Paul Krugman is an esteemed Nobel prize-winning economist: an authority on international trade policy in particular. You might expect that he would have had sharp insights on the Euro to offer to his audience at the Council of European Studies conference in Philadelphia on April 15. But no: we got instead the tired old story that the euro area is not an ‘Optimal Currency Area’ (OCA). Martin Sandbu, who spoke recently at Birkbeck about his new book Europe’s Orphan: The Future of the Euro and the Politics of Debt, was on the podium as respondent and presented an authoritative critique, but Krugman was not swayed, as he explained the next day in his blog.
To be honest, the blog post is so tangential to the issues that one wonders whether Krugman is really following the Euro debate at all. It might help him to understand the force of the criticism directed to OCA theory if he had a bit more idea of the direction the European debate has taken. Here’s a summary in a few paragraphs, for the aid of OCAistas everywhere. (Sandbu has given his own response, more on the economics than the political economy of the debate, in a ‘Free Lunch’ blog entitled ‘I love the smell of devaluation in the morning’, but unfortunately that lunch is only free to Financial Times premium subscribers.)
Put very briefly, OCA theory produces the policy recommendation that countries should only lock themselves into a fixed exchange rate if their economies are sufficiently similar (‘convergent’) that the policy instrument of exchange rate adjustment is not needed. It implies that the countries in the euro periphery have suffered badly in the crisis because they could not devalue. It also suggests that, if the euro is here to stay, then the euro area needs to become more like an OCA by adopting ‘structural adjustment policies’ to make its constituent economies converge. Weirdly, Krugman states his critics advocate structural reform, whereas this is the prescription favoured by OCA adherents.
Critics of OCA theory point out the singular lack of evidence that countries which devalued had a ‘better’ crisis, and ask for the causal mechanism whereby devaluation helps a country to deal with the results of a financial crisis. They note that ‘orderly’ devaluations, whereby the exchange rate is set at just the level the real economy needs, are not available to most countries in our world of high capital flows. Floating exchange rates (such as the UK has) do not help the export sector to thrive, because the exchange rate is an asset price determined in financial markets. Exporters did not rush to invest when the pound depreciated in the crisis, as they were doubtful how long the new parity would last (a well-founded doubt, as it turned out). Krugman interprets these issues as a revival of ‘elasticity pessimism’ (the belief that exports are not elastic – responsive – to changes in relative prices brought about by exchange rate changes). This is a trivialising interpretation: the real issue raised by critics is whether the exchange rate can be made to function as a policy instrument for steering the real economy, given that it is subject to speculative over- and under-shooting.
But most important of all, critics of OCA theory challenge the idea that ‘structural adjustment’ by the periphery is needed to deal with the euro crisis. They offer a different analysis of what has gone wrong in the euro area and a different set of policy prescriptions. Their starting point is that the euro crisis came in the aftermath of a global financial crisis. The euro area did not have the institutions necessary to deal with the financial crisis. The ECB acted as lender of last resort to the banking system, but there was no euro-wide mechanism for bank resolution and restructuring; nor was there a common debt instrument that would prevent sovereign borrowers being picked off by the financial markets. Papers presented at the conference by Waltraud Schelkle and Geoffrey Underhill (the latter co-authored by Erik Jones) set this out in detail. Jones and Underhill have coined the term ‘Optimal Financial Area’ (OFA) to describe the financial institutions needed for stability in a common currency area. The challenge for the euro area is building these institutions, not imposing more structural adjustment on the struggling periphery.
One of the ironies of trying to explain all this to an American economist is that the US offers a great case study of how a currency union might not start life as an OFA. During the C19, the US suffered repeated banking crises which imposed high costs on the real economy due to the lack of institutions to limit their impact. Those institutions were put in place only slowly: progress was impeded by deep conflicts between the north-east and the south-west, which were at least as far apart in their economic indicators as the euro core and periphery are today.
Euro pessimists argue, with some force, that the euro area will not be able to turn itself into an OFA, and it should not even have tried. This might be true, but not for the reasons that the OCA contingent give. According to OCA theory, the problem is that the underlying economic structures of the countries making up the euro area are too different. According to the OFA analysis, economic diversity is not a problem for sustaining a currency union: on the contrary, diversity increases the amount of risk-sharing that can be achieved. Instead, the problem is political: national governments might not agree to build the needed institutions if their perceived conflicts of interest are too deep.
In Paul Krugman’s OCA fantasy world, the alternative to euro membership is that each country has a managed exchange rate, whereby it can adjust its peg as required to maintain international competitiveness. In the Q&A session, he defended the euro’s predecessor, the Exchange Rate Mechanism (ERM), because it allowed pegs to be adjusted. But there were a number of problems with the ERM, not least that it could be subject to speculative attacks, like the one by George Soros that pushed the UK out, at huge cost to the public finances, on ‘Black Wednesday’ in 1992. Krugman joked that the Brits should erect a statue honouring Soros for keeping them out of the euro. It may seem a good joke today, but if the euro area can become more like an OFA, its members may have the last laugh.
Deborah Mabbett is Professor of Public Policy at Birkbeck