Hugh Rockoff on Optimal Currency Areas, “Yellowbacks,” and Free Banking

How the Great Depression helped the U.S. develop into an optimal currency area.

Hugh Rockoff is a professor of economics at Rutgers University and has done extensive work in U.S. monetary history. He joins the show to discuss the criteria for an ideal monetary union and argues that the U.S. didn’t really become an optimal currency area until the 1930s. David and Hugh then discuss whether a present-day example, the Eurozone, fits these criteria. They also talk about interesting chapters in U.S. monetary history, including the Civil War, the Free Banking Era, and the bimetallism debate of the late 1800s.

Read the full episode transcript:

Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected].

David Beckworth: Hugh, welcome to the show.

Hugh Rockoff: Well thanks for having me.

Beckworth: Hugh, how did you get into economics and in particular, economic history?

Rockoff: Well I went Earlham College in Indiana. Had a great professor of economics, Gil Klose.

Beckworth: Okay.

Rockoff: That got me really interested in it. He liked talking about big ideas in class. We read "Capitalism and Freedom" and "The Affluent Society." Then one of our visitors on campus was Bob Fogel, who spent a day talking to students and that was it for me.

Beckworth: You were hooked, huh?

Rockoff: Yeah, I was hooked.

Beckworth: Now I understand you went to the University of Chicago after that and Bob Fogel and Deirdre McCloskey were your thesis advisors?

Rockoff: Yeah, that's right. I went to Chicago. There's a funny story. I've told this before but when I was in college I was the one designated to drive Bob Fogel back to the airport at the end of his day on campus.

Beckworth: Okay.

Rockoff: I told him I was thinking about doing graduate work in economics and I was thinking about economic history. I didn't think I was smart enough, you know? Bob told me, "Well that's not a problem in economic history. There are lots of important questions around, you just have to be willing to go to the library and dig out the data." So after he told me that I thought, "Well okay, I can do this." You know?

Beckworth: Well I think anyone who has looked at your work would argue otherwise. You're definitely a very gifted individual. Would you tell our listeners more about Robert Fogel, or Bob Fogel? He's a well-known economic historian but for listeners who are not familiar, tell us about his work a little bit and the big impact he had.

Rockoff: Right. When I first met him he was doing his great book on the impact of the railroads on American economic development. Fogel did two things, of course, first of all he turned the conventional wisdom on its head. Showing that the railroads, although they were important, were not some crucial element of American development. He also had a tremendous impact on the methodology of economic history. He showed that it wasn't enough just to sort of make these claims. That you had to look at the counterfactual world that you were talking about and try to analyze it systematically. I think from that point on economic history in the United States changed a great deal. Of course his work on slavery, American slavery, was also incredibly controversial and had a long run impact on the field.

Beckworth: Now Fogel won the Nobel Prize for that first work on the railroads?

Rockoff: Yeah I think that was the main thing.

Beckworth: Do you attribute what they call the cliometric, is it, the revolution, to him and others of his generation?

Rockoff: Yes, I think that's right. He certainly wasn't alone. There were other economists and economic historians that were starting to use regression analysis and formal economic modeling. I think Fogel's contribution was showing that most historical questions really involve a counterfactual. If you say, "The railroads were crucial" or that "Franklin Roosevelt saved capitalism" or make any other general claim like that you're really talking about what would have happened if a different policy had been followed. You have to think about that in a systematic way and that's what economics allows you to do. I think in terms of the sort of clarification of methodology that Fogel brought, that was his unique contribution.

Beckworth: Yeah, I read his work in grad school and occasionally go back to it. Very interesting work. He was your teacher, your mentor in grad school. Then you went out and of course made a name for yourself, publishing extensively on U.S. economic history and again, on this show we're going to focus on your work in monetary history in the U.S. Let's move there. You had a paper a few years back that I think kind of encapsulates a lot of your work. Or at least it draws upon a lot of your work. That was a paper titled, "How Long did it Take the United States to Become an Optimal Currency Area?" Really fascinating paper and I would argue very topical over the past few years with the Eurozone crisis. Many people have questioned, "Well did it really make sense for the Eurozone to be under one currency?" There was a huge debate when it was being formed and the debates became resurrected.

What is an Optimal Currency Area?

