Too far in the West?

In the 1990s, to join the Euro was the overriding objective of Portuguese policymakers. The success in this task implied the most important regime shift in economic policy since the Gold Standard in 1854.

For macroeconomists, the decade of 1990 was quite interesting. After the decision of create a single currency for Europe, there was a lively debate about Optimal Currency Areas. It soon became clear that Europe did not fulfill the basic criteria to qualify as one. Then the debate shifted a little bit. The question was no longer if Europe was an Optimal Currency Area, but rather whether Europe could become one after the adoption of the single currency. The argument was that some of the necessary conditions to have an Optimal Currency Area, would be promoted by a single currency. These conditions included stronger financial linkages, more trade among member states, more labor mobility, harmonized monetary and fiscal policies, etc. Ten years after the Euro, what can be said about Portugal?

By the end of this month, I shall present a paper on a related topic in the Royal Economic Society meetings. In this paper, we focus on one necessary condition for Optimal Currency Areas: business cycle synchronization. Given that there is a single currency, every country is constrained to have the same monetary policy. If two countries do not have similar business cycles, then the same monetary policy can hardly be simultaneously optimal for both of them. If Portugal has an asynchronous business cycle with the rest of Europe, then it is quite unlikely that ECB policy is the right one to Portugal. In that paper, Joana Soares (also from the University of Minho) and I have collected data on the Industrial Production for the first 12 countries that joined the Euro and developed a metric to measure the distance between business cycles.

I guess that it was not surprising to conclude that Portugal, Greece and Finland (and possibly Ireland) were the least synchronous countries. Still, it was disturbing to realize that Portugal and Greece have been the only countries whose business cycle has not converged at all to the “European” business cycle. It seems that the Economists who argued that the single currency would help to promote synchronization among the member states were absolutely right, except for Portugal (and, to a lesser extent, Greece). It is as if we have our own idiosyncratic cycle. Based on this, if one had to bet on the first members to leave the Euro, Portugal and Greece seem like appropriate choices.

At some point, I was discussing my results with a German economist, Mathis Schröeder, and I told him that the least synchronous countries were Portugal, Greece and Finland (and possibly Ireland and Italy). His reaction was immediate: oh, that is all about geography. And yes, Mathis was right. The correlation between business cycle distances and physical distances between countries was above 70%. And, if we produce bi-dimensional maps based on these distances the similitudes are perfectly obvious.

At first sight, it seems that the geographical map explains a big chunk of the business cycle map, something that anyone who has read Jared Diamond’s ‘Guns, Germs, and Steel’ would have anticipated. Still, it seems that Spain was able to cross the Pyrenees to reach the heart the Euroland and that Ireland flew away from the Oceanus Britannicus.