Trichet@LSE: EMU as Viable a Currency Area as US

Flashing sirens, extra security guards, financial journalists baying for blood, and the incessant chatter of students and faculty debating the virtues of "EU bonds" and "haircuts": Where else could it have been but at the LSE in eager anticipation of the ECB President Jean-Claude Trichet delivering an address? And so it was last Monday afternoon that Europe's Bulwark Against Market Pandemonium came to speak before our central London institution. With various commentators predicting the imminent breakup of currency union--or at least the removal of some of its more recalcitrant members alike Greece, Ireland, and Portugal--this talk was highly anticipated for followers of European integration. Given that nearly all of the world's major geographic regions are engaged in integration projects, certainly the fate of its most advanced project deserves attention.

While we await the LSE Events folks posting the video clip of Trichet's talk online, let us content ourselves with the presentation slides and the transcript from it. While he unsurprisingly gives a fairly optimistic view of EMU's progress to date, something that struck me was his argument that the EU represented no less an optimum currency area than the US based on measures of economic variation. Trichet compares the dispersion of annual inflation, real growth, and unit labour costs in explaining that differences in economic performance among EMU states are not wildly different from those of US states.

This being the IPE Zone, let us set aside the "international" and "political" aspects for now and consider the "economy" of European vis-a-vis American integration according to Trichet. Since you can read the rest for yourselves, I have chosen to focus on differences in unit labour costs (ULC), defined by the OECD as a "measure the average cost of labour per unit of output and are calculated as the ratio of total labour costs to real output." What follows is the chart for the EU:

And here is the equivalent chart for the US:

Both charts set the context for his argument that, well, economic conditions for using a single currency are not all that different across the Atlantic:

Let us go one step further and investigate the sources of this growth dispersion in the US and euro area economies. This reveals parallels even in the root causes of dispersion in economic performance. Both currency areas comprise regions that experienced a significant boom and bust cycle over the past decade. Both also contain regions that are facing significant structural challenges of a more long-term nature.

Nevada, Arizona, Florida and California in the United States, for example, experienced increases in house prices that outpaced the national average by a wide margin. Steep house price increases and the related strong performance of real estate, construction and financial services probably contributed to above average growth in these states.

Some other US states, particularly the former manufacturing powerhouses in the ''Great Lakes'' region, saw a long episode of below average growth at the same time. Below average performance of the region – and particularly weaker growth rates in the states of Michigan and Ohio – are related to strong reliance on manufacturing. Structural shifts in the US economy towards services have gradually reduced the value added of manufacturing relative to GDP, with implications for areas with a high concentration of companies in manufacturing industries other than information and communications technology.

The sharp fall in house prices in Florida and the south-western US states turned boom into bust. These states experienced the harshest recession among the US states. But GDP growth in the ''Great Lakes'' region, which was below average before the crisis, also remained below average during the crisis.

Some euro area countries experienced asymmetric boom-and-bust cycles similar to those just described in the United States. Several euro area countries had higher than average growth in the pre-crisis years, while a few have experienced growth below the euro area average for the past decade due to structural issues that could have been tackled with more determination.

The effect of the crisis on the different euro area economies follows a similar pattern to those of comparable US states. The countries in the euro area that have been hit hardest are those in which either large asset-bubble driven imbalances unwound or structural problems were left unaddressed before the crisis. More specifically, Ireland and Greece, in particular, remained in recession in 2010.

Those countries that have yet to implement more far reaching structural reforms also have relatively low growth prospects after the crisis. Just a few years ago, Germany was – entirely wrongly – labelled the “sick man of Europe”. Yet Germany is now an example of how big the dividends of reform can be if structural adjustment is made a strategic priority and implemented with sufficient patience.

And then he zeroes in on differences in labour cost as a yardstick for competitiveness:

The relatively low growth rates in some countries are linked to a deterioration of competitiveness, driven, for example, by persistent above average unit labour costs. Ahead of EMU, unit labour costs converged in the euro area. What is more – disregarding the most recent countries to join the euro area – dispersion both ahead of the crisis and during the crisis was very similar in the euro area and the United States.

At the same time, it is worth noting that both currency areas include regions with persistently above or below average growth of unit labour costs. Again leaving aside the most recent countries to join the euro area, here, Greece, Portugal and Ireland, in particular, have lost competitiveness vis-à-vis their main trading partners in the euro area. Germany, in contrast, has been able to lower relative unit labour costs over the same period.

Similar persistent losses and gains in competitiveness are also observed in the United States. Some states have experienced large or persistent increases in unit labour costs, currently exceeding the national average by as much as 20%. Other states, on the other hand, have been gaining competitiveness vis-à-vis the national average over the past decade.

In summary, these results suggest that those who are questioning the viability of the euro area as a single currency area on the grounds of economic heterogeneity are misguided. Over the past 12 years, this has been broadly similar in the euro area and the United States.

So divergences in economic performance among member states in the EMU and US may not be all that different, but then there are matters of international and political configuration. While American federalism may not bind states to the central government as tightly as in some other countries, its working principles for sovereignty are more worked out than those in the EU where supranational authority is still in question. What is Trichet's solution? Being a Frenchman at an institution modelled after the Bundesbank (the ECB), more central surveillance is his reply:

The existing economic governance framework has been incorrectly implemented and, more importantly, has proved to be insufficiently binding while lacking appropriate comprehensiveness.

Today’s reform of the governance framework has to take the current constitutional framework. We have to accept this situation as a given, at least for the foreseeable future, even if I am convinced that we have already to reflect upon further steps for economic governance in the longer term. Today, we have to empower the institutional arrangements that are already in place to the point at which they can really and durably inspire confidence.

The requirements for a very significant reinforcement of the fiscal surveillance of the Stability and Growth Pact and for the creation of a new surveillance of competitive indicators and macroeconomic policy have been discussed widely and in much detail.

As you may know, the ECB takes the strong view that there is the need for more speed and automaticity in the sanctioning mechanism, particularly in the Stability and Growth Pact, but also in the broader macroeconomic policy surveillance framework. The experience of the past months has vividly demonstrated the importance of a timely correction of internal and external imbalances.

Argue if you will with his logic, but it is very much in the "ever-closer union" vein to prevent future crises. Left to their devices, errant members will misreport macroeconomic data to paint a brighter picture of their national situations. To mitigate this "moral hazard," they must be more accountable to the centre. Surely it's a familiar if controversial notion, but that's roughly where the thinking of ECB powers-that-be lies at the current time.

Would Greece have been let into the EU if the true rottenness of its finances were known beforehand? Or, would Greece's situation have been addressed earlier had the magnitude of its problems been known at an earlier date? The ECB is keen on not losing any more sleep in the future over such counterfacturals through far more vigilant scrutiny.