What makes a Union hold together?

Mark Sadowski in a detailed comment to a recent post, ended saying: “It´s taken as gospel that the US is a better OCA (Optimal Currency Area) than the Eurozone. But is this really true? (This might make an interesting post)”.   

His reaction was triggered by a post by Kash, which, in turn, picked up on a post by Gavyn Davies.

I must say that the OCA discussion was revived last year when the Eurozone crisis flared up with the Greek “blow-up”. This post by David Beckworth – and the links within – is a good reference to the debate. At the end of the post he writes:

I will go one further in this debate. It is not clear to me even now that all of the United States is an OCA. Do we really think Michigan and Texas over the past decade or so benefited from the same monetary policy? And do we think both states had an adequate amount of economic shock absorbers? Given the vast differences between these two states in their business cycles, diversification of industry, union influence, and wage stickiness it easy to wonder whether these states should belong to the same currency union. Yes, they have access to fiscal transfers, labor mobility is great (I myself left a job in Michigan for this one in Texas), culturally they are similar, and politically there is will for the dollar union. Still, given the disparate impact of U.S. monetary policy on different regions of the country one does wonder whether all the United States is truly an OCA.

In singling out Michigan and Texas, DB is following up on a much earlier post of his that discussed differential impacts of Monetary Policy:

The differential responses of these two states to the same monetary policy shock are striking. Texas is hardly affected relative to the steep downturn in Michigan. As noted above, these patterns fall more broadly into the regions of the United States with different sensitivities to the federal funds rate shocks. Our research confirms early studies that show these regional differences can be partly explained by the composition of output: those states with a relatively high share in manufacturing get hammered by a monetary policy shock while those states with relatively high shares in extractive industries fare much better. We also find that states with a relatively high share in the financial sector fare better as well. Finally, we find that states that have (1) a relatively high share of labor income compared to capital income and (2) a relatively high rate of unionization also get hammered by monetary policy shocks.

Conventional wisdom has it that to “qualify” as a OCA, there should be high business cycle correlation (symmetry of shocks) among members and individual members should possess “economic shock absorbers” – flexible wages & prices, labor market flexibility, labor mobility and a federal fiscal authority that coordinates fiscal transfers.

Figure 1 depicts this set-up for the Eurozone countries. The correlation between member counties and eurozone RGDP is straightforward. The shock absorber index is constructed from a simple average of an index of protection (rigidity) in the labor market (EPS index constructed by the OECD) and the inflation rate (as proxy for downward price rigidity).

The outcome is what was expected. Portugal and Greece are well within the OCA frontier. Spain and Ireland are polar opposites. Spain has a high business cycle correlation and low shock absorbing capabilities while Ireland shows the opposite characteristics.

Figure 2 shows the business cycle correlation of 8 US regions. Even though, as mentioned by DB above, there are differences in the shock absorbers of different states (maybe not so much when they are aggregated in regions), an index that quantifies these differences is not available. Nevertheless it is noticeable that the range of the variation in business cycle correlation is about the same among Eurozone countries and US regions.

Mark chose to compare the difference relative to trend among states. To keep the analysis consistent, I compare the business cycle correlation of individual states. This is depicted in figure 3, which classifies correlations as high (H,>0.8), medium (M, 0.50 – 0.79), low (L, 0 – 0.49) and negative (N). Here the differences are enormous, with five states showing negative BC correlations and another four registering low correlation!

Michigan (corr=0.85) and Texas (corr=0.69) are singled out in the picture. So, if as in BD´s example, Michigan and Texas make him wonder if the US is an OCA, what is implied by the differential between states above the 0.8 line and those below the 0.50 cut-off point? If the OCA “conditions” were in fact “necessary conditions”, the US should have “blown-up” as a Union a long time ago!

But we know it hasn´t. So why not? Maybe shared language, custom and culture in addition to a central government are more important than some economic indicator conditions. Those are exactly the conditions that the Eurozone countries do not possess.

Figure 4 shows another aspect that might be relevant for “binding the Union” together. The 6 largest states have about 42% of income (RGDP) and 41% of the population while the 6 smaller states have about 1.3% of income and 1.1% of the population.  Pretty equitable, no?

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18 thoughts on “What makes a Union hold together?

  1. My experience is that Euroland is not an OCA, economically, and sure, POLITICALLY. There are some non economic factors that are decisive. For example language. Same language is the more important factor in labor mobility.
    The experience is conclusive. For an spaniard is very hard to go to work in Germany.
    Any american people has any doubt about dollar?
    Is is reasonable to think that you can go to work in Finland speaking english? it is simply foolish.
    it is pure constructivism. Many cultural diferences to be absorved by a money!
    When an american goes out to another state, he or she is naturally admited as an american.
    Society is not mathematics.

  2. M.U. was sell as a prodige -a milacle. On its own, it will reach the conditions for an OCA. That is, thank to MU we will get more productive, more flexible, because the exchange rate didn´t count more for adjustment.
    EXACTLY the opposite of the reallity.
    Now there a high numbers of politics & economists that they will not see the reallity, because the reallity is they have betrayed theyself and their people.

