Geographic Diversity

On the founding of the Euro, many economists held that the European “common market” wasn’t common enough. Martin Feldstein of Harvard, for one, thought that the economic diversity amongst the Euro-zone members–rich Germany, poorer Greece, fast-growing Ireland–meant that uniting under the Euro would paper over profound differences: “the adverse economic effects of a single currency on unemployment and inflation would outweigh any gains from facilitating trade and capital flows.” In a recent talk, European Central Bank president Jean-Claude Trichet argued that contrary to popular perceptions, it isn’t true that Europe is much more economically diverse: the range of economic activity between Alabama and New York is similar to that as between Greece and London–and presumably that Greece and London have benefited by the sorts of trade and capital market integration that Alabama and New York have long had.

Improved trade and capital flows, while beneficial, leave out the third main market: labor. And European labor, despite the lifting of many immigration restrictions, is nowhere near as mobile as in the United States. Moving from New York to Los Angeles is a long trip, but when you arrive, you won’t have a particularly strong bout of culture shock (you’re even used to earthquakes now!). A comparable Euro-zone move would be to head out from Helsinki, Finland and move to Lisbon, Portugal: while this might be a relatively common route for capital flows, it is not a common one for labor. So, much as Feldstein predicted (and as I discussed previously) the disparate impacts have been felt in unemployment–which is 7.8% in Finland and 12.4% in Portugal.

So, does this mean Trichet is wrong and the US is much more homogeneous? No. It simply means that the US has somewhat better coping mechanisms for dealing with inadequate monetary freedom: between fairly free-flowing labor (and fiscal transfers), the US is able to compensate residents of regions that aren’t helped by current monetary policy, in a way that Europeans are unable to do. While the US and Europe have similar economic diversity, America has much less cultural diversity.

But to some degree, this is kind of beside the point. If even the central bankers now agree that there is a high degree of economic diversity amongst both American cities and European countries, then the question next on their minds ought to be: how should we cope with these variations? What sorts of institutions will best enable the less-successful regions to grow while maintaining the vitality of the more successful?

Feldstein was certainly right that European diversity would limit the success of the Euro. In pointing out that America has similar economic diversity, Trichet seems to have learned the wrong lesson: rather than “America is diverse, so the Euro will be fine,” the lesson ought to have been “America is diverse, so perhaps a common currency there is less than optimal”.

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