Ronan Lyons | Personal Website
Ronan Lyons | Personal Website

Can the eurozone survive? Insights from the dollar-zone

Everyone’s favourite made-up Chinese curse runs “May you live in interesting times”. The world economy has certainly been an interesting place over the last few years, with several unthinkables happening in quick succession. First, financial giant after financial giant either went bust or to the taxpayer seeking a bailout, so that now the supposed bastions of the free market have their financial systems owned in large part by the taxpayer. Then, the European Union saw a number of its member states have to turn to the IMF for emergency loans – not just problem economies like Greece and Portugal but also Ireland, an erstwhile poster child for growth and low State debt. And then last week, the U.S. teetered hours from default, a course of events whose obvious consequence was to the downgrading of American sovereign debt for the first time in over a century.

The interesting times continue this week, with two of the eurozone’s largest member states – Italy and Spain, who between them account for one third of the eurozone’s population – in an apparent slow crawl towards expulsion from international capital markets. These events have led many people to question whether the eurozone was ever a good idea to begin with.

While it’s easy to go with the momentum on these things, it’s worth looking at who exactly is, for example, advising UK travellers to bring dollars not euro on their holidays to the continent. You’ll typically find that the people shouting loudest about the impending collapse of the euro are those who for ideological reasons never liked it to begin with. In truth, these commentators are about as instructive as their counterparts, those for whom the euro is an unquestionable part of the present and the future: these people know the answer (and the problem) before they even know the facts.

Show me the money area

But what does economics tell us about this situation? Undergraduate economics students – the good ones anyway – will be able to rattle off what economists believe the four ingredients for a good currency area are. Two are about mobility: whether people and money can move around the currency area to where they are needed. A third is about “risk-sharing”, usually interpreted as the ability to redistribute funds (through taxes and spending). But these three factors would be unnecessary were it not for the final element of currency areas, namely that the various constituent parts have similar business cycles (booms and busts).

Average annual growth in eurozone member states, 2001-2010

The graph above shows the current business cycle in the eurozone. Countries are sorted from left to right by how sharp the contraction has been since 2007: as you can see, Ireland and Estonia have been worst hit, while Malta and the Slovak Republic have merely seen their growth slow down. In the good times, growth ranged from 1% per year in Portugal and Italy to over 8% in Estonia. Since 2007, there has been a similar spread, from growth of 1.6% to annual contraction of almost 6%.

With such a spread of countries across the business cycle, was the euro project an exercise in futility from day 1? It would take a particularly blinkered commentator to think so. The graph below shows the same growth rates for 17 U.S. states, from Hawaii to Maine. No, I haven’t forgotten to change the data in the graph – surprising as it may seem, each eurozone country has a business cycle twin in the USA! Greece is the new Florida, France the new Mississippi and Cyprus the new D.C.

Average annual growth in selected U.S. states, 2001-2010

Average annual growth between 2001 and 2007 in these states ranged from 1% in Ohio to 5% or more in states like Idaho and Nevada. Similarly, since 2007, there have been a wealth of experiences, from growth of 1% in Nebraska to contraction of 4% in Arizona. And these are states that have had the same currency for centuries!

Lessons from States-side

To me, this variety of economic life in the dollar zone shows conclusively that there is nothing intrinsically unworkable about the eurozone. But what about tax harmonisation and the size of the federal government in the US? Surely they are key elements that are missing in the eurozone’s package.

Firstly, remember also that individual states in the U.S. can set their own taxes, with corporate income tax rates varying from zero in Washington State to 10% or more in Alaska and Iowa. The eurozone is most definitely not stuck between a rock (its break-up) and a hard place (fiscal union with tax harmonisation).

Remember also that the “risk-sharing mechanism” in the EU – its ability to share from rich region to poor – is not as weak as many people think. In the USA, excluding healthcare, the federal government spends about $200bn a year in grants to States. About half of this is spread across housing/urban development and transport infrastructure, with most of the remainder spent on agriculture, education and the labour force. $200bn is €140bn, almost exactly the size of the EU budget. Of this, €110bn is spent on what are effectively federal redistributions in areas like education, agriculture and competitiveness.

