Is Bigger Really Better?

Leigh Caldwell (conditionally) thinks so:

As Paul Krugman points out, there’s a theory of optimal currency areas which gives some clues as to the right level for this coordination to operate. I used to be convinced that a bigger area was always better – and in the very long run, I still suspect that’s true. The effects of currency flexibility are essentially monetary ones, and in the very long run the real performance of the economy is neutral with respect to money. But we all live in the short run and I’m no longer certain that the euro is the right level.

I take the view that bigger is not always better, never really has been, and the only reason that was ever nominally true with regard to the US is due to a historical accident (the first half of the 20th century).

Now unfortunately, I don’t know how to adjust for communism. However,the countries that make up the wealthy parts of the world are mostly small countries. Small countries top the Heritage Index of Economic Freedom, and if you subscribe to “happiness measures”, small countries (and US states) dominate those lists as well. China isn’t growing like gangbusters because is has an incredibly large area, it is growing because there are small economic zones where the citizens operate under different rules. The same is true of all of the Asian “tigers”, and India (while large) also changed the rules…but because they are a large unified geographical area, could easily change them back and put a billion people back on the track to hopelessness. I think it’s fairly clear that even in the long run, large countries run into hard limits of economies of scale. This is particularly true of countries that have a high level of diversity in education, productivity, culture, values, and norms.

This is, of course, different for free trade areas. The US was the first modern free trade area…and it reaped the benefits of free trade while others did not, and eventually got decimated by World War II…leaving the US as the only functioning economy (and bonus, it was a highly-coordinated free trade area), and it seems that the US is still riding on those coat-tails — as it does not seem to be an optimal currency area. Our saving grace is that we substitute similar business cycles for fiscal transfers and a high level of factor mobility…but the “rust belt” and California/Arizona/Florida still suffer! The EU does not have similar business cycles, does not have fiscal transfers, and I don’t know about the level of factor mobility — but from what I’ve read, it could be higher…but, fiscal transfers nearly always involve efficiency cost. Bundling those costs with sub-optimal currency areas is, at the margin, piling one problem on top of another.

One other issue that I have with Leigh’s post is this quote:

At the individual company scale, Yahoo is less competitive than Google, but does Yahoo need its own currency to devalue? And 22-year-old new college graduate Travis is less productive than his experienced 38-year-old colleague Kate, but they still spend the same dollar bills. Kate simply has more of them.

Now, transaction costs are the only barrier to having multiple currencies. However, taking this to the level of the individual (or even company) is kind of iffy logic. Money is, of course, a network good. If you run around with your own monopoly money, and fail to convince people of it’s value — it’s worthless. In a world of zero transaction costs, if you do happen to find 10 people that are stupid enough to take your personal currency, it would be perfectly fine, as long as you managed the supply and demand, and the exchange rate well enough. However, in a world with transaction costs, you have to find the right scale to make the marginal cost of conversion “worth it” for a set number of transactions. Unfortunately, we live in a world with transaction costs (albeit very low), so there has to be a certain scale that provides the most efficient trade-off between utility and stability…at this point in history, I think that level is smaller than the US as a whole.