Club Med and the Sunbelt: Adjustment within Monetary Union

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Differences between the U.S. and eurozone monetary unions go a long way towards accounting for how well or badly each has adjusted in the aftermath of large housing bubbles and severe financial crisis.
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The experiences of a few U.S. states in weathering the ongoing economic turmoil could provide some insight into the eurozone’s struggles. In particular, Florida, Arizona, and Nevada (FAN) saw a big housing bubble and subsequent bust, much like Greece, Ireland, and Spain (GIS). Both groups, each part of a monetary union, continue to suffer severely from the after effects of the crisis, but FAN recovered earlier and have not faced the trauma of a sovereign debt crisis. Some initial comparisons can be made about the experience of the two groups that could ultimately help shape the eurozone’s long-term adjustments.

Market-Driven Adjustment to the Crisis

The fact that the United States comes much closer to being an optimal currency area than the eurozone has been widely discussed in the literature (see Table 1 for a closer look). But how did the differences between them affect the adjustment in GIS and FAN? Differences between the U.S. and eurozone monetary unions go a long way towards accounting for how well or badly each has adjusted in the aftermath of large housing bubbles and severe financial crisis.

GIS and FAN experienced trends that diverged remarkably from the eurozone and the United States, respectively, in the pre-crisis years. Between 2000 and 2007, average annual GDP growth rates in FAN were 1.3 to 2.4 percentage points above the U.S. average, and their recessions were steeper (in 2009 their respective GDPs declined between 2.6 and 3.4 percentage points more than the U.S. average). But they have since returned to growth, though their GDPs remain between 6.9 and 9.1 percent below their 2007 peak, even as U.S. GDP has recovered its pre-crisis level.

GIS experienced an even-sharper boom compared to the rest of the eurozone. GDP growth in GIS over 2000–2007 was between 1.4 and 3.4 percentage points higher than the euro area average. However, the fall was also steeper, and there has been no sustained recovery: Greece is experiencing its fifth year of recession, while Spain is again in recession this year and Ireland is sputtering. In 2011, Greece’s real GDP was 13.2 percent below its pre-recession peak, Ireland’s was down 9.5 percent, and Spain’s was down a more modest 3.1 percent but is declining rapidly.

The rise in FAN unemployment since 2007 was less than half the increase in GIS, despite the fact that the decline in GDP from its peak level in both groups is of similar magnitude.1Moreover, while unemployment in the three U.S. states has declined by 1.2 to 2.8 percentage points since the worst days of the crisis, unemployment in GIS is still on an upward trend (see Chart 1).

Differences between the U.S. and eurozone monetary unions go a long way towards accounting for how well or badly each has adjusted in the aftermath of large housing bubbles and severe financial crisis.

In both groups, the bursting of the housing bubble was associated with an abrupt interruption in the growth of the labor force, presumably mainly the result of a cessation of the big net migration of the pre-crisis years (see Table 2). In Ireland, the collapse in the labor force is especially notable. The much-larger rise in unemployment in GIS is largely the reflection of a far-larger decline in employment than that seen in FAN. The very large drop in GIS employment rates may reflect widely held expectations on the part of employers that the crisis will be long lived.

Table 2. Change in Employment, Unemployment and the Labor Force
(Percent of labor force in 2007)
Change between 2007 and most recent value Change between 2003 and 2007
  Employment Unemployment Labor Force Labor Force
Florida -3.8% 3.9% 0.1% 10.5%
Arizona -4.8% 4.1% -0.8% 9.5%
Nevada -3.8% 6.7% 2.9% 11.6%
Greece -11.9% 12.7% 0.7% 3.3%
Ireland -14.7% 9.0% -5.7% 14.8%
Spain -11.9% 15.0% 3.1% 11.6%
Sources: Bureau of Labor Statistics and Eurostat

A possible reason for the quicker recovery of FAN is the rapid adjustment of those states’ housing prices compared to Greece, Ireland, and Spain (see Chart 2 for a case in point). Declining housing prices can be expected to accelerate the recovery (or at least the stabilization) of construction activity and force loss recognition and more rapid restructuring of bank balance sheets.

Differences between the U.S. and eurozone monetary unions go a long way towards accounting for how well or badly each has adjusted in the aftermath of large housing bubbles and severe financial crisis.

The pre-crisis increase in home prices was broadly comparable in FAN and GIS. Between 2000 and 2006, home prices more than doubled in FAN (120 percent in Florida, 106 percent in Arizona, and 108 percent in Nevada) while they increased by 76 percent in Greece, 86 percent in Ireland, and 121 percent in Spain.

However, the downward adjustment in prices after the crisis was much faster in FAN. Between 2007 and 2011, housing prices fell by 43.2 percent, 42.7 percent, and 53.5 percent in Florida, Arizona, and Nevada, respectively. In contrast, home prices in Greece, Ireland, and Spain fell by 11.6 percent, 33 percent, and 15 percent over the same period. Concern that banks in GIS carried large, unrecognized real estate losses deterred lending to them, accentuating the credit crunch. 2

State-Federal Relations and the Sovereign Debt Crisis

In FAN, automatic fiscal stabilizers—lower tax liabilities to the federal government and increased receipts of transfers, including unemployment insurance, food stamps, Medicaid payments, and welfare—played a critical role in cushioning the shock. Although a detailed accounting of FAN–federal government transfers over the course of the crisis lies beyond the scope here, according to Martin Feldstein, the effect of these automatic stabilizers is typically to offset as much as 40 cents of every $1 decline in state GDP. This amounts to a large fiscal stimulus over and above that imparted through the American Recovery and Reinvestment Act of 2009, which amounted to 2.8 percent of U.S. GDP over the course of 2009 and 2010 and which benefited the hardest-hit states disproportionately.