Beckworth: You wrote a really great paper that shed some light, and I think it's an important paper because many people look to the U.S. as a benchmark for the optimal currency area. Could you begin by first describing what is an optimal currency area? What does it tell us?

Rockoff: Well I think it's really a simple idea in a way. It's, just like all economics, you have to look at the costs and benefits. When you're thinking about combining two areas into one currency area, you have to think about what the benefits are. So ease of transaction, transparency and price setting and so on. You also have to look at the cost. You no longer have the exchange rate flexibility if you want to make adjustments. Optimal currency area is just a way of saying that you want to try to keep going until the marginal costs and benefits are equal. I think it's just applying kind of the standard way that economists look at any decision making process and applying it to this idea of setting up currency areas.

Beckworth: Yeah and it's interesting because people will look at Europe and talk about it, "Well is that an optimal currency area? Did it make sense for all those countries to come together with one currency?" You show in your paper in the U.S. you can think of it as a similar experiment, right? A huge undertaking, a number of states came together and it grew over time, more states were added. It makes sense for those to join a currency... a dollar union. Just to flesh out this idea of the optimal currency a little bit more, so you outlined it's a discussion of the benefits versus the costs of adding another region or joining a currency union if you are the region. Just to kind of flesh out this idea, so the trade off is if you do join a currency union you want to have either a similar business cycle to the currency union, because you're going to have kind of a one size fits all monetary policy. Everyone in the Eurozone gets the same monetary policy from the European Central Bank. That would be ideal.

Beckworth: Now of course that doesn't happen. If you don't have that kind of business cycle alignment with the other parts of the currency union, then you got to have some kind of shock absorber to offset that. If the ECB sets monetary policy and it's not right for you then the offset is, to still make it work, would be you need to have some kind of shock absorber like labor mobility, fiscal transfers. In the case of Greece, let's pick Greece here because we all know Greece got hammered hard in the Eurozone crisis. In the ideal world this optimal currency area people in Greece would pack up and move to Germany where there aren't jobs. Or there'd be big government transfers from Germany down to the people in Greece and that way it would kind of offset the cost of having one currency over all those different countries.

Beckworth: Now that idea, I guess, is what you did in your paper is to apply that understanding to the United States. Let's begin by talking about the beginning of the currency union. You trace it back to 1788 with the signing of the Constitution and you mention that the monetary union was viewed as a natural prerequisite for the political union. Can you tell us about that discussion and why that was the case?

The Currency Union throughout U.S. History

Rockoff: Yeah I can. I'm not, I have to say, a great expert on these Constitutional debates but I think it was partly just tradition that if you're a colony you have to use the currency of the mother country. If you're your own country you have your own currency. I think that was a big part of it. Just the tradition, just making the statement of independence. In addition, of course, it's a source of revenue. If you're going to have a strong central government and especially one that can raise revenues quickly to fight a war it makes sense to have your own currency. I think people, and of course especially Hamilton, but others just thought of that as a natural part of having your own country would be to have your own currency.

Beckworth: Was there also any pushback from the Revolutionary War, the high inflation that had occurred? They had a sense that, "You can't trust the states, the states have issued their own paper money, we need to have kind of a uniform process to avoid the high inflation of the Revolutionary War?"

Rockoff: Yeah, I think that's right. You're not going to have a paper money. The currency should be gold or silver. That you might have to go off during a wartime emergency but you're going to... peace time, you want a stable currency. You don't want to give the government the power to just create money at will.

Beckworth: That was spelled out in the Constitution, right? That it needed to be gold or silver coin?

Rockoff: Yeah, I think so. I think basically it was just assumed that that's the way you run the country.

Beckworth: Yeah, the idea of paper money, which we take for granted today wasn't really a given back then. If I can just delve a little bit deeper into the Revolutionary War, I once read a historian write this statement about it. He said in so many words that the, "U.S. rode the wave of hyperinflation into existence." So I have this image of Uncle Sam on a surfboard and behind him this big wave of hyperinflation. Is there any merit to that? Would the U.S. have become independent had they not relied upon inflationary finance?

Rockoff: Yes, I think there is. The guy whose been doing all the work on this in recent years is Farley Grubb and he shows that a high percentage, maybe 75%, I'm just kind of picking that out, of the expenditures of the Continental Congress were covered by printing money. It's not obvious how they would've been able to keep the armies in the field unless they had done that.

