Tim Worstall

Not an Optimal Currency Area

Want further proof that the euro was not a good idea?

Bernard Connolly, global strategist at Banque AIG,
said the markets mistakenly viewed Germany as a proxy for the whole
euro-zone, even though monetary union is in reality splitting into
Germanic and Latin blocs.

"They’re treating the
euro as if it was the old German D-Mark, but it’s not. Germany has
regained competitiveness. It has a whopping current surplus and can
withstand a higher euro: France, Italy, Spain, Greece, and Ireland
cannot.

"The full effect of currency rises peaks
after 18 months, so the strong euro is going to hit these countries
just as their domestic demand booms are turning to busts. They’re
facing a double whammy in late 2008," he said.

Spain’s
current account deficit is now 9pc of GDP. The country will not be able
to cushion the inevitable downturn because it has given up control over
interest rates.

As we don’t actually have a "European" economy, we can’t therefore deal with a single European interest rate. Thus we can’t have a single European currency.

In

12 responses

  1. mark Brinkley Avatar
    mark Brinkley

    Tim,
    Your analysis is nonsense. Whilst you are quite right to suggest that there isn’t a “Single European economy”, it doesn’t follow that there shouldn’t be one currency. There isn’t a single British economy either: London’s economy is more different to, say, Burnley’s than Germany’s is from Spain. Are you inferring that the pound should be dismantled because of this? No, of course not. Every one can learn to adapt to a single currency, just as Scotland learned to adapt to the English pound. Tweaking interest rates is never a good solution to badly managed economies and suggesting that the Latin countries should be allowed to go back to their bad old ways of deflating seems a curious stance for an otherwise impeccable free market thinker. The only logic behind lots of small currency blocs is to enable each bloc to try and cheat their rivals.
    Tim adds: Err, no. Whether an area should have the same currency depends upon whether it is an optimal currency area. If it isn’t, it shouldn’t. The EU isn’t, therefore shouldn’t.

    Reply
  2. mark Brinkley Avatar
    mark Brinkley

    Well that’s an open and shut case then. “Optimal currency area” being, presumably, something defined by TW.
    Tim adds: No, by real economists.

    Reply
  3. mark Brinkley Avatar
    mark Brinkley

    Oh come on Tim. You can do better than that! Your whole blog is dedicated to seeing through other people’s bullshit, and you mostly do it brilliantly. So why hide behind some obscure bullshit nostrum such as an “optimal currency area” as defined by “real economists.” You don’t have to be a fan of the European project to see that large currency blocs are infinitely preferable to mickey mouse Balkanised currencies. They are just a cheat’s charter.
    Tim adds:
    http://en.wikipedia.org/wiki/Optimum_currency_area

    Reply
  4. Bob B Avatar
    Bob B

    How well I recall from the lead up to the launch of the Euro in 1999 the many prophecies of the catastrophe that was to befall Britain’s economy if we continued to remain outside the Eurozone. What’s more, house buyers in Britain with mortgages would be denied the opportunity of benefitting from those wonderful low interest rates that prevailed in EU countries participating in the ERM and which went on to join the Eurozone.
    Instead, the British economy has performed relatively well by remaining outside the Eurozone and I dread to think what would have happened to the boom in house prices in Britain if interest rates did fall to the level in the Eurozone.
    The quote in the Telegraph is from the same Bernard Connolly who reminded us in the preface to his book: The Rotten Heart of Europe (1998):
    “just a few years ago the then-Finance Minister of Belgium (now the president of the European Investment Bank) said outright that, ‘The purpose of the [European] single currencyis to prevent the encroachment of Anglo-Saxon values in Europe’.”
    So now we know. Btw Bernard Connolly, a British economist, was dismissed from his post in the EU Commission for making critical comments on the rush towards European monetary union:
    http://www.internetional.se/emucon.html
    Curiously, even Delors in an interview with The Times in 2004 said that we were wise to not to join the Eurozone:
    “JACQUES DELORS, the former President of the European Commission, fuelled the controversy over the euro yesterday by admitting that Britain was justified in opting out of the single currency because its launch was flawed.
    “In a remarkably frank interview with The Times, the one-time bogeyman of Eurosceptics also predicted that Britain would stay out for years, not least because Gordon Brown was so ‘passionate about his contempt for Europe’.
    “In another startling admission, the veteran French leftwinger said that the European Union was in a ‘state of latent crisis’ because of weak leadership. He blamed member state leaders, including President Chirac of France, for putting national interests before the common good. . .
    “But his most surprising comments were on the euro. He lamented that EU leaders had failed to heed his warning that monetary union must be matched with close co-ordination of economic policies, and argued that the euro was consequently less attractive than it could have been.”
    http://www.timesonline.co.uk/article/0,,740-967150,00.html

