Does one size fit all?

by Andreas Hoffmann

In a recent article in the WSJ, David Wessel sees a “fundamental problem” in the euro zone’s one-size-fits-all policy.

We know from Mundell (1961) that a one-size-fits-all monetary policy cannot guarantee low inflation and unemployment in all members of a heterogeneous currency area, given e.g. labor markets are not fully flexible as in the euro area.

In general, capital market integration and free capital flows in two regions have the tendency to bring about convergence of real – not necessarily nominal – interest rates (assuming no risk premium) as capital is allocated to its best uses. But in a currency area, like the euro area, nominal interest rates are the same everywhere as they are set by a central authority. Thus, real interest rates can be zero or even negative in regions that experience higher inflation, while they are positive in regions with lower inflation. Then policy is too expansionary in some regions and too tight in others, while the average inflation rate may stay relatively stable at the target level.

Germany faced relatively tight monetary conditions when the ECB started to set nominal interest rates as an average of the euro zone. To not cause deflation and stagnation in Germany, the ECB seems to have loosened monetary conditions – D. Wessel argued it followed a German rule – which allowed for money growth of 6-8 percent above the productivity growth in the euro area. While risks were perceived widely equal throughout the union, for the periphery economies the ECB interest rate was too low. Inflation ate up real interest rates. Holding nominal interest rates even lower to prevent a stagnation in Germany, therefore, further pushed down real interest rates in the rest of Europe. This contributed to the bubble in the periphery economies.

Following Mundell (1973) financial and capital market integration distributes the risks of investment over the whole currency area. Therefore, when a bubble bursts in one region, other regions are drawn into the maelstrom of the crisis. For instance, German banks that financed the boom in Spain face losses. On the contrary, everybody participates in the the boom. Therefore, business cycles have a tendency to be widely synchronized in a currency area. But even though business cycles were highly correlated, when one region grows substantially more or has substantially higher inflation than another, one-size-fits nobody. We currently observe that this can be a major problem in the euro area.

For similar reasons, one-size-fits-all can be a problem in the dollar area. In fact, Mundell (1961) originally applied his argument to the US. The WEST was different from the EAST. Also today, different regions in the US develop differently. As Jerry O’Driscoll pointed out at the ‘Colloquium’ on monday, only 5 states saw a housing bubble. Clearly Texas, California. Iowa and Ohio are very different. Since unemployment in e.g. California is higher than in e.g. Texas, it is unclear whether labor markets are sufficiently flexible for a one-size-fits-all monetary policy. For one-time shocks, transfers could smoothen the cycle and make e.g. California better off (if this is a shock?). But transfers may cause moral hazard of the recipients and do not help if the differences are not due to a single shock that washes out in the medium run. In Ohio and Michigan whole industries are gone today.


Mundell, R. (1961): A Theory of Optimal Currency Areas. American Economic Review, 51, 657–65.
Mundell, R. (1973): Uncommon Arguments for Common Currencies, In The Economics of Common Currencies (Eds.) H. Johnson and A. Swoboda, London: Allen and Unwin.

8 thoughts on “Does one size fit all?

  1. Thanks to Andreas for this excellent post.

    I have long been amused by the credit Mundell has taken for the Euro. Yet from the beginning it has been clear that Euroland was not an optimal currency area in Mundell’s sense. Now the inner contradictions of the project are manifest.

    I wonder how much role the continued extensions of unemployment benefits have played in the stubbornly high unemployment rates in places such as California. They amount to a reintroduction of welfare.

  2. Hi Jerry,

    thanks for the remarks. The question about the US maybe for someone else.

    But I want to bring up another issue: Despite its flaws, it maybe unfair to judge the euro (and the dollar) mainly on current economic crisis news.

    Particularly the euro, was – in my opinion – a political idea. Intentions are good and it gave some sort of identity to the “EU people”. This can have dramatic positive effects e.g. if it lowers the likelihood of wars. Obviously there is also the opposite risk of economic wars when one country benefits more than others.

    Even economically, at least for the crisis countries, the euro may still be better. They grew rapidly for almost 10 years. Now risks are shared via financial linkages. And the current crisis economies were prone to crisis before as well.

    So it maybe that the euro and ECB with its aims for macroeconomic stability are still better from their perspective than their old monetary authorities that actually intented to inflate and fund governments (even thought the ECB does this, too, right now – but I hope not in the long-term).

    One has to keep in mind that many of these economies were relatively “poor” a few years ago and are now on a comparable level as France. Ireland went from the poorest to one of the richest economies. If it ends up in the middle. This is not a shame.

    Still, this does not mean that the problems are trivial. We certainly do not have an economically first or second best solution in place.

  3. There is still the question of whether monetary union was necessary to achieve the benefits–the trade union & the lifting of various obstacles to capital and labor mobility may have been sufficient to achieve high growth in a country like Ireland.

  4. Andreas,

    I think most of what you attribute to the Euro came from free trade and the relatively free movement of capital. The Celtic Tiger arose from homegrown policies: low corporate tax rates and deregulation. The Euro’s contribution was to allow Irish property devlopers to borrow at artificially low interest rates, fuel a property boom, and bring the country to its knees.

    I don’t know anyone who has argued that what unified America into one country was the dollar. I can make no sense of the argument, frequently repeated, that a currency gives people a national identity. I’ve never met anyone in Europe who identified himself as a “European.” To this day, when I ask a German where their from they’ll say something like Baden-Wurtenburg or Munich. Almost never “Germany.”

  5. Jerry, I agree again with slight nuances.

    For the identity – you are right – but those were the hopes.

    Also with Ireland, I agree. Spain would have been a better example. They were relatively unstable before with high inflation.

    Simply introducing a more independent monetary policy would have done a better job, though.

  6. Yes, Spain is the big shoe yet to drop.

    Portugal now appears headed for a bailout. Ireland is chaffing under the terms of its support. And it is difficult to see how the Greeks see this through.

    Iceland stiffed its creditors, and has done relatively well. When will an EU country get the message?

    Meanwhile, EU leaders focused on the fiscal situation, which while not good, was not the source of problems except in Greece. It’s their banks that are most troubled, and no one except perhpas the UK wants to tackle them.

  7. Congratulations to all on an insightful post
    and discussion.Andreas is right that the euro was not a ‘first- or second-best solution’ to the task of economic integration.To the contrary,it has become
    — as Milton Friedman predicted in 1999 —
    a “first-bust” victim of the hubris of its
    original political designers: Friedman
    foresaw that it would start to come apart
    at the hinges once a recessionary tumble
    The economic and political tensions that
    are being created by one-size-fits-all in
    the Eurozone are now enormeous: Portugal and
    Greece face prospective real wage declines
    of perhaps 25%.Germany,on the other hand,
    fears becoming the perpetual source
    of bail-out funds for Eurozone governments
    with high fiscal deficits.Indeed, the problems go even wider,as the UK — outside
    the Eurozone,but inside the EU — is also
    being forced to contribute very substantial
    funds for the Irish bailout (soon to be
    followed by the Portuguese one).If, in
    Jerry’s terms, the Spanish shoe were also to
    drop on the floor, the British government
    might well withdraw from the bail-out,
    on the grounds that it is not part of the
    Eurozone, and has quite enough fiscal
    problems of its own.

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