  3. I´m affraid it could be a Great Implosion, Boooommmm…
    Do you think that the return to national money is absolutely necessary to return to a certain normality? I think so.
    I think that:
    1) The current financial problems are the fault of the euro. The euro has play a rol some thing similar to the MBS AAA.
    2)to absorb all the 5 million of unemployed (only in Spain) is impossible without a devaluation.
    3) to solve both problems, financial & economic,is impossible without a default & a devaluation.

  4. Marcus,
    Thank You. I didn’t think you would actually take my suggestion.

    I actually spent the day yesterday with an old high school friend but all the time my thoughts were on the data concerning relative RGDP dispersion since 2007.

    I note that many of the states that have fallen the most below trend in 2007-2009 (AZ, FL, GA, NV) still have high business cycle correlations with the US as a whole. (What data are you using to compute the correlations?)

    This is another perspective that seemingly confirms my intuition. The US is seemingly not as good an OCA as the Eurozone. But as you note, a shared language, custom and culture (mostly), in addition to a central government (although many resist this), and the domination by large states helps to overcome these impediments.

    But this has important implications for the conduct of monetary policy in the Eurozone. Germany is not doing that much better than the rest of the Eurozone despite all of their crowing.

    • I suppose that I would rather focus on the response to the “shock”.

      There has been a divergence in performance in both the Eurozone and the US. But the dispersion in response by the US states, even after weighting for size reveals that the US has “splintered” in terms of relative economic performance whereas the Eurozone has displayed a far more “cohesion” than suggested by the media coverage.

      For example, consider Florida and Pennsylvania. One was 6% of GDP and 14% below trend in 2009 whereas the other was only 5% below trend and 4% of population. In contrast the largest country deviating from overall Eurozone performance was Finland (less than 2% of GDP) being 14% below trend versus an approximate 8% average for the Eurozone and no large nations overperforming that average by a significant degree.

  5. Mark
    The data come from the BEA (State RGDP 1997-09).
    Notice that the “divers” – Florida, Nevada, AZ – were states with big rises and drops in house prices.
    Forgot to mention the “power” of a 224 year old Constitution.

    • So the European data is over the same time period and annual as well?

      It’s difficult to make comparisons when you change formats. How about making an RGDP by country graph for the Eurozone for instance?

      And how about the first graph. Can that be reproduced for the USA?

  6. The Euro data is for the same period. I´ll send you a country RGDP for Eurozone countries.
    The first graph cannot be reproduced for the US because I don´t know of indices that measure state (or region) “shock absorbers” .

  7. Marcus,
    You wrote:
    “The first graph cannot be reproduced for the US because I don´t know of indices that measure state (or region) “shock absorbers” .”

    I suspected as much. The US doesn’t care about such data.

    But the PPP adjusted GDP graph by country is easy. It would show a similar picture. In other words four nations comprise roughly 80% of Eurozone output.

  8. You got it (almost) spot on; The largest 4 (Germ, France, Italy and Spain) comprise 76.5% of the “group of 12″, consisting of:Germany, France, Italy, Spain,
    Netherlands, Belgium, Austria, Ireland,Greece
    Finland, Portugal & Luxembourg, presented by RGDP size.

    • I was rounding. With all due respect I breath these numbers.

      You’ve done a lot already. I was just trying to point out that a similar situation prevails in the Eurozone.

      • For others information, the other four are Slovakia, Slovenia, Cyprus and Malta (a hill of beans).

  9. I´ve not follow your argument about numbers, so I don´t understand well what you are looking for.
    But I think that is a case that never will fit well only with number. In fact, I think the weight is decisively on history, cultural and social differences.
    The US History is a common one since the beginning, the language is one from the beginnig, the heroes are the same, whith similar participation of all the regions in all the highest circunstance.
    In Europe we haven´t that at all.
    In spain we on´t like very much italian films, In france they like ONLY french films, not in any case German ones, etc.
    Obviously, there is a cosmopolitan minority that pretend to be the elite and the dictate of the culture. But the pop culture is completly ignored by the similar level of comsumer in the neibourgh country.
    Ther is no a european sentiment, and insitutions are vacuous and in the elections voted with less than a minimum enthusiasm.
    Europeans are truly adict to consume products of their own country, whith little exceptions. A Belgian doesn´t like to buy german products, or french, including sales by internet.
    I fit better seing an Indian film, that an swedish one. I suppose that an spanish film is absurd for a sweden. No so an american film, that it is followed with pleasure in any part of Europe, from Rusia to Portugal. That s the reason I see a mistake to forbbiden or taxes (as in Spain) US films: They are a factor of union between us!
    When America will decay, EU will decay, sure.

  10. Luis
    The “numbers” represent the “necessary conditions” indicated by the OCA theory.
    I agree with you that the “numbers” have little relevance. In a comment on MS, I mentioned that I had forgoten to mention the presence of a 224 year old Constitution. What about the Flag. That´s also indicative of many thigs shared. Do you see Eurozone countries adopting a Single Flag? Neither do I. Take Brussels, the Euro Capital.The Belgians have a “language frontier” within its boundaries. In the early 1970´s the University of Louvain (Leuven) founded in 1425, so older than America, had to be broken up and the French (and the more important part of the U) had to move to the other side of the language frontier. Need more be said?

  11. Yes, necessary conditions, true. But the numbers also don´t fit well with a monetary union.
    BTW, The other “cualitative factors” determine a lot the number, foe example, in labor (non) mobility.

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