    Reply
  5. mark Brinkley Avatar
    mark Brinkley

    You are still missing the point. It’s not whether Britain is worse off or better off in or out of the euro: we can do perfectly well in or out. The UK’s done well out, Ireland’s done well in. This proves precisely nothing. It’s just that the world would be a better place if there was only one currency. Just as the world is a better place for having one common business language: something you don’t hear Eurosceptics complain about, just possibly because it happens to be English.
    Tim adds: No. The world would not be better off with one interest rate. Which is what one currency means.

    Reply
  6. Bob B Avatar
    Bob B

    “It’s just that the world would be a better place if there was only one currency.”
    C’mon. When the full Gold Standard prevailed internationally pre-WW1, only small variations in exchange rates were possible – because in the last resort creditor traders could take payment in Gold. In the trough of the inter-wars depression in 1931, the new national government in Britain unpegged Sterling from its Gold parity in September that year and thereafter Sterling floated. With a floating exchange, it was feasible to maintain low interest rates through the rest of the 1930s with the result that we had thousands of new houses built in speculative developments. The unemployment rate remained high mainly in the industrial north because of regional dependency on traditional industries there, but overall Britain’s economy grew strongly after 1931 through to 1938.
    In 1944, during the deliberations over a post-WW2 settlement at the Bretton Woods Conference, there was an option then to return to a Gold standard but there was (fortunately IMO) little inclination to do so. Instead, the main trading nations on the allied side opted for a system of adjustable pegged exchange rates which prevailed through to 1972. Economic historians generally dub the period 1950-73 as the Gold Age of Capitalism because GDP growth rates for the affluent, industrialised economies were then higher than during any comparably long period in their previous history.
    The basic rationale for preferring floating exchange rates over rigidly fixed rates is that the social consequences of policy adjustments to restore internal balance in the labour markets and external competitiveness are (usually) much less painful with floating rates than with fixed rates.
    Germany has had to go through a long and socially painful adjustment process to restore competitiveness after entering the Euro at an over-valued exchange rate for the DMark in 1999. The adjustment for Germany has meant years of low GDP growth and relatively high high unemployment – compared with Britain, Denmark and Sweden, which all stayed outside the Eurozone. This inevitable adjustment process as a consequence of joining the Euro and the associated social pain were widely anticipated among German economists. In an open letter to the Financial Times in February 1998: “More than 150 German economics professors . . called for an ‘orderly postponement’ of economic and monetary union because economic conditions in Europe are ‘most unsuitable’ for the project to start.
    “The call to delay Emu ‘for a couple of years’ is made in a declaration signed by 155 university professors and sent to the Financial Times and the Frankfurter Allgemeine Zeitung newspaper in Germany. It signals intensified opposition to the government’s euro policy.
    “The declaration was organised by Manfred Neumann, professor of economic policy at Bonn university and chairman of the Bonn economics ministry’s council of expert advisers. It signals concern among professional economists about Bonn’s determination to begin the single currency on January 1 1999. . .”
    http://www.internetional.se/9802brdpr.htm

    Reply
  7. Bob B Avatar
    Bob B

    Btw one leading reason Ireland has done so well from EU membership is simply because under prevailing EU budgetary arrangements, Ireland in per capita terms is the leading recipient from the budget. Least readers think I exaggerate, try this source from Ireland:
    “Irish top per capita beneficiaries in EU15 at €396”
    http://www.finfacts.com/irelandbusinessnews/publish/article_10003360.shtml

