The Triumph of Peter Kenen, The Revenge of Robert Mundell

In America, it’s sad when your friends move away; in Europe, it may be a tragedy.

Back in the 1960s, a new concept emerged in international macroeconomics: optimum currency area theory. The question it sought to answer was, when should countries adopt a common currency? Everyone noted that by adopting a common currency, countries would give up much of their policy independence; the question was how costly that would be, and how large the benefits.

One variant, pushed by Ronald McKinnon, stressed the amount of trade; the more two countries trade, the bigger the advantages of not having to change currencies, and arguably, also, the less adjustment is needed to correct trade imbalances. Another (actually the first paper on the subject), by Robert Mundell, stressed labor mobility: you don’t need as much policy independence if unemployed workers can move to where the jobs are. A third, stressed by my late colleague Peter Kenen, stressed fiscal integration: if countries or regions share common budgets for major programs, there will be a lot of automatic compensation for “asymmetric shocks”.

As I’ve argued in the past, it turns out that Kenen, not Mundell, is the best guide to problems in Europe right now. And while I didn’t think of it until now, there’s even a case to be made that labor mobility within Europe is actually worsening the problem, making the euro less sustainable.Via FTAlphaville, Frances Coppola documents the extraordinary rates of emigration among young people in Europe’s disaster economies — not really a surprise when you consider the incredible levels of youth unemployment. But as she says, once those young people are gone, who will pay the taxes to support retirees?

The point is that the interaction among large welfare states, relatively high labor mobility, and lack of fiscal integration in a currency area may turn out to be really deadly.