Detroit, Migration And Optimal Currency Areas

Andrew Watt

Andrew Watt

News that Detroit has filed for bankruptcy are interesting not least from the perspective of the ongoing travails of the euro area. How’s that?

The euro area is often seen as failing because, at bottom, it is not an optimal currency area. Countries joining a monetary union lose policy flexibility, in particular the ability to set interest rates and adjust their exchange rate. This is only likely to work well, according to optimum currency area theory, if certain conditions are met. Two of these are fiscal redistribution from thriving to struggling regions/countries and labour mobility. The latter works as an adjustment mechanism because labour can flow from areas hit by recession (“asymmetric shock” in the jargon), limiting or even avoiding a rise in unemployment and reducing the need for wages and prices to adjust.

Along these lines Paul Krugman, for instance, contrasts the monetary union that is the USA with the euro area, writing:

Well, suppose – to take a not at all hypothetical example – that the state of Massachusetts takes a major asymmetric hit to its economy that sharply reduces employment – which is, in fact, what happened at the end of the 1980s. If Massachusetts workers can’t or won’t leave the state, the only way to restore full employment is to regain the lost jobs, which will probably require a large fall in relative wages to make the state more competitive, a fall in relative wages that is much more easily accomplished if you have your own currency to devalue. But if there is high labor mobility, full employment can instead be restored through emigration, which shrinks the labor force to the jobs available. And that’s what actually happened. (…. B)y the mid-90s it once again had an unemployment rate below the national average, because workers moved elsewhere.

Alongside the lack of centralised, redistributional fiscal mechanisms, then, a major weakness in Europe is that workers in crisis-hit countries such as Spain and Greece (unemployment above 25%) are unwilling or unable to move to regions, such as southern Germany, which are close to full employment.

The story of Detroit, however, cautions that this is, at the very least, oversimplified. In the 1950s “Motor City” had a population of 2 million. It is now down to less than 700,000. This massive outward migration has, presumably, kept a lid on unemployment in the region. On the other hand it has also destroyed its fiscal basis. Its tax revenues have fallen 40% since 2000, such that, according to the state governor,

“Detroit simply cannot raise enough revenue to meet its current obligations and that is a situation that is only projected to get worse absent a bankruptcy filing.”

Note that this fiscal crisis, largely induced by outward migration, has occurred in spite of the substantial fiscal redistribution mechanisms in the US (in the above-quoted article Krugman mentions falling federal tax payments from a US region in crisis, rising federal unemployment insurance payments and food stamps, federal bank deposit insurance, among other things).

Coming back to Europe, it is evident that outward migration from the crisis countries is, at best, a two-edged sword. It can contribute to short-run labour market adjustment. But in the longer run it undermines the productive potential of the region, particularly given that fact that migration tends to be concentrated among the young and high skilled. It saps aggregate demand and thus also reduces employment in sectors not immediately affected by the crisis. This makes it harder to pay down accumulated debt. The danger of a downward spiral is very real, especially given that the fiscal redistribution mechanisms remain so weak in Europe.

On the whole I think that post-enlargement migration within Europe has been broadly beneficial (for details see here and here, for a summary here). However, its propagation as a crisis-resolution mechanism is, as the Detroit example shows, not without problems, to sy the least. It is certainly not an alternative to some form of fiscal federalism.

  • Bob G

    Nice idea but decades of corruption and unemployable people may be more to blame. Note that the former mayor and many associates are serving long prison terms essentially for theft. Employed people have moved to suburbs a few miles away to escape the sinkhole of failed services.

  • Guest

    Dear Mr. Watt,

    Thank you for your regular posts. I generally appreciate what you have to say,
    however, I have come to quite strongly distaste the way you say it. Perhaps not
    so much in this post as in many other posts, your writing exhibits a very high
    degree of sarcasm paired with fatalism and what might be perceived as arrogance
    towards those who take an opposing position. While you seem to speak from a
    well-informed point, such an approach minimizes the chances that your voice is being heard by those who you want/need to reach.

    Moreover, your writing can appear so much beyond any self-doubt that I come to wonder how much recognition there is of the often tortured and inconclusive routes social sciences – in which I include economists – take in their efforts to ‘contribute to society.’

    I would like to re-affirm how important, I think, your strong dissent on some of the most vital policy decisions in the EU is and how much more potent it could still become.

    Your,
    Reader

  • A reader

    Dear Mr. Watt,

    Thank you for your posts. I generally appreciate what you have to say, however, I have come to quite strongly distaste your style. Perhaps not so much in this post as in many others, your writing exhibits a very high degree of sarcasm paired with fatalism and what might be perceived as arrogance towards those who take an opposing position. While you seem to speak from a well-informed point, such an approach minimizes the chances that your voice is being heard by those who you want/need to reach the most.

    Moreover, your writing can appear beyond any self-doubt; I came to wonder how much recognition there is of the often tortured and inconclusive routes social sciences – in which I include economists – take in their efforts to ‘contribute to society.’

    I would like to re-affirm how important, I think, your strong dissent on some of the most vital policy decisions in the EU is and how much more potent it could become.

    Your,
    Reader

    • Andrew Watt

      Thanks for these comments. I sometimes wonder whether I should avoid all sarcasm.It is painful to watch how much avoidable suffering is being inflicted on ordinary Europeans. And I think if you look back at what I have written on these pages during the crisis, then I think you can fairly say that if Europe had adopted early on the approach that I recommended, things would – at least – not have developed so badly. One word I take exception to is “fatalism”. In fact I have contiunually sought to provide alternative suggestions. And criticising existing policies is not fatalistic but speaks to a hope for improvement. But I appreciate your comment, as I do indeed want to reach as many people as possible. I guess there is no one style that pleases everybody. By the way I agree with you that social science, including economics, should be more modest about what it can achieve.