    Reply
  8. mark Brinkley Avatar
    mark Brinkley

    You are getting there. You have to go through painful adjustments in order to buckle down to the discipline of being part of a large currency, but get there you do, just like Germany has. And Italy maybe will one day. There are “long and socially painful adjustment processes” but its worth it in the end, just like it was worth Thatcher taking on the unions in the 1980s. If you keep baling out and saying “we’ll adjust our currency instead” you are like an alcoholic trying to improve their problem by switching from wine to beer – you never address the underlying problem.
    If you took your Balkan currency viewpoint to its logical conclusion, you would keep splitting up currencies every time one area ran into economic problems. Maybe the south of Italy should introduce the Sicilian lira, whilst the north can have the Lombardy one? Just imagine how the USA would be if every state had its own currency? One of the main reasons it is such an economic powerhouse is that it is one large currency trading bloc. You have transparency, you have clarity, you have a level playing field, and you get more trade. It’s that simple.
    The world would in time adjust to one currency, and one interest rate and it would be the better for it.
    Tim adds: There are those who point out that it took the USA some 200 years to become an optimal currency area. What was that Keynes quote? “In the long run we’re all dead”?

    Reply
  9. Bob B Avatar
    Bob B

    To be entirely candid, I regard that as a bad prescription.
    The Bretton Woods Conference of 1944 (very sensibly) rejected the option of going back to the Gold Standard (which would have rigidly fixed currency exchange rates) not only because too much social pain is then required of countries with balance of payments deficits but also because too much of the adjustment process is required of deficit countries and too little of surplus countries which can simply coast along piling up international reserves indefinitely and doing little to nothing to curb their surpluses. Indeed, that ultimately proved to be the downside of the adjustable peg system too.
    As Tim W very rightly points out, the EU is nowhere near an optimal currency area – which is why Germany now has a growing current account surplus after it painfully restored international competitiveness at the cost of enduring low growth and low employment rates, while Spain has an increasing current balance deficit. EU economies are still too different to be able to cope comfortably with the same interest rate set by the European Central Bank.
    The fact is that in the EU15, since the launch of the Euro economies outside the Eurozone (Britain, Denmark, Sweden) are performing better than economies in the Eurozone. As Blair regularly boasts nowadays, Britain has become the second most affluent G7 economy – which doesn’t say much for his earlier enthusiasm for getting Britain to join the Euro.
    Readers may like to try this debate between Friedman and Mundell on the respective merits of flexible or fixed exchange rates:
    http://www.irpp.org/po/archive/may01/friedman.pdf
    And this attempt at a balanced assessment by Paul Krugman which end up sitting on the fence:
    http://www.econlib.org/library/ENC/ExchangeRates.html

    Reply
  10. mark Brinkley Avatar
    mark Brinkley

    Bob,
    Fixed exchange rates are not the same thing as a common currency. It has all the disadvantages and none of the advantages. For a start it always leaved the tempting possibility of floating again at some point in the future. Like an ex-alcoholic who keeps a bottle of whisky in the larder “just in case.” A common currency removes the temptation.
    The Bretton Woods decision in 1944 was quite probably the right one. For 1944. Though in truth, no one can tell, because we can only take one course of action – we can only speculate about what might have happened if decisions had been made differently.
    But it’s not 1944 anymore and we live in a world which is now instantly connected and has huge amounts of money changing hands across the globe, facilitating a tenfold increase in trade. And we are not living with the aftermath of world war.
    It’s all very well arguing that Germany and Spain are not an “optimal currency area”, but by the same token neither are England and Scotland. That is a point that neither you nor TW has addressed. The UK pound has its interest rates set in London and the decision is driven in great part by what is happening in London and the difficulties Londoners are having with absurdly high house prices. Because house prices are increasing, the Bank is thinking about raising rate yet again. But the reason house prices are so high in the SE is only marginally to do with interest rates and is largely a structural problem to do with lack of supply and high demand, a situation having its roots in planning decisions made decades ago. Trying to fight this little bushfire with interest rates is bizarre – it’s not Scotland’s problem, it’s London’s, so why is Scottish suffering with higher interest rates than it needs? If you are being consistent, why are you not arguing for a break up of the pound for the self-same reason as you are arguing for a break up of the euro? More to the point, why isn’t Alex Salmond making this argument? The man is too timid.
    Or is your argument that England and Scotland have had one currency for so long that they have become an “optimal currency area” willy-nilly? Just like New York and Oklahoma. If so, then just let Germany, Italy and Spain get on with it and they’ll eventually get there too.