Beckworth: That's interesting. Yeah, so it's interesting to look back at our history and see how we kind of clawed our way into existence, to hook a crook, including financing through inflation. Did creating the Constitution and the monetary experiment that it set out, did it resolve or did it push us any closer to being an optimal currency area? Was the early nation, early founding nation, was it still plagued by problems of regional differences? Did the early U.S. meet the criteria of an optimal currency area?

Rockoff: Well I think that what you're getting at is right. The South was a different region and was dependent on the staple crops and was subject to a different set of shocks than, let's say, the New England or even the middle-West, yeah. In principle if he could've conceived of it, a different currency, probably would've worked smoothly.

Beckworth: Yeah I think back to an analogy, kind of compare this, the early formation of the Eurozone. In 1999, Ireland was growing faster than 10% in real terms, real GDP growth that's faster than 10%. Germany was barely 2% and so you come in with the European Central Bank, what should it do? Should it set interest rates according to Ireland's needs growing rapidly? It's getting too hot. Or Germany, which is too slow? Whoever you pick, someone's going to be getting the wrong type of monetary policy and they didn't have those shock absorbers, right? You see monetary policy was ultimately geared more towards Germany's slow growth and that helped fuel the fire in Ireland. Since 2008, if you look at a Taylor rule for the Eurozone area, it's interesting. The Taylor rule suggests that the core countries, such as Germany, France to some extent, particularly Germany, that what the ECB's been doing is roughly appropriate for them but it's been way too tight for the periphery... Spain, Portugal, Italy, Greece. It really strikes the observer that it's not an optimal currency area.

Beckworth: The early U.S., similarly speaking, we had one currency but we had these very different regions in terms of economic performance, economic growth, the structure of the shocks were different  ... I guess my question is did they have any of the shock absorbers? Was there great labor mobility between the regions? We know there weren't fiscal transfers at this point but was labor mobility in any sense large enough to offset a severe shock to the South?

Rockoff: Well there was a great deal of labor mobility and of course there was a frontier. You could pick up and leave Virginia or wherever and head West. Typically the Southerners headed from the South to Texas and so on and Northerners headed into the Midwest. So yeah, we always had, I think, labor mobility as a way of adjusting to these shocks. For African Americans, of course, it was a very different story because of family ties and the difficulties they faced moving North. That was a very difficult time of movement decision for them than for white Americans.

Beckworth: Okay now the early part of the republic there were two central banks that were setup. You go over these in your paper, "How Long did it Take the U.S. to Become an Optimal Currency." I highly recommend it to our listeners. In that paper, I mean you've written about this in other places as well, your textbook, other articles. We had the First Bank of the United States, which was really Alexander Hamilton's project, his baby, from 1791 to 1811. Had a 20 year charter from the U.S. Congress. Then soon after that the War of 1812 erupts. I think that's part of the story for why the Second Bank comes out in sort of the same ... Correct me if I'm wrong, but the Second Bank also gets a 20 year charter. It's 1816 to 1836.

Beckworth: I guess for our listeners, can you explain? In some sense these were a private bank with special privileges. They weren't like the Federal Reserve today but yet they were central banks. Maybe just set the backdrop for us. How was money created? Because it was very different back then. How was the currency created and how did these banks get a special role that effectively made them a central bank?

Rockoff: Well of course they were modeled, I think to some extent, on the Bank of England and maybe the Bank of Scotland and Scottish banks, as well.

Beckworth: Okay.

Rockoff: They issued their own paper money, bank notes. They were in competition to some extent with commercial banks that also issued paper money. All of it redeemable in gold or silver. These were claims to what people regarded as the real money, the legal tender. These banks had branches in the major cities. Well the first bank and the second bank. They held the basic monetary reserve of the country in sort of the same way that the Bank of England did. They were private banks but also proto-central banks, I think.

Beckworth: The way of doing banking back then, the main needs, it issued money, bank liabilities, was through actual bank notes. Opposed to today, you think of checking accounts or savings accounts. Back then they were bank notes. The actual, physical cash you'd use was a note issued by your bank which may be very foreign to many of our listeners. Let me ask this question, if I went on a trip and, say I'm in Atlanta, Georgia and I have my bank of Atlanta, or whatever the bank may be called, First Bank of Atlanta bank notes and I go up to, say, Charleston, South Carolina. How did people accept those notes? Did they accept them at all? Would they take my notes? Would they take them at a discount? How did notes from a different city get transmitted to another region?

