FTAlphaville and optimal currency areas.

There are a lot of talking points in this fun post on FTAlphaville by Matthew Klein.

The piece is a spirited defence of the idea of returning to the gold standard, based on logic that Martin Sandbu uses as a defence of the multi-country-currency euro.  If you don’t like it, he wants us to believe, then for the same reasons, you should not like the euro.

What this misses out is the notion of an optimal currency area, which goes back at least as far as Mundell.

The larger the geographical area, the more likely that area is to embrace regions with asynchronous economic conditions.  (Unless there is literally no variation by region in the type of economic activity).  So long as fiscal policies are imperfect substitutes for having a different monetary policy, and there are costs of adjusting prices, wages or of moving, the case against mounts as the geographical area grows.

Also, the larger the area, the less strong are the financial and trade linkages that motivate eliminating financial currency transactions and price denomination differences.  So the case for a common currency weakens.

So it’s perfectly possible to argue for the euro, but against a global currency.  Equally, it’s possible to argue for national or multinational currencies, but against individual bank, firm or person fiat monies.  Although there are asymmetries in economic conditions across small economic units like banks, firms or people, and government policies or private markets don’t do a perfect job of sharing the risk that results, the costs of asset management, transactions and figuring out prices under individual currencies would far outweigh the benefits.

As to the question of whether a global should be the gold standard.  Klein notes the problem caused by the physical path of gold supply, determined by [until we develop alchemy] the amount in the ground and resources devoted to extraction.  Assuming there is no new great discovery, this means a falling path for prices, since the growth of gold will be exceeded by the growth of the real economy.   If you believe in downward nominal rigidity, that isn’t great, as it means some relative prices won’t be at their optimum.  With rising prices, its less likely that any sector requiring real/relative wage cuts would need a nominal wage cut.

A gold standard also means no monetary policy tool to deal with aggregate economic fluctuations.  Klein makes the argument that this might not be any more inconvenient than the peripherals found the common Eurozone monetary policy.  But the difference here is that for aggregate fluctuations, all countries would feel the pain and conclude, rightly, that they would be better off with fiat currency.  That’s with the proviso that its printing could be managed as well as the best nation states do it.

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3 Responses to FTAlphaville and optimal currency areas.

  1. uberdaveblog says:

    I just cannot accept the idea that Ireland and Lithuania, Greece and Germany, Portugal and Finland belong in a currency union. Mississippi and California are different to be sure, but the common language, government, and institutions make them far more compatible and closer to an OCA. Even worse are the strictures of Maastricht and Fiscal (In)Stability Act and the forced commitment of CEE countries (Romania, Poland, Bulgaria, Hungary, Czech) to join.

  2. John Sweeney says:

    I’d be interested in longandvariable’s thoughts on the inability of domestic politics to adjust — in the absence of compulsion — to an inflexible currency, be it the Euro or gold….

    • Tony Yates says:

      Hard to discuss in the abstract. Having a joint monetary policy with another country requires more active fiscal policy, and, in particular, fiscal policy that redistributes across the currency region. The Eurozone doesn’t have nearly enough of this, and further hampers domestic adjustment with the stability and growth pact. Not ideal.

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