    Reply
  11. rhodium Avatar
    rhodium

    The argument that the so-called “golden era of capitalism” was due to Bretton-Woods, is a classic example of false assignment.
    The clock struck 6am, and it got light out. Therefore, the clock striking 6 is what causes the earth to rotate on its axis.
    uhh….no.
    Is it possible that the postwar ‘prosperity’ was caused instead by the HUGE investment in technology during the war; coupled with massive increases in energy-consumption? Why yes, yes it is possible.
    And there were a dozen other significant factors also coming into play in that timeframe.
    Whether bretton-woods had anything to do with that ‘prosperity’ or not would be VERY difficult to say; since there’s no way to re-run the hundred-variable experiment with only that one changed.
    It is good to bear in mind that Bretton-woods -ended-, and ended because the US had taken on so much debt (wonder where that ‘prosperity’ comes from?), and inflated the dollar so badly (which is effectively stealing from citizens and dollar-holders), that it could no longer balance its accounts in gold. Thus, we arrived at the end of fixed-price gold and the end of Bretton-Woods.
    It is interesting to see people declare that the decision not to return to a reality-based exchange rate (i.e. gold standard or similar) was “a good thing”, without ever giving a lucid and believable reason for it.
    It smacks of knee-jerk regurgitation of propaganda or indoctrination (i.e. ‘schooling’).
    If all currencies were related to a fixed measure of a universally-desirable real-world substance (e.g. gold, oil, kilocalories of wheat), then there is at least -some- correlation between a country’s productivity and the value of its currency.
    The current system provides absolutely no connection between currency-value and physical reality. That’s why they call it FIAT money. The current system of 24-hour currency trading is the only mechanism which forces at least a little reality into every country’s currency.
    Why people continue to insist on ever more centralization is beyond me. In what way are the crooks…err…people in Brussels or Geneva wiser or higher in integrity than in the national capitals? Or in your own town hall? They are NOT.
    They’re just plain old crooks…err…people. Same as anyone else. No wiser, no more honest. But with VASTLY more power; that a well-conditioned mob of morons gave them; by swallowing whole the endless indoctrination that “big central is good…local and individual control is bad”.
    There is no PROOF that centralized works better. In fact, considering the MASSIVE debts built up over the past 50 years (which is where your ‘prosperity’ actually came from), and the MASSIVE numbers of death-by-government (numbering in the hundreds of millions), a very VERY strong argument can be made that centralization is CLEARLY worse for society as a whole than the much-maligned “balkanization” is.
    Compare the value of your currency today, to 100 yrs ago. Yes, it’s about ONE PERCENT of its former value. Picture what that has done to the value of your family’s savings and investments over the past century.
    Yes, that’s correct…the government that continuously inflated your currency, STOLE from you. Very good. Now you’re an economics-expert. Which looks more evil now? The gold-standard? Or having the value of your money set by the whim/fiat of poli-whores in ritzy taxpayer-funded faraway ‘centers of government’ ??

    Reply
  12. mark Brinkley Avatar
    mark Brinkley

    Next time you exchange money, look at how much you are getting in return. You will be lucky to get 95% of what you should. You are being ripped off. If there was a really cool reason to put up with this currency farce, then it might be worth paying for. But there isn’t. All you get is tired old arguments about how hell will freeze over if we lose our precious pound and how Britain would be “much worse off.” But it’s money, for chrissake. It’s just a tool, not an object of worship. In my book we are all much worse off by persisting in this mirage that somehow we are able to “manage” our economy by shifting interest rates around. Remember, all you can really do with a currency is inflate it. Big deal.

    Reply

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