Rockoff: Well let me go back to something you said just a moment ago. Deposit banking was getting underway in this region-

Beckworth: Oh it was? 

Rockoff: Yeah so it's not a case that people are just using paper money. Businessmen often wrote checks but in smaller transactions it would've been, I think, coins or paper money. If you had a note from an Atlanta bank and you're in New Jersey or something you would have to go to a note broker who would exchange them for local money for you and would charge some kind of charge for making a conversion to local money. I compare it sometimes to going to an ATM machine and it's not your own bank so you have to pay something to take cash out of the ATM. That's essentially what you're doing, I think.

Beckworth: Now my understanding is that one of the challenges of this period was that if I had a bank note from some other part of the country, the farther away I went the more steeply it got discounted. I might get, if I'm going from Atlanta to Chattanooga, maybe I get 95 cents on the dollar but if I go from Atlanta to New York City I might get 80 cents on the dollar. Is that correct?

Rockoff: Yeah I think it's correct except you're putting it in pretty big-

Beckworth: Okay so smaller discount. Smaller discounts, okay. Fair enough.

Rockoff: Yeah. Yeah.

Beckworth: Yeah. Now, the First Bank and the Second Bank ... Maybe I should step back. My understanding is also, and correct me if I'm wrong here, the reason you had these discounts is because there was unit banking. My bank in Atlanta might be the only branch whereas the First Bank and Second Bank, they had branches throughout the country so it was easier to use their notes. Is that right?

Rockoff: Yes, they had a big advantage in that way and were very effective competitors for the commercial banks. Couldn't branch across state lines so yeah, I think you're right. Absolutely.

Beckworth: That's probably one reason they were really hated, too, right? You think if your bank is only allowed one branch and your notes can only go so far before they start getting discounted then here comes this behemoth, the First Bank, which has branches throughout the country, can do things you can't do. Ultimately their notes become the reserve currency because of this special advantage. Well let me ask this question, did having the First Bank and then the Second Bank, did it at any way make the country move closer towards being an optimal currency area? There still these regional differences but did having these banks help in some sense making the country more practical in terms of being a common currency area?

Rockoff: Yeah, I think so. It's a very difficult think to try to document. Jane Knodell has argued looking at interest rates and discounts on bank notes that the Second Bank had an effect of getting you to that advantage of a common currency area, which is kind of smoothing the process of inter-regional trade. I think at least in that respect there's some good evidence that that worked to some extent.

Beckworth: Then we have Andrew Jackson and he becomes president and he begins his famous war on the Second Bank. He did not like the Second Bank, everything it stood for, the elitism, at least he perceived of it. When he won the election I believe in 1832 he kind of won it on a mandate to shut that bank down. Is that correct?

Rockoff: Yeah.

Beckworth: That blows my mind. It'd be like a president running today on the mandate, "I'm going to end the Federal Reserve. If you elect me, that is my key thing." That's a fascinating story. He wins, he shuts it down and again, going back to kind of our overarching theme here, this journey the U.S. took towards becoming an optimal currency area, when Andrew Jackson won he eventually got his way. The bank eventually shut down. It wasn't immediate but they didn't renew the charter. I guess my question, the absence of the Second Bank after Andrew Jackson's victory over it, did that kind of push us back away from the optimal currency area?

Rockoff: Yeah, I think it did push us away from an optimal currency area. You have the problem, to add another sort of layer to the story, the problem was you had all these separate banking systems, especially the South was particularly vulnerable. These banking crises could hit repeatedly in the U.S. In Canada, where you had nationwide branching, they really didn't have that problem. What a central bank could've done if it had been around maybe would be to come in during these banking crises and pour some money on financial markets. That was what the Bank of England was able to do but we didn't have that. We had a combination of a very weak, fragmented banking system. Charlie Calomiris has written about this recently. Combined with no institutional offset for that, so it was a very, very inefficient system.

Interstate Branch Banking vs. Unit Banking Laws

Beckworth: So why is it that the Canadians had interstate branch banking, branches across the entire country, where in the U.S. we had these unit banking laws where you could only own one branch? Is there a story behind that?

Rockoff: Well yeah. First of all there are states, and there were states, that had branch banking systems.

Beckworth: Okay.

