Canada and the Eurozone: a comparison

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?

Comments

[Patrick]

OT, but I wanted to point out the latest numbers from the AB gov't on major construction projects in the province:

December: $270727.3 x 10^6
November: $279300.0 x 10^6
October: $286527.2 x 10^6.

If the trend continues, and if my mental arithmetic is correct, we're heading for a 20% annualized decline from October 2008 levels (5% each quarter x 4 quarters).

[Stephen Gordon]

A tangental remark: this episode should kill off once and for all the project of a Canada-US monetary union.

[Nick Rowe]

Patrick: That's *on* topic! It's an asymmetric shock. Fortunately we have higher labour mobility, so many workers will move back home, just like in the early 80's. But the houses can't move. (I think you forgot the compounding, but it won't make much difference.)

Stephen: Also bang on topic. I hadn't thought of that. My God! Just imagine if we had a common currency now with the US! Imagine the debate over the Fed's vs, Bank of Canada balance sheets, and who was really paying for the bailouts, via seigniorage! The fights are bad enough as it is, but just imagine if we also had a Canada vs US fight over who bails out what. But that's exactly what will happen in EuroLand. We dodged a bullet. I don't remember if this was discussed much during the Amero debates a few years back. Do you? Does anyone?

[Andrew F]

Would an obvious solution to this problem not be the creation of a Euro federal authority with serious taxing powers? I think given the prospect of Argentina-style meltdowns, some nations might be willing to swallow the infringement on their sovereignty.

[Nick Rowe]

Andrew: Yep, but I don't see it happening. It would be an elite response, totally at odds with the facts (or national sentiments) on the ground. Especially not during a crisis. "You want to tax us Y's to bail out those X's?"

[Andrew F]

Well, isn't it in large part to protect the X's from serious economic upheaval cause by collapse of Y?

[Ryan Stotland]

http://www.youtube.com/watch?v=gACEVoqT7cY

[Patrick]

Many of the internal migrant workers (if that's even a term) are from the Maritimes. There's nothing to go home to, except maybe better EI benefits.

Maybe I'm too pessimistic, but I think AB is in for a rough ride, even if energy turns around soon. It will manifest slowly because it takes time for big projects to run their course. But low energy prices and a credit crunch has created a gap in the capex project pipeline that will last at least a year. Even once the capex spending starts to flow again, it takes years to plan big projects.

The AB gov't pursued pro-cyclical polices that pumped-up an already too-hot economy. They didn't save, they didn't diversify the economy. Now our relatively high wages and cost of living (both 'sticky') is a recipe for a coming wave of unemployment. EI might keep food on the table, but it ain't going to pay the mortgage on a $300K-$450K house (which was close to the average price of a house in Edmonton/Calgary for the past few years), nor will it pay the maxed out credit cards or the payment on the $60K pickup.

The plea on the bumper sticker not withstanding, I think we can safely say that AB has pissed away another oil boom.

Sorry. I'm grumpy today.

[Stephen Gordon]

Oh yes, I blogged about labour market flexibility a couple of years ago. It had a couple of neat graphs.

Labour market flexibility and interprovincial migration

[Kosta]

Great post, and a great blog.

Let me ask you a tangential question prompted a comment from this Credit Writedowns Blog on Denmark joining the Euro http://www.creditwritedowns.com/2009/01/denmark-wants-in-on-the-euro.html. The blog closed with the line "unsynchronized business cycles in Ireland, the UK and Spain make these three countries equally problematic for the Eurozone."

I'm not entirely sure that having unsynchronzied business cycles is entirely a bad thing. I think of Canada, and have noted that the different regions of Canada have often had unsynchronized business cycles, for intstance there have been periods where Alberta's boomed while Ontario has not and have always thought that during these periods, at least on average, the country was doing OK, and that would be better than having the entire country go through boom and bust cycles simultaneously. But I really haven't thought the problem through.

