America Isn't an "Optimum Currency Area"

Those damn NIMBYs and the legacy of Robert Mundell

The Canadian economist Robert Mundell, winner of the 1999 Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel, died Sunday at the ripe age of 88 in his Italian pallazo. Mundell was a low-tax supply-side swami who made vital contributions to the intellectual climate responsible for the “Reagonomics” of my Reagan-loving youth. But that’s not why he bagged economics’ top prize. The Swedes honored Mundell for his watershed work on the ways in which international currency exchange rates affect national fiscal and monetary policy. His notion of an “optimum currency area” led many countries to break their pegs with the U.S. dollar. He was also a champion for the adoption of the Euro, despite the fact that he had made it clearer than anyone why this was bound to lead to trouble.

There was, for me, a sort of serendipity in the timing of Mundell’s passing. Yesterday I recorded a terrific podcast episode (out next week) with Yale’s David Schleicher. In my role as a Senior Fellow at the Progressive Policy Institute, I’ve been hard at work researching a paper on mechanisms to encourage municipalities to ease up on restrictive land-use regulation. David’s 2017 paper “Stuck! The Law and Economics of Residential Stagnation” is, for my money, the smartest, most interesting thing anyone’s written on why it is that draconian municipal zoning restrictions pose a huge macroeconomic problem. And his insight here is drawn directly from Mundell’s conditions for an optimal currency area.

Paul Krugman gets to the gist of it in his 1999 reaction to Mundell’s Nobel:

The debate over how to define an “optimum currency area” is an endless one, but Mundell set its terms, suggesting in particular that a key feature of such an area would typically be high internal mobility of workers, that is, the willingness and ability of workers to move from slumping to booming regions. (This is a criterion, incidentally, that Europe–whose single-currency regime Mundell now enthusiastically supports–manifestly does not satisfy.) [emphasis added]

Likewise, this is a criterion the United States of America does not meet. Restrictive local land use policy is one reason why.

But let’s back up a second. What’s the deal with this optimum currency area business? Great question. I hope you like excitement!

In a nutshell, floating currencies are valuable because they enable central banks to respond to demand shocks. If your country’s currency is pegged to another country’s currency, your central bank won’t be able to goose demand by injecting more money into the system. Unless the country you’ve pegged your currency to is undergoing a similar slump in demand, its central bank is unlikely to risk overheating its economy by making its money printer go “brrrrr.” Nor can you get the same effect by cutting nominal wages and prices, one by one, across the entire economy because prices are sticky and it’s just too damn costly and complicated to renegotiate millions of contracts. (This is called “internal devaluation” and it sucks. Ask the Greeks.)

One of Mundell’s cool insights is that floating national currencies, like the U.S. dollar, are in effect internally pegged. Which is to say, the West Virginia dollar is pegged to the California dollar is pegged to the Michigan dollar, and so on. Once you see it this way, it become clear that the same problem that besets international pegs can beset the internal peg.

As Schleicher writes:

Falling oil prices harm the economies of Alaska, Louisiana, Oklahoma, and Texas, but benefit the economies of California and New York. When the Federal Reserve sees falling oil prices, it faces a dilemma: should it increase the money supply? If it does, it can alleviate unemployment in the regions that have been harmed, but only at the cost of spurring inflation elsewhere. But if it does not increase the money supply, economic dislocation in oil-producing states will get worse. Having a single currency only makes sense if the benefit of reduced transaction costs outweighs the cost of not having tools to respond to asymmetric shocks.

But the benefits of having a common currency may not outweigh the costs of forgoing an internally floating currency regime if a country’s economy is sufficiently heterogeneous.

[emphasis added]

Now, regional heterogeneity doesn’t necessarily mean that the territory of a nation-state is a sub-optimal currency area. As long as there’s enough “internal factor mobility” the system can adjust. That’s what Krugman was on about. It’s not a huge problem if there’s slack demand and a ton of unemployment in, say, Kentucky as long as those idle workers gravitate toward the bonanza of openings and high wages of, say, the Arizona labor market, which is tight as Lululemons. In that case, unemployment will go down in Kentucky and inflationary pressure will ease in Arizona without the central bank doing anything.

But it is a huge problem when disused labor and capital just hangs around in downcast economies. If the Fed constantly finds itself in a position where it needs to both reduce unemployment in one region and check inflation in another — if its constantly stuck like Buridan’s ass between the bales of the dual mandate — that’s a sign that the regional economies of the common currency area are too different for monetary policy to work its magic across the whole economy. Arizona and Kentucky could both end up better off if Kentucky Bucks could float against the Arizona Peso, despite the increased transactions costs and financial risk this would entail.

But we’re totally not going to carve the U.S. into multiple closer-to-optimum currency areas, are we? So we’ve got a big problem, because regional heterogeneity is very real. Less rich places stopped catching up to richer places around the end of the Carter administration. Since then, the regional gap in productivity, output and income has only widened. That’s forty years of divergence! That’s one reason we get tangled up in fruitless debates about, for example, whether or not the American Rescue Plan will “overstimulate” the economy. There’s no such thing as the economy, exactly. Which means that there’s often no single correct answer in macroeconomic policy. It’s all trade-offs. We’ve seen how that plays out in Europe. When the Germans get what they want, the Greeks get fucked.

A spate of papers estimating the costs of zoning to growth by Hsieh and Moretti, Herkenhoff, Ohanian and Prescott and Parkhomenko have made it pretty clear that local over-regulation of land use has cost the American economy a bundle. It’s hard to get your head around the scale. According to some of these estimates, over the past forty years, regulations that price workers out of our most productive labor markets have generated losses in the neighborhood of Canada’s entire economic output over the same span of time. I’m pretty sure this overstates it, but the point is just that the loss is big.

This is a seriously underappreciated point, but the Mundell-inspired point Schleicher makes is different and even more underappreciated. State and local policies that disincentivize labor mobility sharpens regional differences in economic conditions — i.e., they push the territory of the United States further and further away from the conditions for an optimum currency area — which throws a wrench in the central bank’s ability to execute on its mandate. It screws up the ability to handle demand shocks through fiscal policy, too, for similar reasons. But effectiveness of fiscal and monetary policy have a huge effect on growth rates. To the extent that local overregulation of land use is borking the conditions for effective national macro policy, that’s an additional economic loss on top of the straightforward Canada-sized losses due to sclerotic labor mobility. I don’t know how you could possibly estimate the scope of the damage, but I’m an art major. The point is: the NIMBYs have fucked us all over big time.

I find the mismatch between the huge scale of the problem and the exceedingly modest ambition of most land-use reform proposals completely baffling. The main reason I wanted to talk to a brilliant Yale Law guy like David Schleicher is that it’s not at all clear to me, given the nature and seriousness of the problem, why Congress can’t just straightforwardly legislate limits on local land-use regulation. After all, the problem is precisely that pricing people out of our most dynamic, prosperous, and innovative cities creates huge economic losses by thwarting interstate labor mobility. What, exactly, is the Commerce Clause supposed to be for if it doesn’t authorize Congress to knock down state policies that massively interfere with interstate commerce?

Moreover, if local regulations screw up the “internal factor mobility” that helps us to roughly approximate an optimum currency zone, reducing the economy-wide effectiveness of both monetary and fiscal policy, it seems that the federal government has an incredibly strong “general welfare” interest in intervening to straighten out the misalignment between local political incentives and the performance of the national economy.

So what did David say about all this? You know, I’d really love to tell you, but I know you hate spoilers. Tune in to the podcast next week to find out!

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