Rockoff: Virginia before the Civil War even had a branch banking system and California, of course, always had a branch banking system. I think that the real weakness was that branching ended at the state line. Every state, whether it was unit banking or branch banking, had it's own banking system. I think in the U.S... It was really part of the larger issue of states’ rights. The Southerners did not want to see their banking system controlled from New York or Philadelphia or Washington D.C. I think it was part of these huge regional, political differences that didn't exist in Canada.

Beckworth: Okay, so the strong state right system that was setup actually hindered the U.S. from becoming an optimal currency area at an earlier time?

Rockoff: Yes I think that's exactly right.

Beckworth: Well let's briefly talk about something you've written extensively about, I think you're well known for, and that's the Free Banking period. You did seminal work in this period. Tell us briefly about the Free Banking period. Why is it called the Free Banking Period?

The Free Banking Period

Rockoff: You had these so called "Free Banking laws," were very complicated. They were an attempt to provide a very safe currency so the banks issued bank notes based on government bonds but at the same time you had free entry into the banking. The "free" part of the law was the free entry and if you wanted to set up a bank in a small town you could do so. It was also free in the sense that if you followed the rules that were laid out in the legislation you could get a bank charter. Before the free banking laws, you had to go to the state legislature and get a charter and of course that was viewed and was a very corrupt system. It was free in some ways but not in others.

Beckworth: Now my understanding is that the record was a mixed record in terms of success. States like New York had a fairly successful free banking system where like Michigan had a very spotty one. Is that correct?

Rockoff: Yeah that's right. There were a lot of successes but usually when the law was first introduced sometimes there were problems with it.

Beckworth: I raise that point because you often hear historians talk about the awful days of free banking but a more nuanced, careful assessment says it's a little more complicated than that. There were good cases and bad cases, it just depended on the way the laws were written in the states themselves.

Rockoff: Yeah I think that's the right conclusion to draw.

Beckworth: Let's move to the Civil War, the next kind of big shock or change in the U.S. monetary system. The U.S. suspends gold convertibility at the beginning of the war and all the way up to 1879 they resume it. We have a fiat currency during that time with the greenback. I think most of our listeners are probably aware or somewhat familiar with this notion that we had greenbacks, fiat money, during the Civil War and then afterwards up to 1879. Then during the Civil War there was also the Confederate currency in the South that, after the war the currency ceased to exist. You highlight, and I think our listeners should really appreciate this and I would encourage them to read your paper in the Southern Economic Journal on this, but interestingly there was a currency out West called the yellowback. We had the greenback in the East, fiat currency, then we had the dollar in the West backed by gold, the yellowback. Tell us about that experience and kind of the uniqueness of it.

“Yellowbacks” and the U.S. Civil War

Rockoff: Yeah so by this time we have the national banking system and the currency is issued by national banks. In the East they issue notes that are backed by greenbacks but in California the national banks issued what were called "yellowbacks" and the notes were redeemable in gold coin. The basic currency in California and on the West Coast was a gold backed currency. They remained on gold while the East was on the greenback.

Beckworth: What's unique about this though, as you mention, this is a rarity because you have a strong political union, so from 1865 on to 1879 so the period after the Civil War up until we have gold resumption across the entire country. We have a strong political union, as you mentioned, untouched by war with two currencies, the greenback and the yellowback, and there's a floating exchange rate between them. Is there any other example or a case where you have a country that's stable with two different currencies within it floating? Or is that unique to this period here between 1865 and 1879?

Rockoff: Well of course there are lots of cases where, let's say a foreign currency is used, right? You have a local currency and a dollar currency that are circulating next to each other. I'm open to learning about this but I haven't seen an example where you have different regions within the same country with a lot of big regions, with a lot of trade and two different currencies in use. I'm sure maybe one of your listeners will come up with-

Beckworth: Well I think this is unique. It's fascinating. Several questions. One kind of a practical question, what would happen if you were traveling from the East, say from New York, and you went to California. You brought your greenback with you. Could you use it in a store? Would you have to go to an exchange center first and get a yellowback?

Rockoff: I think typically people would go to a bank and trade them in for local-

Beckworth: There was a floating exchange rate between these two currencies, the yellowback and the greenback, now this might have some implications for the Eurozone. There were several people during the crisis, I think in 2010, 2011 suggested that maybe you could keep the Eurozone but break it into two different currencies. Have kind of the core area has their austere, hard currency. Maybe on the periphery they share a currency. This experience suggests, it's not entirely the same because this is the U.S. and in Europe there's different countries but it does suggest that there might be a solution found in that.

