One size fits nobody?

by John Quiggin on January 22, 2011

Much recent discussion of the future of the euro, most notably that of Paul Krugman, has started from the idea that Europe is not an optimal currency area, and that a ‘one-size fits all’ monetary policy is therefore bound to lead to the kinds of problems we are now observing. At any given time, some countries would benefit from a more expansionary policy and others from a more contractionary policy, so the effect of monetary union is an unsatisfactory splitting of the difference.

Without resolving that issue in general terms, I want to argue that this is not an accurate description of the current state of the eurozone. It’s true that Germany is doing a lot better than the eurozone as a whole, and the peripheral countries a lot worse. So, the optimal policy for Germany alone would be tighter than for the rest of the eurozone. The peripheral countries might benefit from an even more expansionary policy (though that’s not as clear to me as it seems to be to others. A heavily indebted country that undertakes monetary expansion is likely to find it hard to sell bonds denominated in its own currency).

But when you look at the actual policies of the ECB, including Trichet’s recent threat to raise interest rates, it’s hard to see that this policy is optimal for any EU country, even Germany.

Particularly in GDP terms, Germany’s recovery has not been that strong, and an expansion based on exports could easily be derailed by the kind of currency appreciation that would follow an interest rate rise, or even a really credible commitment to hold inflation down. And given the difficulties of handing out explicit haircuts, a modest amount of inflation seems likely to be a low-risk way of easing debt burdens without endangering the (largely German and French, and also UK) banks that hold a lot of the debt.

As has been pointed out here on previous occasions, to say that the problem is the ECB rather than the euro is, for some purposes, a distinction without a difference. But in other respects it is critical. If the optimal currency area analysis is correct then a breakup of the euro is probably inevitable and the big question is how to manage it. On the other hand, on the analysis offered here, the ECB must, in the end, be bluffing. Faced with the end of the currency it has been set up to manage, the ECB must eventually back down on everything else, including its inflation targets. The problem on this analysis is how to broker the politics of pushing the ECB towards large-scale quantitative easing and a higher inflation target.

This is, of course, complicated by the fact that, as discussed in a number of the contributions to the seminar below, the actual policies being pursued and advocated by Germany don’t necessarily correspond to any reasonable conception of Germany’s national interest. In particular (and by no means uniquely to Germany) policies that are primarily driven by the interests of banks have become the basis of a popular backlash against other scapegoats – in this case the citizens of the peripheral economies who are on the hook for failures of the financial sector. Until that’s understood, the disastrous policies of the ECB will continue to go unchallenged.

{ 42 comments }

1

Jack Strocchi 01.23.11 at 12:56 am

Pr Q said:

In particular (and by no means uniquely to Germany) policies that are primarily driven by the interests of banks have become the basis of a popular backlash against other scapegoats – in this case the citizens of the peripheral economies who are on the hook for failures of the financial sector.

Why does every major problem have to have a single head-line bad guy? I am second to none in my denunciation of bankers. But they are not the only culprits, especially in a stuff-up as big as the GFC.

My understanding of most deals is that they require a minimum of two parties. For a deal to go wrong at least one party must foul up. But its perfectly possible for both parties to be in the wrong, which makes the stuff-up go global.

Can’t the EU’s economic problems be a combination of bad business from both the top-down (swindling British bankers) and the bottom-up (skiving Greek tax-“payers”)? The evidence that the average Greek in the street is not pulling his weight in the tax department is pretty overwhelming. Or is it now politically incorrect to point out the bleeding obvious in economics as well?

Just as the US’s financial problems were a combination of bad business from both the top-down (Wall Street sharks) and bottom-up (Main Street suckers), plus morally hazardous government bank rollers wrapping the whole thing together.

Less hedgehog, more fox please.

2

SK 01.23.11 at 1:52 am

Sorry if this is a bit off topic, but with respect to not only the Eurozone, but also other “big issues” in global political economy (thinking China-US, Japan’s “malaise”) might analysis which focuses on overproduction as well as underconsumption yield slightly different results, and hence policy prescriptions?

