Optimal Currency Areas and Optimal Free-Trade Areas: The Case for Economic Borders

by: Ian Fletcher

Why have nations at all, economically speaking?

This question is provoked by the fact that every few months, without fail, somebody writes to me and asks why, if the protectionism I advocate between the U.S. and the rest of the world is rational, why isn't it rational to have tariffs between the various states of the U.S.? And since it clearly doesn't make any sense to have tariffs on trade between, say, California and Oregon, it follows that nations shouldn't practice economic protectionism either.

Sounds good. In fact, some people proffer this argument as if it, on its own, settled all questions in the complex field of trade economics.

The first thing to understand is that valuing nations as economic units doesn't entail the idea that every nation is necessarily an appropriate economic unit. We are lucky enough, here in the United States, to live in one that is, but many are not. This is why many of the great protectionist thinkers of the past were also advocates of policies that created larger economic units than were then in existence. For example, the great German protectionist economist Friedrich List, whose ideas still influence policy from Berlin to Beijing today, was also an advocate of the German Zollverein, or customs union. This helped solder the German principalities of his day (Prussia, etc.) into a single German economy. And Alexander Hamilton, the intellectual father of American capitalism (and protectionism) was also a strong advocate of national union upheld by a strong (if small) central government.

So far, so good. But sometimes, the above argument is presented more radically. People argue that it's irrational (or even evil) to care about national economic well-being at all, because globalization has rendered nations economically irrelevant (or outdated constructs that do nothing useful and just start wars).

The odd thing about this idea is that it tends to come from two otherwise-opposite ideological quarters: from the libertarian far right, for whom individuals are the only thing that matters, and from the universalist far left, for whom humanity as a whole is the only thing that matters. For purely ideological reasons, neither of these groups have much use for nations, so they assume that the modern economy hasn't, either.

Therefore, it's well-worth reviewing why it's a normal and reasonable thing for nations to exist as economic units, and for us to care about their well-being. We should neither expect nor want them to go away. And this is a matter of economics, not politics - let alone nationalist ideology, though you can believe in that (or not) if you want to.

The recent debt crisis in Europe illuminated in stark fashion some of the key facts that make national economies still relevant and economic borders still valuable.

In case the reader isn't familiar with the story, what basically happened was that, when the euro currency was created in 1999, this gave all the governments of Europe roughly the same ability to borrow money. Granted, there were still some minor differences, but nothing like the differences (measured by the different interest rates on the bonds issued by different nations) that prevailed before. Previously, when the government of Greece, for example, wanted to borrow money, it either had to borrow in drachmas (and was thus limited by its own national savings rate) or borrow in a foreign currency like dollars or deutschemarks and take the risk that exchange rates would move against it. So borrowing was constrained (imperfectly) along the lines of ability to repay.

Then came the euro, which erased all those squiggly lines that used to divide up the European currency map and gave American tourists such a fascinating variety of pictures of dead politicians to bring home at the end of their vacations. And what happened? The result was a borrowing binge in the less-creditworthy nations, which had suddenly been granted access to money on (close to) the same terms as financially-prudent export powerhouses like Germany.

Uh oh.

In some countries, like Greece, this resulted in excessive government borrowing. In others, like Spain, it resulted in a real-estate bubble as cheap mortgage credit (whose price was calibrated off of the rate the government can borrow at) flooded the country.

Then, of course, there was a bust in all these countries. Like our own 2008 financial crisis, it generated a lot of secondary turbulence (and considerably more street riots) and exposed a lot of the previous decade's apparent prosperity for a sham built on a house of cards called debt.

The lesson? Europe would probably have been better off keeping a lot of its old national currencies. These don't stop international flows of money, of course, but they do impose a cost, in the form of exchange rates, when you move wealth from one country to another. They are a meaningful but not prohibitive barrier.

The lesson here is that treating all national economies like they are the same - by dropping the currency barrier - doesn't work when they are not the same. An absence of economic barriers presumes economic similarity on both sides of the barrier. The barrier doesn't have to (indeed shouldn't) be absolute - you can exchange one currency for another at a bank - but it is still a meaningful constraint. It makes things you shouldn't do expensive.