Rockoff: Yeah, I agree with that. I think it's a reasonable analogy and so I think this idea of a Northern currency and a Southern currency for Europe could be made to work and might actually relieve some of the other problems, immigration problems and so on. So yeah, I guess I do see it as a reasonable analogy. Of course it was something that was forced on the U.S. We went to the greenback during the Civil War and the Californians decided to stay on gold. Here I think you have the political problem that this would be an admission that the original plan had failed and that's a tough thing to sell.

Beckworth: Yeah. In some sense this is kind of a natural experiment. We got lucky, by chance this happened and it'd be hard, maybe, to actually implement it and deal with the transition costs.

Rockoff: Yeah.

“Wizard of Oz" as a Monetary Allegory

Beckworth: Well the gold standard is resumed in 1879 so again, from 1861 to 1879 we're off gold but we get back on gold. That in itself is an interesting story. You've written about this as well. Can you kind of touch on the transition and then also that whole period of the 1890s? You have a paper in the Journal of Political Economy, "‘The Wizard of Oz’ as a Monetary Allegory." The whole saga of the late 1800s of gold versus silver, can you just kind of touch on that and summarize what happened?

Rockoff: Yeah so the problem was deflation and especially commodity price deflation in the early 1890s that was hurting the South and the Midwest. Farmers were in debt and wanted relief from that and they found their champion in William Jennings Bryan. He advocated going to a silver currency that would produce inflation and help out his farmer supporters. Of course Bryan was, to some extent... this was a moderate position. There were a lot of greenbackers around who just said, "Let's have a fiat currency the way we did in the Civil War and have a fiat inflation." Bryan's idea of, "But we'll keep a commodity standard. It'll just be a silver, but metallic standard" was sort of the moderate position.

Rockoff: Of course Bryan was a good quantity theorist and what happened after Bryan, of course, is that a lot of gold was discovered in South Africa and some other parts of the world and you began to get a gold inflation. Bryan, very thoughtfully, said, "Yes, this shows that I was right. Who knew that the gold standard was going to produce what I was advocating?" It did help farmers, I think, to some extent.

Beckworth: So William Jennings Bryan has that famous line from a speech in the 1896 election, says, "We will not crucify mankind on a cross of gold." Great, great line. Now I guess going back to our big theme here today and that's the journey of the United States to becoming an optimal currency area. This experience speaks to it still not being there, right? You have the regional, the South and the West and William Jennings Bryan's speaking for them, saying, "Hey, we don't like what the gold standard is doing for us. We want to go to a silver." So this suggests that we're still not at the point of being an optimal currency area. Is that right?

Rockoff: Yeah, I think that's it. I think the shock, the deflation shock, prices in general were falling but the relative price of these agricultural commodities was falling even more and that was, in real terms, was hitting certain regions of the country and they wanted relief from that.

Beckworth: Now some of that transition was also structural and not just monetary in the sense that the U.S. was industrializing then. At some point those farmers just would no longer be on the farm, right? They would have to move to the city and get a job there. The country was transforming at this point from an agricultural based economy to more of an industrial one, right? We're speaking in terms of the monetary story but there's also the structural change going on at the time. Well let's talk about that point a little bit more. You note in your paper, again this paper is titled, "How Long Did it Take the United States to Become an Optimal Currency Area?" I highly recommend it to our listeners. You mention a couple of other interesting works that suggest and point to the U.S. not being an optimal currency area during this time and even beyond this time. You point out Gavin Wright's 1996 work, "Old South, New South" where he shows that the U.S. South, its labor market, even though it was integrated internally was almost closed off from the rest of the country. In fact, I had Jason Taylor on this show a few episodes back and he talked about how the South was basically a backwards economy. From the Civil War up until the New Deal World War Two era it was a completely backwards, largely separated market from the rest of the country. The rest of the country is progressing, it's developing and the South is still stuck. So it was very distinct regional economy. You point to that as another example of why the U.S. was not an optimal currency area. Any thoughts on that?

Rockoff: Yeah, I think that's exactly right and I just mentioned earlier that there was a frontier but of course by the 1890s that had really disappeared so it was very difficult for even white, poorly educated workers to find some place to move and to find new work. Of course, for African Americans it was really difficult. Labor mobility was very difficult for the South.