Seems to me that much current debate and commentary emphasises the latter, while there is an – in this context disconnected – area of ecological PE to which emphasis is placed on the environmental impacts of overproduction.

But maybe the two ought to be analysed together, yielding results and policy prescriptions which address issues in GPE “from both ends”, i.e. from the supply-side and demand perspective, addressing production and consumption collectively.

Just thoughts – but maybe a bit too much for a sunny Sunday!?!!?

3

eddie 01.23.11 at 2:25 am

Because the banks are not the main culprits. Rather the main culprits are mortgage holders but governments just don’t have the balls to tell them that their wanting everything on tick has messed us all up. It’ll really mean massive property devaluation.

4

shah8 01.23.11 at 4:47 am

Eeeehhhh…

This is the oversimplification:

Disinflation enables stable class structure and maintains status quo of winners. A dynamic economy, while nominally preferred, is practically discouraged because this involves new players with different priorities than the ancien regime.

That’s why there are no common sense answers being utilized to clear out bad debt, which is the crisis of our age, after global climate change. Long, stagnant eras with no real rivalries generates elites that loves super-hard currencies and debt peonage. It is very unlikely that the euro would be dropped in this context, absent revolution (which I do think will eventually come).

5

otto 01.23.11 at 10:03 am

“the actual policies being pursued and advocated by Germany don’t necessarily correspond to any reasonable conception of Germany’s national interest”

This – more than the ECB – is the fundamental here. If Germany wanted a different policy, e.g. 4% inflation target, apparently constraining ECB personalities and rules would vanish in a puff of smoke. And, what’s more, Germany’s policy attitude has very long-standing roots in Germany’s political economy, so it can’t be expected to change.

6

Farah 01.23.11 at 10:23 am

The whole argument would be more convincing if, coming from Americans, there was some acknowledgment that the dollar as a single currency across a vast landmass with widely different local economies, also has major problems. This was identified way back in the 1870s and is usually represented by hostility to “Eastern Bankers”.

7

Guido Nius 01.23.11 at 10:28 am

The whole argument would be more convincing if it didn’t implicitly hold that there is some sort of sens in speaking of ‘currencies’ fitting ‘areas’.

8

Phil Armstrong 01.23.11 at 10:59 am

Can’t the EU’s economic problems be a combination of bad business from both the top-down (swindling British bankers) and the bottom-up (skiving Greek tax-”payers”)?

I believe Greek debt is mostly owed to French and German banks. The UK banks were lending to Spain and Ireland instead. The Greek bailout was therefore really a bailout of Société Générale and Deutsche Bank. (Equally, the money funnelled to Ireland has bailed out RBS & co.) TBH, I’m not sure skiving Greek tax-payers are entirely to blame: they haven’t changed their behaviour at all, it’s just that a bunch of European banks decided that the advent of the Euro clearly meant that the Greek attitudes would change overnight & it was obviously now safe to lend them huge amounts of money at a far smaller premium over German bunds than was sane.

9

Barry 01.23.11 at 11:57 am

Adding on a few kicks to the bankers. The policies that the government of Germany is following might be considered to be far more in the ‘national interest’ if the ‘national interest’ was defined as ‘the short-term interests of the financial elites’.

I would sneer here, but I live in the USA, where that’s almost written into the Constitution.

10

Kevin Donoghue 01.23.11 at 1:31 pm

“Faced with the end of the currency it has been set up to manage, the ECB must eventually back down on everything else, including its inflation targets.”

I’m not sure about this. I don’t know any ECB bigshots but I get the impression that some of the Germans, in particular, wouldn’t be unhappy to declare the euro a failure and take their old Bundesbank jobs back.