So, I thought I'd ask you. Would Canada be better off if the business cycles of each province were synchronized, or does a degree of decoupling improve overall growth?

[Nick Rowe]

Thanks Kosta!

There are synchronised shocks, and there are synchronised *consequences* of shocks.

If you all have the same money, and same central bank (like Canadian provinces), then it is better that the shocks be synchronised. If they are synchronised, and if the Bank of Canada can see the shocks and respond quickly enough, then the Bank can offset them all, and prevent those shocks having any consequences.

But all we observe are the consequences of shocks that the Bank cannot offset, either because they hit too quickly and unexpectedly, or because they are unsynchronised.

So, I would prefer the predictable shocks to be synchronised, so the Bank can offset them. But I prefer the unpredictable shocks, and the effects of shocks, to be unsynchronised, so the lucky provinces can help the unlucky provinces.

[Andrew F]

That's interesting Nick. I had never considered that different shocks would yield different answers.

[David Beckworth]

Great posting Nick. I have been wondering whether the U.S. is an optimal currency area. Yes, the U.S. has relatvely flexilbe labor markets and fiscal transfers, but we also have regions with vastly different business cycles. For example, compare Michigan with Texas. Michigan has been in a recession more or less since 2000. Texas, on the other hand, has been booming and continues to shine relative to other states. If Michigan had had its own currency over the past decade or so it would have depreciated given its dismal economy. In turn, this should have increased Michigan's external competitiveness. Instead it was tied to the U.S. dollar which continued to climb up through 2002. The downside, of course, would be increased transactions costs for the U.S. Just wondering.

[Nick Rowe]

Thanks David! I liked your recent post on the savings glut. Very balanced, I thought.

With Michigan, if it's been in recession for about 9 years, as you say, you begin to wonder if it might be a real rather than monetary phenomenon. Prices don't adjust instantly, which is why we need flexible exchange rates, but 9 years ought to have been long enough. It makes you wonder about hysterisis effects. Some people move away; the others learn to live with it. Culture changes. Same in Canada.

[David Beckworth]

Yes, Michigan's problems are more real in nature, but having its own depreciated currency may have made the needed structural adjustments easier. Of course, a depreciated currency could have also made Michigan more complacent in making such changes.

By the way, my claim that Michigan has been in a recession since about 2000 is based on a look at the employment in the state and a measure of regional economic activity:

See http://macromarketmusings.blogspot.com/2008/12/michigans-eight-year-recession.html

See http://macromarketmusings.blogspot.com/2007/10/regional-economic-activity-in-usa.html

[pointbite]

Correct me if I'm wrong, but are you essentially arguing for one world government? Why stop at Europe.

[Stephen Gordon]

No, I don't think that's the argument. It's more like 'If you *must* have a single currency, then you better have a single government that is capable of reallocating income across regions.'

If you don't insist on having a world currency, then there's no need for a world government.

[pointbite]

Why did the gold standard work for so long?

[Nick Rowe]

^I agree with Stephen.

On why did the gold standard last so long: that's a lovely question. (If gold standard can survive without a central government, why can't the Euro standard survive too?)

Dunno. Part of the answer is that under the gold standard, countries could and did regularly suspend gold convertibility in financial crises. (Someone with better monetary history than me should butt in here.) So they would temporarily switch back to their own, fiat paper national currencies at times like this. That option is not available under the Euro, without introducing a new national currency.

But that still leaves the question: why did they keep on going back to gold, for so long?

I wish I had thought of the gold standard when writing the post.

[pointbite]

Is it possible that gold worked because prices were allowed to adjust? What is the difference between fixed currencies with floating prices, and floating currencies with fixed prices? In that case, the real culprit is not the inability of governments to interfere with monetary policy, but the over-interference of government with monetary policy. We shouldn't care about CPI.

[pointbite]

* replace the second monetary policy with fiscal policy. It seems governments shouldn't deficit spend to prevent deflation afterall.