Beckworth: Okay. You've done some work on this, on what I'm about to talk about, and that's regional interest rates. You also point to work by Howard Bodenhorn-

Rockoff: A Rutgers PhD, I'd like to point out.

Beckworth: Was he one of your students then?

Rockoff: No, actually he was, Eugenie White-

Beckworth: Okay.

Rockoff: I was on his committee.

Beckworth: You can take some credit for him.

Rockoff: Yeah, I can.

Beckworth: Absolutely. As an aside, let me ask this question, do you guys still produce a lot of economic history PhDs like Howard?

Rockoff: No, to be honest we don't. We got a lot of students, and a lot of dissertations these days, are sort of three essays and sometimes we're able to get a student who's doing econometrics or macro to do an essay on economic history but it's a tough job market for economic history.

Beckworth: Yeah so going back to Howard's work, your former student, and you too, I saw a recent paper you did on this but there were regional differences in interests rates. If you imagined if it was a truly integrated capital market ... Well I guess the other story could be that there's risk differences across the regions, as well, but does the differences in regional interest rates in the U.S., does that also point to the fact that the U.S. is not an optimal currency area during this time?

Rockoff: Yeah, I think it does show the lack of an optimal currency area. Part of it, again, has to do with the fragmented banking system. Again, in Canada you don't see the same kinds regional differences that you see in the U.S. system. Partly that's because when you have a fragmented banking system then there's no way within the banking system, really, to diversify these risks if there's a shock. The price of cotton or something like that, you know, there's no way to off lay that risk onto some other part of the banking system because you just have these regional systems.

Beckworth: All right now all of this kind of comes to a head in the 1930s with the Great Depression. You argue in your paper and I think very convincingly that the Great Depression once and for all kind of changed this trajectory and put the U.S. firmly on an optimal currency area footing. Can you talk about what happened during that time that made the U.S. an optimal currency area?

The Great Depression and U.S. as an Optimal Currency Area

Rockoff: Yeah, I think there were a number of things. One thing, just because I was thinking just now about the banking system is you have deposit insurance comes in during the 30s. You no longer have this problem that a regional agricultural, well I wouldn't say don't have it, but you no longer have as big a problem that the regional agricultural shock could suddenly lead to the collapse of the whole banking system in that region because people now know that their deposits are safe in a bank in Georgia even if the price of cotton goes down. I think that helped a lot. Of course now you do begin to get things like Social Security and unemployment insurance and so on that helped in terms of bringing federal money into a region that's suffering from a business cycle shock. I think you're getting now the offsets to the problems created by having an optimal currency area.

Rockoff: I think there are also, sort of as you were talking about before, real changes going on that area also going on during the Depression. It had been going on for some time but you're getting industrialization in the South so you're getting more diversified economy. Birmingham is, this is the Depression particularly, but Birmingham is developing getting the petrochemicals in Texas and Louisiana. We're getting more diversification and integration in the industrial side of the economy.

Beckworth: Yeah, it's interesting to see how the South explodes after World War Two. The rate of growth was I think for the most parts faster than the rest of the nation up until the 80s or so. So it's rapidly catching up, you have that deeper integration going on. You mentioned bank deposits, which kind of solved the regional bank risk problems, given you had this one size fits all monetary policy. Then fiscal transfers, so now we have, the idea is during a time where maybe one region is hit hard, another region is more prosperous. The more prosperous region, their taxes effectively are sent down to the other one. For example, I think today Michigan versus Texas. I know Michigan more recently has been doing well but in the 90s it was bleeding quite rapidly. If you look at employment, it's secular decline. People in Michigan, they're losing their jobs, for whatever reasons but Michigan is bleeding. Texas is thriving. Texans end up paying more income taxes, they're doing so well, that income tax and payroll taxes, they get funneled up to people in Michigan.

Beckworth: I guess I would also note people in Michigan also can easily pack up and move to Texas. Great labor mobility, too, in the U.S., which makes the U.S. much more of an optimal currency area. On that last point, again I was talking to Jason Taylor and you, I think, allude to this also when you mention Gavin Wright's work. World War Two and the New Deal, but I think World War Two more so, really opened up the South in terms of the labor markets and I would argue even just the way of thinking, right? If the South had been closed off from the Civil War up to World War Two, it's not just people don't move up North because they don't know, they're ignorant, they don't have the understanding, the awareness. In World War Two, suddenly there's all these military bases built in the South, people from the North are coming down here and seeing for the first time, "Wow, this is what the South is like." People in the South for the first time are leaving home, going other places, up North, overseas to Europe.

