Type into Google “the father of the light bulb.” The first page of results will have Thomas Edison as the main character in each hit. Edison is certainly the one we remember, but others added significantly to the modern light bulb.
To be sure, Edison was indeed the first to produce something that resembles today’s incandescent illumination, but his filament, produced in 1880, was made of carbonized bamboo, the longest burning material he could find and produce at the time.
Later, in 1910, a scientist working for General Electric invented a method for manufacturing tungsten filaments which are still used throughout much of my house today.
Economic knowledge comes into the world in a similar fashion. One person typically starts the ball rolling, but the perfection comes after others have added key ingredients. Progress is collaborative.
Now type into Google “the father of optimal currency region theory.” The first page of results will have Robert Mundell, my old international macroeconomics professor, as the main character in each hit. The first paper to reach the public on this topic was published by Mundell in 1961.
In his article, “A Theory of Optimum Currency Areas,” Mundell set out to explain the conditions necessary for a region to have one and only one currency. This has come to be known as “optimal currency area” theory, or OCA.
Mundell theorized that all areas of a currency region should have similar economic dynamics. All areas should exhibit synchronized booms and busts. This insures that accommodative or restrictive monetary policies are appropriate across the currency area.
In addition, Mundell considered that labor mobility, the ability of workers to move around the currency region, to be necessary.
To understand the issue, suppose that Boston is experiencing a financial boom while Portland is in a temporary slump with high unemployment. If workers in Portland cannot move to Boston, then a separate currency for Maine and Massachusetts can make an adjustment.
Specifically, the Maine currency can go down, making Portland labor cheaper in the eyes of the Bostonians. This can then encourage employers to build factories in Maine thereby taking advantage of the lower wage rates created by the lower currency value.
In contrast, if, when Portland is in a slump, workers can easily move down to Boston, the unemployment in Maine and the over-employment in Boston can be cured without the need for a separate currency, and all is well. Or is it?
As with Edison’s incandescent light bulb, Mundell’s optimal currency area theory was a great starting point, but not by any means a finished product. Among others, Peter Kenen, a brilliant international economist at Princeton University added an essential ingredient to Mundell’s paradigm.
In his 1969 paper, “The Theory of Optimum Currency Areas: An Eclectic View,” Professor Kenen hypothesized quite correctly that regions of a common currency area should have a degree of fiscal integration to minimize the impact of a localized economic shock.
To see his point, let us take our Portland-Boston example one step further. Let us presume that all social services are funded and produced locally, and both Portland and Boston share a common currency, the dollar. When Portland suffers some sort of shock, workers are laid off.
As a result of the lower employment, the city of Portland as well as the state of Maine experiences a drop in tax receipts. Since neither Maine nor Portland produce their own currency, prudence dictates that they balance their government budgets. Lower tax receipts means that they must raise tax rates and lower spending.
Both of these fiscal changes reduce economic activity and drive employment even lower. This in turn further reduces tax receipts prompting more austerity ad infinitum.
Now let us assume in this mess that labor is perfectly mobile to move from Maine to Boston. The unemployment in Maine impacts the young workers the hardest. They are also the most willing move to Boston and find employment there, and they do.
Is this a happy outcome? Not really. Sure, the young unemployed of Maine now have work in that great city to the southwest, but these young workers have been removed from the labor force and economy of Maine. They reduce the economic possibilities here as well as the potential tax base to pay for public services. Maine is thus weakened in the process.
Is this real? Indeed it is. Check out what is happening around Europe. Public services are provided locally, by each country. Young workers in the stressed countries are emigrating from their home lands to central Europe where the jobs can be found. This is a ticking time bomb.
Contrast this scenario with the one which we actually have in the U.S. at the moment. Some of our public goods such as unemployment insurance, health insurance for the elderly (Medicare), retirement funding (Social Security), highways, and other infrastructure are funded publicly. We do not rely upon Maine workers and the Maine economy to provide these, and that is a very good thing.
In Maine, we have a significant brain drain. We raise children, educate them, and then send them out of state for work. As a consequence, Maine enjoys the oldest median population in the country. I say “enjoy” since with age comes acumen. We have a wealth of wisdom, I mean real scar tissue, don’t we?
It should be no surprise that Maine is in the bottom quintile of states ranked according how much they contribute to the federal taxes coffers versus what they get in return. We are a net drain on the federal system, since our contributions to the whole (our families) leave the state for greener (?) pastures.
So what does all of this mean? What is the practical takeaway? Our entire nation uses one currency. Interestingly, our nation fails one of Mundell’s key elements needed for a single currency region. Specifically, our states are not coordinated in their boom-and-bust cycles. When oil drops in price, the oil producing regions suffer a catastrophe while regions like ours are happy at the pump and at the thermostat.
During the Great Recession, the effects of which still linger, Florida and the Southwest were hit much harder than other areas.
So how do we survive with a single currency? How is it that we can violate economic theory and prosper? The answer lies in the federal government.
When public services are funded on a national level, they act as an essential element of stability. One region, without even being aware, automatically aids another. The federal government participation in our economic smoothes out the bumps, some of which can be quite severe.
It is difficult to stress just how important this is. Without a significant federal footprint in our economy, we lose our most important ballast. Thus, as an economist, I can see why some might argue to move education funding from the local and state governments to the federal level. I can see why one might argue that funding most of our public services federally is prudent.
In contrast, I become alarmed at the call to shrink the federal footprint. This is the eurozone model of instability.
(Marcus Hutchins, MA, M. Phil., Economics, Columbia University, NYC, is a former economist, treasury bond arbitrage trader and hedge fund manager. He retired to Southport in 1997 where he resides with his wife Andrea and his youngest daughter Abbey. He welcomes feedback at coastaleconomist@me.com.)
