One of the big issues in the debate over the euro is whether Europe is an optimal currency area, that is, whether prices in Europe move sufficiently closely together to make a common monetary policy a reasonable idea. Looking at the issue when the move to the euro was agreed most observers would have said that Europe wasn’t an optimal currency area. A plausible counterargument is that monetary union will produce the kind of economic integration required. A quick scan of the web didn’t turn up much[1], so I thought I’d do a quick and rough check of my own, so I World Economic Outlook Database, which gives, among lots of other useful things, estimates of purchasing-power-parity adjusted exchange rates for all the countries in the data set. Since the calculations are based on the EU-centric international comparisons project, comparisons of relative price levels between EU countries should be pretty good.

So I looked at the log variance of the $US PPP exchange rate for the euro-12 countries from 1995 to 2005 and here’s what I got

The log variance is a measure of the extent to which real price levels differ and, as the chart shows it has declined smoothly since the beginnings of the move to the euro.

Another interesting feature of the data is the average PPP exchange rate is around $US1.16 to the euro, very close to the rate that actually prevails.

fn1. I found one study by Robert Hill of UNSW, but it only went up to 2000 and covered the whole EU not just the eurozone. Hill found some convergence in price levels, but not as strong as this, but a surprising divergence in relative prices. It would be interesting to check on this.

Ben Bernanke has been appointed to replace Alan Greenspan, who’s been Chairman of the US Federal Reserve for just about as long as I can remember (the Volcker squeeze was in the early 80s, so he hasn’t been there forever, but it often seems that way).

Bernanke was the obvious candidate, but there was always the possibility that Bush would decide to mend fences with the base by appointing some obscure[1] supply-sider a la Harriet Miers.

Bernanke’s appointment suggests a general bias towards an expansionary monetary policy for the US, and therefore continued low short-term interest rates for Australia. He was prominent in saying that the Fed would not tolerate deflation, and could print money if necessary. More recently, he’s taken a very relaxed view of the US current account deficit, seeing it as the inevitable counterpart to a ‘global savings glut’. I agree with him on the first point but not on the second; there’s a significant risk that the wheels will fall off the entire policy, leading to a rapid depreciation of the dollar and an uncontrolled increase in interest rates, both of which would flow through to Australia.

Market movements were consistent with this analysis (stock prices went up, the dollar fell and the 10-year bond rate rose), but weren’t very big, suggesting that no-one is expecting really big changes.

fn1. This is a redundancy, as there are no prominent supply-siders in the US economics profession. That is, not in the sense of supply-side popularised by Jude Wanniski and Arthur Laffers, although Mundell shares the supply-side liking for a gold standard. Almost all economists are supply-siders in the sense that they think attention should be paid to the supply side of the economy as well as the demand side.