Beckworth: It's really an exogenous culture shock I think that opens up the South and makes, maybe on the margin, makes labor more mobile down there, as well, so they can move around, too. The World War Two story, I think, is a very convincing one. New Deal, World War Two story, it really I think is a big shock, really brings things together and I think it's a very convincing piece. That's why I like your paper. It ends on that note. Of course I guess the hard part of the story is it took 150 years roughly, right, to get there?

Rockoff: Yeah, yeah.

Beckworth: That's not very hopeful for the Europeans, huh?

Rockoff: No. It's not. I wish I had more hopeful-

Beckworth: Yeah, I would say not only it's 150 years in the U.S. and we had a clean slate, right? We started from scratch where in Europe you got thousands of years of oftentimes bitter history between these nations so it's really hard to see the Eurozone project, of course, I'm an American saying this but to see the Eurozone project as ever working out the way it's currently set up. It's interesting going back and looking at the literature on the Eurozone. There's been some people who've done this but many of the American economists who wrote in the 90s about the Eurozone were very pessimistic. They said, "This is not going to work out. You guys shouldn't try it." The Europeans were much more positive. "We'll have an endogenous optimal currency area. Yeah we're not optimal now but maybe if we link ourselves together we will endogenously grow into an optimal currency area."

Europe’s Hopes for an Optimal Currency Area

Beckworth: I think time has shown that this simply hasn't happened, especially in a place like Europe where they have all this history going against them. Any thoughts on Europe's future?

Rockoff: Yeah, I think you've described it pretty well. This idea that it would kind of endogenously or naturally evolve in the right direction was a pretty powerful one and in fact Bob Mundell wrote a paper where he said exactly that. Europe is not an optimal currency area but if they have a single currency, if they introduce one, then that'll be the solvent that eliminates these problems and become one. Maybe it will, you know? Maybe when we do this podcast again 50 years from now-

Beckworth: Right they'll look back at Beckworth and laugh at me. Well that's true. I mean, hey, they've survived this long. I've been surprised that the Eurozone project has survived because the crisis keeps reemerging and it doesn't want to go away. It just keeps reappearing every six months, every year or so. I want to mention one other thing about that project. Paul Krugman did a post, I think 2011, just to highlight the difference between the U.S. and the Eurozone in terms of currency areas. He mentioned in particular Florida versus Spain and he just kind of did a back of the envelope comparison. Both Florida and Spain had these huge housing bubbles followed by bust and he goes, "Well there's a big difference. There's huge fiscal transfers from Washington to Florida that didn't occur for Spain." Of course, we'd add on top of that the lack of labor mobility.

Beckworth: I'm just going to run through some of these numbers he mentioned. He said, "From the IRS stated we find that Florida's tax payments to Washington fell approximately $25 billion between 2007 and 2010, the bottom of the slump. Labor department we find in 2010 special unemployment insurance programs, extended benefits paid from D.C. were about $3 billion in 2010 from SNAP, the food stamp data, we see benefits to Florida rose about $3 billion over the same period." He goes on to say, "So as I read it, between falling tax payments without any corresponding federal benefits plus safety net aid, not counting Medicaid, which would've made the number even bigger, Florida received what amounted to an annual transfer from Washington of $31 billion plus, or more than 4% of state GDP." That's a transfer. That's not a loan. That's very big. His point is Spain simply was never going to get something like that on that scale. It makes it tough for the Eurozone project to thrive.

Beckworth: Any closing thoughts from you, Hugh?

Rockoff: Well I think Paul made a good case. I still believe in looking at economic history. I think a lot of lessons there and I just wish I had a long time ahead to study those. Thanks for having me on this. This is a lot of fun.

Beckworth: That was a lot of fun. Our guest today has been Hugh Rockoff. Hugh, thank you for being on the show.

Rockoff: Sure. Thank you.

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About Macro Musings

Hosted by Senior Research Fellow David Beckworth, the Macro Musings podcast pulls back the curtain on the important macroeconomic issues of the past, present, and future.