?

    Hasn't the impact of the GFC brought to attention the implacable contradictions and asymmetries within the Eurozone?

    There is a distinct difference generally in economic performance between the northern European states and the southern European states. This has engendered the recycling of surpluses via lending by the northern countries to the southern countries. Given that these southern countries have financial difficulties and may not repay in total these debts, it could be said that future debt haircuts are effectively fiscal transfers, other policies not having succeeded in bringing financial stability.

    You mentioned Italy. Prior to the Euro, Italy was able to develop a strong industrial sector, with the aegis of a weak domestic currency. Now its industrial sector is a shadow of its former self having succumbed to the competitive ravishes of a more efficient Germany and other low cost European countries. Its industries have moved to places like Romania. It can no longer defend itself within the common currency area without severe internal deflation.


  36. "I am also a big meter fan. I don't think each country needs its own measure of length"

    John, given that statement, it sounds like what you think would be ideal is to have just one world currency, with one world central bank.

    1. ... is the idea to maximize convenience? That's why I like the meter.

  37. "Stanford has extremely sticky wages (tenure), and suffers "demand" shocks, (positive lately), without offsetting fiscal stimulus and tremendous labor immobility. It takes a year to hire faculty. But nobody thinks Stanford should have its own currency, and periodically devalue that currency. Why not? Because we are open."

    Confirming this post from MR? http://marginalrevolution.com/marginalrevolution/2015/07/the-rise-of-stanford.html

    This Booth '11 grad will be sorry to see you go

  38. So if we follow John Cochrane's in this and other posts, we go to a global central bank that seeks international deflation, and outlaws cash.

    1. ... that was (kinda) my conclusion too (above).

  39. It is hard to believe that the metaphor about the meter came from someone with a PhD in Economics.

  40. I prefer war to a fiscal union. It seems more and more that a war against the non-wanted EU for the sovereignty of my country is the only option left.

    What is wrong with these social engineers? As if people like this haven't caused enough deaths with the socially engineered communist programs in the seventies and eighties, they want to repeat new social engineering plans (ofcourse they think they are rational plans, just like the communist thought of themselves like rational) based on a make believe society as the EU until they caused new deaths and civil wars. People like John Cochrane are anti-democratic and immoral beings who are aiming to destroy whole societies in Europe based on the new fairy tales of prosperity. Just like all totalitarian and destructive dreams are based on the promise of a "new society" and prosperity in the future.

  41. Prof Cochrane like this piece and numerous other studies that have compared EU/EZ have a fundamental flaw in the analysis which is the case of languages, anytime you compare EMU with US you are implying that they have a common language and thats where the whole unconventional analysis like the one you have presented breaks down. Secondly sitting in Chicago (presumably not at the Harper Library) and having conversation with politicians/reading newspaper articles/Economist magazine is very different. Get down here and live here like a common man and you'll experience the cultural differences that exist in this union not just in Member states but within them, fiscal transfers in Italy (from North to the South) still happen after more than 150 years of unification, in Germany fiscal transfers still happen between the West and East Germany. Look back at European history which is marred with violence coupled with two World Wars, people are still alive who fought in the Second World War. A Union by definition means that people agree to be together and surrender national sovereignty for a Federation like after the Civil War in the USA. These issues are far more complex in EU where they have taken a foreign currency like Euro/Deutsche Mark but haven't changed their lifestyle (there isn't any Creative Destruction). On your point that Federal fiscal transfers only started in the 1930s. Even though America had a currency union in 1790, it enacted the Federal Reserve System only in 1913. Prior to this every state was printing its own US Dollar and Dollars printed from Chicago were traded at a discount when exchanged in New York (which infact is having different currencies but albeit with the same name). The period before 1913 was marred with repeated bank failures and bank runs were a common occurrence.

  42. This (http://fistfulofeuros.net/afoe/greek-politics-and-poisonous-statistics-an-on-going-saga/) is must reading for those trying to understand the Greek crisis. Given the level of political corruption documented, how can the EU, IMF or any other international body effectively deal with this crisis. Note that there seems to be no accountability for misdeeds and politically motivated witch hunts against the honest few.

  43. What about price level determination? The problem with the euro is that it combines a bunch of different fiscal authorities. If one of those fiscal authorities pursue active fiscal policy (in the sense of Leeper 1991), then there will either need to be passive monetary policy for the whole eurozone or the country with active fiscal policy will have to (probably painfully) switch fiscal policy regimes or default. There needs to be a large degree of fiscal commitment in order for a currency area to work. In this way, a currency area can't be optimal unless all the fiscal authorities choose not to have similar fiscal policies.

  44. I agree that the real question is whether the convenience of a common currency is worth giving up independent monetary policy. And I agree that the value of independent monetary policy is proportional to the magnitude of local demand shocks.

    Of course, this is an empirical matter. However, I would argue that we have strong evidence that local demand shocks are large. The evidence is the Euro crisis itself: many small countries around the European periphery (GIPS, Iceland, Latvia, etc) experienced very severe recessions. Compare their experience with Germany.

    This is prima facie evidence of strong local demand shocks that were not common to Europe as a whole. We saw large capital flows from core to periphery countries, and then we saw the reversal of these capital flows. This is analogous to the "typical" emerging market financial crisis caused by a sudden stop in capital flows. But now the usual monetary policy adjustment mechanism (which in a small open economy is currency depreciation) is unavailable. And so we've seen sky-high and persistent unemployment.

    By contrast, variation in economic conditions across US states is much less (though still substantial) because of fiscal integration and greater labor mobility compared to Europe.

  45. I really thought that Milton Friedman had utterly destroyed the argument for fixed exchange rates over a half century ago. But now Cochrane stamps his foot and says "I don't believe it!" and we're supposed to take him seriously?

    Cochrane says rather than recognize the reality of sticky prices, we should be feverishly trying to unstick them. The whole point of Friedman's argument was that that task was both impossible and unnecessary.

    1. Milton Friedman of all people would have disparaged arguments from authority, or fixed maxims in economics.

      Yes, he liked flexible exchange rates. Among large, relatively closed economies with competent central banks. And versus a status quo of supposedly fixed exchange rates, but buttressed by extensive capital controls and financial repression. He also wanted central banks to follow fixed money growth targets, and you have to choose between a peg and a money growth target. If you want floating rates, you have to answer "at what value." For Firiedman, the money growth target and let the market decide is the answer.

      Friedman certainly did not endorse the current fashion that you need flexible exchange rates so that central banks can actively set interest rate targets or deliberately devalue in order to artfully offset "shocks." And he believed money was measurable and its demand was stable.

      If you're going to quote from authority you can't pick and choose; take the whole Friedman plan or none of it. But Friedman believed more than anything else that one should follow the evidence, and that economic ideas can and will change as the evidence changes.


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