Not only does the eurozone not need harmonisation of tax rates, it doesn’t even necessarily need any ramp-up in the level of redistribution across member states. For the eurozone to have a healthy future, it will need to explore issuing euro-bonds and concurrently formally setting aside the first percentage point or two of VAT and/or corporate tax receipts as revenues for the top level. Individual states will certainly have to sign up to new rules in relation to how they spend, while the punishment for a state going bust will have to be set out.

However, tax harmonisation and a big increase in federal-level spending are not necessary ingredients. Those who argue that these are foundations of the solution are about as useful as those who argue out of economic illiteracy that economies as varied as the eurozone’s can’t share a currency.

  • Martin Neary ,

    An excellent article which puts the current doom and gloom about the future of the Euro into a reasoned context. I still feel though that tax and social harmonisation will be part of the Eurozone future.

    • Ronan Lyons ,

      Thanks Martin. Those willing to reap the rewards of a much more rigorous discussion of the US and its history as a currency area are referred to:

      With a full tip of the hat to Charles Larkin, PhD.

      • Giovanni ,

        nice post! I am advertising your blog among my analyst colleagues!
        I appreciate the optimistic message in such troubled times. I just wanted to point out how a more accurate, albeit harder to measure, measure of the state of the business cycle would be output gap rather than absolute growth. That might pick up sharper differences between for example western/eastern and norhtern/southern Europe.
        Moreover, even with not excessively asymmetric shocks to the cycle, in my opinion an issue is how the different economies in Europe can cope with shocks. In the past few years, for example, structural differences between the European economies have resulted in very different response dynamics. What do you think about that?

        • Ronan Lyons ,

          Hi Giovanni,
          Thanks for the comment (and for doing free advertising for the blog with the analysts!). That’s a very fair point regarding how to measure business cycle dynamics – I’ll have a look at the OECD stats. I would have two concerns:
          – However bad a measure (real) GDP is of what’s actually going on (on account of how much estimation and interpolation that has to be done), I’d be even more concerned that available metrics of the output gap are influenced as much as administrative assumptions by statistical agencies as by what’s actually going on in the economy. What is potential output, for example?
          – Suppose we could measure the output gap perfectly but we had a currency containing Spain, with a young expanding population and trend growth of 4%, and Italy, with an old static population and trend growth of 1%. Couldn’t there be no output gap in either economy but still they don’t form an optimal currency area for “business cycle” reasons? Just a thought…

          Anyway, hope all’s well in Milan – it’s certainly a baptism of fire in the markets!


          • John Mack ,

            Yes, true, the Eurozone can work IF the politics are right. But, sadly, the EU lacks a George Washington and lacks the intellectual nut practical Federalist group tat put the American Constitution together and created the United States.

            My father, an immigrant from Ireland, always commented that Ireland was on a bad course because its founding lacked a George Washington and the Federalists. Cosgrove and DeValera were no bargains.

            I see no political leadership in the Eurozone capable of making the EU work well through this crisis.

            • Justin Collery ,

              Hi Ronan,

              Good counterpoint. There are a couple of circles I cannot square.

              1) Eurobonds. Who decides how many can be issued? Who decides that Italy can raise €100bn Eurobond and Ireland only €10bn Eurobond. If there is not a higher layer of EU wide governance, do you think that 17 country leaders can agree this, and that their leadership will be effective (using recent past as a guide)?

              2) State borrowing. For this to work, do you propose that individual nation states should be precluded from borrowing?

              3) Eurobonds are effective transfers from richer nations to poorer ones. Why should a 64 year old working German subsidise a 59 year old retired Greek or Irish?

              I’m pro EU, but the primary problems are political, with some economic ones. I want it to work, but see problems which those in charge have not demonstrated they have the ability to solve.

              Having said that, if we are to make it work, it is important to focus on the good things!


              • happy boy ,

                thanks ronan, i am learning economics at school and this website is very helpful

                • The Eurozone is stabilising - Page 254 ,

                  […] Lyons recently wrote a very interesting article comparing the EuroZone and the US DollarZone. Can the eurozone survive? Insights from the dollar-zone | Ronan Lyons A very interesting analysis – I quote his conclusions … 'To me, this variety of economic life […]

                  Leave a comment