Martin Feldstein on the euro

I rarely agree with Harvard economist Martin Feldstein, but his writings always make me think. His latest Project Syndicate column is no exception. The essay is not original, but it is didactic, and for this reason useful. Feldstein explains in clear language why some countries who adopted the euro are in difficulty, although he stops short of offering them advice on how to get out of the mess they find themselves in.

Feldstein argues that a common currency works well in the United States, but not in Europe, because of three characteristics of the American union. First, US labour is very mobile across state borders. Unemployed Americans move easily from states with high unemployment to states where jobs are plentiful. Second, the US has a centralized fiscal system, with automatic transfers to states in recession: “… each dollar of GDP decline in a state like Massachusetts or Ohio triggers changes in taxes and transfers that offset about 40 cents of that drop, providing a substantial fiscal stimulus”. Third, US states are required by law to balance their budgets. “Even a state like California, seen by many as a poster child for fiscal profligacy, now has an annual budget deficit of just 1% of its GDP and a general obligation debt of just 4% of GDP.”

None of these features of the US economy would develop in Europe even if the eurozone evolved into a more explicitly political union. ….

The most likely effect of strengthening political union in the eurozone would be to give Germany the power to control the other members’ budgets and prescribe changes in their taxes and spending. This formal transfer of sovereignty would only increase the tensions and conflicts that already exist between Germany and other EU countries.

Martin Feldstein, “Europe is Not the United States“, Project Syndicate, 29 November 2011.

I would add that Feldstein’s third point, which implies a ‘no bailout rule’, is the most important, and possibly a sufficient, explanation for currency union success. Panama, since it broke away from Colombia in 1904, has used the US dollar as its sole legal currency, albeit with the name ‘Balboa’. The government of Panama issues Balboa coins (of 50 cents or less value), but not paper notes, and has no political ties with the United States, other than treaties governing commercial trade and capital flows.

The list of independent countries that followed the example of Panama includes two Latin American countries (El Salvador and Ecuador), Zimbabwe in Africa, two small territories in the Caribbean (British Virgin Islands, Turks and Caicos Islands) and four in the South Pacific (East Timor, Marshall Islands, Micronesia, Palau). None of them suffer from belonging to the US currency union, despite the fact that they do not enjoy free access to the US labour market, nor do they benefit from automatic fiscal injections in times of economic recession. One characteristic they share with US states, however, is the ‘no bailout rule’,

An important caveat: I am neither a macroeconomist nor an expert on finance, so I might be totally off base with these comments. Sometimes, though, it takes a non-specialist to see that the emperor is not wearing clothes!

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