Friday, May 07, 2010

Does a common currency area need a centralized fiscal authority?

Paul Krugman has a thoughtful and thought-provoking column on Greece today.

A large part of his argument is that Europe is not an optimal currency area because it lacks a large central government enacting transfer payments among the various regions.  That argument will be familiar to students of macroeconomics.  (See, e.g., the case study on monetary union in chapter 12 of my intermediate macro textbook.)


Once upon a time, one might have said that the U.S. back then had a particularly vicious business cycle.  But Christy Romer's path-breaking research has demolished that claim. 

One might argue that the 19th century had a different set of labor institutions than we have today, and these facilitated the adjustment of wages.  That argument, suggested by the research of Chris Hanes, may have some merit.  If that is the case, then maybe that is the path forward for Greece and the rest of Europe.  As Paul suggests, increasing wage flexibility won't be painless.  Yet it might be easier than giving up on the Euro experiment.

A final possibility is that the key difference is labor mobility: Americans were willing to move among the states, whereas Greeks have to stay in Greece because they don't speak German.  If that is the key difference, then Paul may well be right that the Euro experiment is over.

Update: More from Paul.