One of my brightest students recently asked if Robert Mundell would be stripped of his 1999 Nobel Prize because of the problems stemming from Greece’s fiscal problems. It won’t happen, but the slow-motion train wreck unfolding in the euro zone makes this a good time to re-examine the implications of Mundell’s ideas for the current global crisis.
The Canadian-born economist, now 77, got the Nobel for research on what would constitute an “optimal currency area,” the geographic or political region where society would be better off with one currency rather than several. Mundell did the work nearly four decades earlier, but it constituted an important part of the theoretical underpinnings of the European Union’s move toward monetary union in the 1990s.
This Mundell-euro link was why he got the prize in 1999, the year the new currency went into general circulation. There was a wave of triumphal self-congratulation across Europe. It seemed appropriate to honor the economist whose ideas had started it all.
There was a big problem, however, mentioned only by a few killjoys: The EU did not meet most of the criteria Mundell laid out as necessary for a common currency to work across multiple nations. Followed to their logical end, Mundell’s ideas do more to predict the eventual failure of the euro rather than its success. (Mundell probably realized this but perhaps thought it churlish to rain on Europe’s parade by pointing it out.)
Moreover, the problems Mundell predicted for a common currency area if his criteria were not met are precisely why not only Greece but also Portugal, Italy and Spain and some of the more recent euro joiners are in trouble right now. So while my student poses a brilliant question, the answer is that the euro’s blowing up would enhance Mundell’s long-term reputation rather than tarnish it.
Mundell said the success of a common currency required several conditions:
- Labor had to be free to move across political boundaries. This had to be true not only legally and physically but also required a lack of cultural barriers like different languages.
- Capital had to be able to flow freely.
- Wages and prices had to be flexible, able to go down as well as up.
- There had to be some sort of risk-sharing system to help out member countries that got into financial jams.
- Member countries had to have business cycles of recession and prosperity that were in phase with each other.
Despite the number of Poles who have become plumbers in Paris or waitresses in Ireland, there is little movement of labor across national borders in the EU. Language and culture are the primary barriers, but so are incompatible national retirement systems and other policy factors.
Capital does flow freely, but this is probably the only one of Mundell’s criteria fully met. Wages and prices are particularly sticky, as the strikes and protest rallies by unionized Greek workers demonstrate.
The euro zone had no established mechanism for fiscal transfers, and the haphazard response by the other nations to Greece’s problems illustrates how ineffective ad hoc responses can be. And finally, business cycles were not fully synchronized, although several, including Spain, Ireland and Portugal, shared simultaneous growth of their own asset bubbles in the years running up to 2008.
Despite stock market exhilaration on every bit of good news about the mess in Greece, the prognosis isn’t good. Let Greece default, and financial markets will swoon. Impose too-stiff conditions for help, and the Greek economy will enter such a harsh recession that the government of George Papandreou (a St. Paul native) and Greece’s very participation in the euro may go by the wayside. Achieve a carefully balanced bailout, and you still have to deal with Italy, Spain and Portugal.
Why should we in North America care? After all, total U.S. financial institution exposure to Greek debt is less than $200 billion. That isn’t chump change, but it is small in comparison with some losses already booked.
There are two reasons for concern.
First, economic growth is extremely weak, and further problems anywhere could tip both the European and North American economies back into recession.
More important, financial institutions as a whole remain fragile. A cascade of defaults across southern Europe could trigger a cascade of failures of financial institutions. Many Americans discount this. There was much scoffing when former Treasury Secretary Henry Paulson testified recently that unemployment might well have hit 25 percent if the Bush administration and the Fed had not stepped in after Lehman Brothers failed in September 2008. But Paulson was right; we did stand at the edge of an abyss, and we are no more than a step or two away from the rim right now.
© 2010 Edward Lotterman
Chanarambie Consulting, Inc.