The currencies of different nations should have different values, to reflect the fact that the economies whose output makes these currencies worth something are meaningfully different. Different economies have different productivity levels, different levels of accumulated wealth, different propensities to save rather than consume, different labor laws and thus personal behavior, and so on. Treating these different national economies like they are the same just invites economically irrational behavior - like borrowing money you can't afford to repay.

Removing the currency barrier between disparate national economies also deprives them of the ability to fix certain problems by adjusting their currency value so that it accurately reflects their economic condition. Having different currencies functions something like a universal joint in engineering: it transmits torque, but it's also flexible. As economist Paul Krugman recently explained it:

Imagine that you're a country that, like Spain today, recently saw wages and prices driven up by a housing boom, which then went bust. Now you need to get those costs back down. But getting wages and prices to fall is tough: nobody wants to be the first to take a pay cut, especially without some assurance that prices will come down, too. Two years of intense suffering have brought Irish wages down to some extent, although Spain and Greece have barely begun the process. It's a nasty affair, and as we'll see later, cutting wages when you're awash in debt creates new problems. If you still have your own currency, however, you wouldn't have to go through the protracted pain of cutting wages: you could just devalue your currency - reduce its value in terms of other currencies - and you would effect a de facto wage cut ... In the current crisis, it took Ireland two years of severe unemployment to achieve about a 5% reduction in average wages. But in 1993 a devaluation of the Irish punt brought an instant 10% reduction in Irish wages measured in German currency.

But you need the currency barrier between nations for it all to work. At bottom, this means accepting the fact that national economies are different, and function best when this difference is recognized, not denied.

The creation of the euro was predicated on the idea that having a common currency would of itself cause these nations' economies to become similar. On paper, this is, of course, perfectly logical, in the sense that if the European economies had converged to similarity, these problems would not have occurred. But they didn't. National economies are not paper abstractions that can be manipulated at will. The fact that Germany, for example, has the economy it has, and Greece the economy it has, is rooted in decades (if not centuries) of economic history, different political systems, different cultures, and other things that just don't go away at the stroke of a pen. Even if you leave out all the political and cultural factors, national economies are still very different simply qua economies: they have different skills, tend to specialize and excel in different industries, have billions of dollars committed to different industries, have their particular drawbacks and flaws, etc. For example, as Michael Porter of Harvard Business School explains it:

Competitive advantage is created and sustained through a highly localized process. Differences in national economic structures, values, cultures, institutions and histories contribute profoundly to competitive success. The role of the home nation seems to be as strong as or stronger than ever. While globalization of competition might appear to make the nation less important, instead it seems to make it more so.

So contrary to the endlessly-repeated myth of a world converging on one big economic sameness, economic diversity (a concept that is poorly understood compared to, say, ethnic or cultural diversity) is a fact of life -- and almost certain to remain so. Economic policies that assume a homogeneous world, whether they take the shape of a pan-European currency or global free trade, are an attempt to defy this basic fact. And the cost of failure runs into the trillions.

What's the connection to trade? It is that free trade is like having a shared currency: it makes it impossible to draw the distinctions that sometimes need to be drawn between different economies. This isn't a matter of cutting off all trade, any more than having separate currencies means you can't exchange one currency for another. But it does mean there should be trade barriers that reflect the real (and quite legitimate) differences between national economies.

Let's start with an example that's easy to understand, one quite familiar from complaints by the unions and the environmental movement: What if environmental or worker-safety standards are higher in one nation than in another? Then having free trade is obviously an open temptation to just move production from the former to the latter. It may not literally be a race to the bottom, i.e. fast and reaching the absolute worst standard, but it sure produces pressure in that direction.

And this is just the tip of the iceberg when it comes to economic differences. What if nations differ not in their environmental standards, but in, say, their propensity to save vs. consume their income? For example, the fact that the U.S. currently practices free trade means that, because we have a high preference for immediate consumption as opposed to savings, we are gradually selling off our country and going into debt, thanks to the trade deficit. This is the well-nigh inevitable result of having free trade between a country with a very low savings rate and one with a very high one (like China). If we were just trading with ourselves, we'd be going into debt to ourselves, so our overall net worth wouldn't change. But because foreign debt is involved, our national net worth can be reduced this way.

