I keep an eye on various European economics blogs (especially VoxEu and Maverecon). We often compare Canada and the US. I want to compare Canada and the Eurozone, just for a change. I want to revisit the Optimal Currency Area question, in the light of the financial crisis. The Eurozone is like Canada would be, if we abolished the Federal government, and had to rely on the provincial governments only. That's very worrying (for the Eurozone).
Canada is like the Eurozone in having a single currency, where monetary policy is managed by a single central bank. Canadians regions, and Eurozone regions, may face asymmetric shocks. The monetary policy that is best for Alberta may not be best for Ontario. The monetary policy that is best for Spain may not be best for Germany. Basically the same.
Canada is like the Eurozone in having free labour mobility, at least in law. (OK, there are some provincial licensing barriers in Canada, and probably a few more national licensing barriers in the Eurozone). In practice, labour is probably more mobile in Canada. A difference in degree.
The big difference is that Canada has a Federal government with serious taxing and spending powers; the Eurozone doesn't. That difference didn't seem to matter so much before the financial crisis. Now I think it matters a lot.
1. If the recession hits some areas of Canada harder than others, the Federal government can and will transfer funds towards the worst-hit provinces. I don't see the Eurozone doing that to anything like the same extent. We have a federally-funded EI (unemployment insurance) system for example. They don't.
2. If the Bank of Canada runs out of ammunition, the Federal government can and will use fiscal policy to supplement monetary policy. If we were the Eurozone, we would have to rely on expansionary fiscal policy by the provincial governments only. The Eurozone "provincial" governments face the classic "beggar-thy-neighbour" coordination problem. Each provincial goverment sees the full costs of a worsened debt/GDP ratio, but only a few of the benefits of the increased demand, because of leakages into higher imports from other provinces. (As I explained in a previous post, this coordination problem affects governments within a common currency area, but is not a problem outside the currency are, since flexible exchange rates prevent leakages.)
3. In Canada, the Federal government knows that a fiscal deficit will be money-financed, at least in part, which will make it more effective and also reduce the costs of financing the future debt (as I showed in a previous post). The individual Eurozone "provincial" government, if it is small relative to the Eurozone as a whole, knows that very little of its deficit spending will be financed by increased seigniorage from the European Central Bank. So they will be more reluctant to use fiscal policy.
4. As a last resort, perhaps at the cost of abandoning the inflation target, the Canadian Federal government can always print money to pay the national debt. The Eurozone "provincial" governments cannot, and would be forced to default. If there were a "run" on Canadian government bonds, similar to a bank run, where bond-holders refused to roll over the maturing debt, the Bank of Canada could act as lender of last resort to the Federal Government, just as it would to a commercial bank. The Eurozone "provincial" governments have no such lender of last resort facility at the ECB. It is as if their debt were denominated in foreign currency, which they cannot print. This is very worrying, because without a lender of last resort, the Diamond-Dybvig model of bank runs shows us that expectations of runs can be self-fulfilling. This same model could be applied to any short-term debt. Even if they can solve the coordination problem, some Eurozone provincial governments would fear a "run" on their bonds if they adopted an expansionary fiscal policy. (Presumably the Federal government would act as lender of last resort to a Canadian province facing a similar "run"?)
5. If a Canadian commercial bank gets in trouble, the Bank of Canada and the Federal government can get together and decide whether and how to bail it out. It might not be an easy decision, but at least they don't have to worry about who pays for the bailout, since the government owns the Bank of Canada. It all comes out of the same pot eventually. If a European commercial bank gets in trouble, it's not so easy. Does the money (understood both literally and metaphorically) come out of the ECB or the "provincial" government. Which provincial government(s)?
The Eurozone is like Canada, only without the fiscal capacity of the Federal government. On thinking this through (by writing this down) I am now much more of a Euro-sceptic than I was before. They face much bigger problems than we do. In particular, the risk of a "run" on the debt of a Eurozone government is significant. It is greater than the risk of a "run" on the debt of a Canadian provincial government, and much greater than the risk of a "run" on the debt of the Canadian Federal government.
Let me stick my neck out further. Unlike Willem Buiter, who makes a well-reasoned case against any country leaving the Euro, I think this is possible, maybe even likely. Financial crises are especially dangerous where the fiscal authorities cannot coordinate with the monetary authority. Argentina under the US dollar is one example. A Eurozone "provincial" government facing a liquidity crisis due to a "run" on its debt will be forced to understand these dangers, and will deeply regret not having its own lender of last resort printing press. It may then issue emergency scrip. After a very messy period when the scrip circulates alongside Euro currency (the banks will be closed), that scrip may become the new national currency.
Why couldn't a Eurozone country do an Argentina?