Optimum Currency Area Theory And The Eurozone Crisis

This is copy of an address by Paul Krugman to the National Bureau of Economic Research.  He describes the two basic ideas behind optimum currency area theory and shows how the theory would predict problems like those faced today in the eurozone.  He gives examples in the US of how each of the optimum ideas worked to help Massachusetts and Florida out of economic difficulties.  Massachusetts suffered an economic shock when the states largest employers went out of business when the mini-computer industry was destroyed by the PC.  Unemployment increased dramatically but it was easy for unemployed mini-computer industry employees to migrate to states that needed additional labor.  The level of employment in Massachusetts has not recovered to the level that existed when the mini-computer industry existed, but the unemployment rate is lower because the Massachusetts labor force is smaller.

Florida was hard hit by the bursting of its housing bubble. It has been helped out its slump by its fiscal relationship with the federal government.  Florida sent fewer dollars to Washington during the slump than its citizens received from federal social welfare programs like Social Security, Medicare, Food Stamps and unemployment insurance support.  Net transfers from Washington to Florida amounted to 5% of Florida's GDP.

Fiscal integration was by far the most important factor to troubled states in the US that were hardest hit by the bursting of the housing bubble.  It would be difficult to obtain that level of fiscal integration in the eurozone.  Krugman argues that the availability of a central bank that could work as a lender of last resort to struggling banks, and as well as providing deposit insurance to limit runs on the banks in the periphery, would be a step in the right direction for the eurozone.  He argues that it is in everyone's interest to preserve the concept of a more united Europe that led to the development of the common currency.