It's important to understand that the above problems are not defects in the functioning of the free market. They represent the free market doing exactly what it's supposed to do. But this doesn't mean these problems are not problems.

What are the implications?

In the first case above (the environment), the implication is to tax imports from nations with lower environmental standards.

In the second case (consumption vs. saving), the implication is to tax U.S. imports sufficiently to bring our trade into balance.

In technical economic terms, the way to say all this is that the whole world is not an optimal free-trade area. Optimal free-trade areas haven't had a lot of attention lately from economists (most of whom believe in free trade simpliciter as the best option), but optimal currency areas are a reasonably well-developed concept, the key thinker here being Robert Mundell of Columbia University. What economists need to take more seriously is the similarities in the underlying reasoning between the two.

The ideal free-trade area may be quite large. And the ideal tariff between many nations may not be that high. But the ideal free-trade area isn't the entire world, and the ideal tariff isn't always zero.

There are plenty of other reasons to maintain national economic borders. One of them, which is increasing in importance in our increasingly high-tech world, is that there is an unavoidable publicly-financed component to innovation. Despite the Silicon Valley myth of rugged individualism (which I hear all the time here in San Francisco), the reality is that government inputs to major high-tech industries from semiconductors to aircraft have been huge. And it's hard to justify spending money on supporting, say, basic scientific research if that research is just going to be commercialized abroad. Worse, without capturing its value here, we won't have the tax base to pay for the next round of research.

All of the above is very complex and, of course, endlessly debatable. But what drives me up the wall is when people try to smuggle "one world" economic assumptions into the debate while pretending they're doing nothing at all. Economics should never be used to "prove" the inappropriateness of caring about national economic well-being - something it does not do. People who reject the national economy (or the national economic interest) should do so openly, not hide behind theoretical constructs that do this on the sly. (By the way, these theoretical constructs are the same "efficient market" thinking that conned us into the policies that led to the 2008 financial crisis, if that helps the reader evaluate them.)

Globally, for good or ill, the nation-state is still where the buck of political legitimacy stops. Higher and lower political entities, from Kansas to the United Nations, enjoy legitimacy only because nation-states have given it to them. So even if other instruments for controlling the world economy can be developed over time, the nation-state will be the bottleneck for developing them. A blanket rejection of even the mildest economic nationalism simply hands a blank check to multinational corporations, foreign powers, and (distorted) market forces to do as they please. It doesn't result in the world all holding hands and creating some free-market utopia.

Economist Herman Daly of the University of Maryland, best known for his work on ecological economics, once pointed out that with regard to all these problems:

Free trade makes it very hard to deal with the root causes at a national level, which is the only level at which effective social controls over the economy exist.

Because we have a national government, because Americans care about what happens to their economy, and because it is the national debate on the question that will bring changes or fail to, our trade problems will be fixed in Washington - or not at all.

What are the investing implications of all this? A few things:

One, don't bet on any monetary projects, like the euro, which are premised on the idea that nations are either economically similar, or that it doesn't matter that they are different. We've come to grief in Europe over this once already; don't mistake this for a one-off crisis or merely the result of corruption or incompetence. It's a structural problem.

Two, don't bet on any economic policies which assume the world economy can be globalized simply by throwing all the nations in a blender and hitting the "on" button. Here Europe actually has some sense: other aspects of European economic integration, like infrastructure and labor markets, have actually been harmonized far more gradually - as they should be, if at all.

Three, national economies and the investing opportunities they offer are seriously different. I know this sounds trite, and on some level it's a mere truism, but there have been an awful lot of people running around in the last 20 years who have taken the opposite as a core (if sometimes unstated) premise. The different kinds of competitive advantages that nations, and firms based in them, have are often deeply rooted, and understanding those roots can tell you a lot about what investment strategies in those countries will have staying power.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.