While the net fiscal transfer from the federal government to FAN during the worst of the recession may have amounted to 5 percent or more of their GDP, and remains substantial today as the states’ GDPs remain well below pre-crisis levels, nothing of comparable magnitude exists within the eurozone. The widely advertised headline numbers of the support given or planned to stem the crisis are impressive even if they cannot be simply added up: 700 billion euros in the combined European Financial Stability Facility and future European Stability Mechanism, or roughly 7 percent of eurozone GDP; over 1 trillion euros in European Central Bank (ECB) liquidity injections under the long-term refinancing operation; over 200 billion euros in purchases of government bonds by the ECB; and over 700 billion euros in Target2 credits by Germany to the rest of the euro system, for example.

However, most of these measures have their less-heralded parallel in Federal Reserve liquidity support to banks, quantitative easing, and the automatic working of the U.S. monetary union. Moreover, the intergovernmental transfers take the form of loans to the troubled eurozone countries, adding to their debt, and are not automatic. They are instead the outcome of tortuous and protracted negotiations that are a continuous source of uncertainty and speculation.

But the most striking difference between GIS and FAN is the avoidance of serious crisis in the latter’s government finances. FAN governments represent a small part of state GDP (the federal government and independently financed municipal authorities play a bigger role than in European countries) and broadly abide by a self-imposed balanced budget rule; consequently, their deficits and debts represent a small part of their GDP (see Table 3). As the crisis evolved, GIS saw its credit ratings collapse and its spreads soar. Greece’s debt fell to junk status; Ireland’s is just above junk at BBB+; and Spain’s debt was recently downgraded from A to BBB+.

Table 3. Government Finances in 2010
  Spending as a percent of GDP Fiscal balance as a percent of GDP Debt as a percent of GDP
Greece 50.2 -9.3 143
Ireland 66.8 -31.2 92
Spain 45.6 -10.3 61
Florida 11.1 1.36 5.5
Arizona 13.2 -0.07 5.6
Nevada 10.3 0.9 3.5
Sources: Bureau of Economic Analysis, U.S. Census, Eurostat

The FAN governments were placed under considerable strain (and a few municipal governments failed to meet their obligations), but their debt problems have not snowballed into statewide crises, and their credit ratings remain solid at AAA (Florida), AA- (Arizona), and AA (Nevada). Unlike GIS, which was forced to cut its deficits while in recession—circumstances that often afflict emerging markets rather than advanced economies—the FAN governments were able to engage in countercyclical spending and recover more quickly from financial crisis.

The credit crisis in GIS has been greatly augmented by the linking of sovereign risk and banking risk, which is partly the result of large holdings by banks of bonds issued by their national authorities. Such links are much less apparent in the United States.

The Eurozone: A Work in Progress

The severity and persistence of crisis in Greece, Ireland, and Spain as compared to Florida, Arizona, and Nevada following a similar asymmetric shock appears to owe relatively little to the inflexibility of the GIS labor markets and more to the vulnerability of their government finances, the absence of countercyclical transfers, the link between sovereign risk and banking risk, and the slow pace of adjustment in their housing markets. Still, the realization that the effect of the crisis on FAN continues to be so severe five years after their housing bubbles burst, despite the support given to them by the rest of the United States and their greater labor and product market flexibility, is sobering. In fact, it raises a legitimate question about how far the United States is from an optimal currency area.

A more complete treatment would examine the divergence of competitiveness (as measured, for example, by unit labor cost) between GIS and FAN and their respective monetary union partners. The relatively new eurozone arrangement has seen the opening of a very large gap in costs between Germany and the European periphery—as much as a 25 percent difference—while nothing comparable appears to have occurred within the United States. For example, between 2003 and 2011, the mean hourly wage in FAN remained steadily about 10 percent less than the U.S. average. The probable implication is that, given the inability to devalue, the adjustment in GIS would be expected to take much longer than in FAN even had fiscal and banking arrangements been more similar to those in the United States.

The relevance of this comparison for crisis fighting in the eurozone today is limited because the differences highlighted are structural and institutional. They change slowly over time, and reform is politically fraught. The comparison may nevertheless help us understand why the euro crisis is so severe and may provide some pointers for how the eurozone might evolve in the very long run.

Uri Dadush is the director of Carnegie’s International Economics Program. Shimelse Ali is an economist in Carnegie’s International Economics Program. Zaahira Wyne is the managing editor of the International Economic Bulletin.

[1]. It is striking that Arizona and Florida saw only a modest increase in unemployment relative to the United States despite the fact that GDP fell by so much more from its pre-crisis peak. This in part reflects the outward migration from these states.

[2]. More generally, slower bad loan recognition and the absence of a Europe-wide deposit insurance scheme and an adequate Europe-wide resolution processes (paralleling the Federal Deposit Insurance Corporation) have contributed to increased fragmentation of the European banking system and the credit crunch in the troubled countries. Bank lending among euro-area banks fell from $2.3 trillion at its peak in 2008 to $0.96 trillion at the end of 2011, a 60 percent decline and eurozone banks have relied much more heavily on borrowing and lending to the European Central Bank.

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About the International Economics Program

The Carnegie International Economics Program monitors and analyzes short- and long-term trends in the global economy, including macroeconomic developments, trade, commodities, and capital flows, drawing out their policy implications. The current focus of the program is the global financial crisis and its related policy issues. The program also examines the ramifications of the rising weight of developing countries in the global economy among other areas of research.




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