11

mpowell 01.23.11 at 3:42 pm

The actions of the ECB contribute most to my opinion that policymakers in Europe do not even have a basic understanding of the interaction between government policy and macroeconomics as they attempt to grapple with this crisis. In the US there is plenty to complain about, but at least the head of the central bank understands what is minimally required to maintain the financial system, even if we haven’t taken actions to really address underlying causes or provide real relief for the middle class. Of course, the fed has a dual mandate which probably helps. The mistake with the ECB is not recognizing that even if you don’t have a dual mandate, if you fail to maintain economic growth badly enough, you will be out of a job eventually, one way or another.

12

Lemuel Pitkin 01.23.11 at 5:41 pm

Absolutely right. This is a very important point.

You can find the same thing in monetary debates during the interwar period. As Robert Triffin (among others) pointed out, the debates were typically framed in terms of the failure of the gold standard system to adequately adjust relative prices between countries. Whereas the real source of instability was monetary and demand fluctuations that acted in the same direction across all major trading countries.

Here’s the interesting question, though: When Krugman makes the same argument for the world as a whole that he makes for the Euro area, is he wrong there too? Or is that a case where the failure of relative prices to adjust really is at the root of the problem?

13

Lemuel Pitkin 01.23.11 at 5:45 pm

Disinflation enables stable class structure and maintains status quo of winners. A dynamic economy, while nominally preferred, is practically discouraged because this involves new players with different priorities than the ancien regime.

This is also true. But I don’t think it in any way contradicts John Q.’s analysis. It just provides the political-economy background to it.

14

Lemuel Pitkin 01.23.11 at 5:49 pm

(Sorry, 11 is in response to the original post, not to mpowell as it may appear.)

15

Chris E 01.23.11 at 6:21 pm

“This is also true. But I don’t think it in any way contradicts John Q.’s analysis. It just provides the political-economy background to it.”

It does contradict the point that the ECB is going to be ‘forced’ to do somesuch at some point in the future.

16

Lemuel Pitkin 01.23.11 at 6:54 pm

OK, John is probably overconfident on that point. But I still think he’s got the big picture right.

17

P O'Neill 01.23.11 at 8:01 pm

Cherchez L’Homme:

WSJ: What do you think the risk is that this wrenching process will cause the breakup of the euro or its membership?

TRICHET: Of course the euro is there and will be there in the future. I do not comment on what I consider absurd hypotheses. I am used to such questions from the very beginning of the euro. The paradox is that, years ago, the question was about Germany supposed to be at that time the “sick man of Europe”. I was responding that Germany was doing hard work that its economy was catching up on competitiveness. Now the same hard work has to be done by those that were growing rapidly over the past years but at the same time had lost their competitiveness. One has to accept that within a vast economy that has the size of the euro area, with 331 million people, there are economic differences. For instance when I look on both sides of the Atlantic I see that the differences between the fastest and slowest-growing U.S. states, it is more or less of the same order of magnitude as between countries in the euro area, for instance between Oklahoma and Nevada, 13 % differences in growth in 2009; between Slovakia and Ireland more than 9 % in growth in 2008.

WSJ: The U.S. copes with these differences through labor mobility and a federal budget. Does the euro zone ultimately need a big federal budget?

TRICHET: The quantum leap we are asking for in surveillance of fiscal policy has to be the equivalent, in our own institutional framework, of what a federation could do. And we should not overestimate labor mobility in the U.S. and underestimate it in Europe. If I take the U.S. state with the highest unemployment and the state with the lowest, I am not that far from what we observe in the euro area, for instance in 2009 between 18% and Spain, 3,7 % in Netherlands, and between 13,6 % in Michigan, and 4,3 % in North Dakota, 4.3%.

18

Oliver 01.23.11 at 8:10 pm

There he neglects to mention that the US has labor mobility. The Eurozone doesn’t. All legal equality doesn’t remove language barriers.

19

timber sales 01.23.11 at 10:05 pm

agree with Oliver On labor mobility. skillful labor help to boost up your economy. I think Europe needs to concentrate on it?

20

Myles 01.23.11 at 11:59 pm

Particularly in GDP terms, Germany’s recovery has not been that strong, and an expansion based on exports could easily be derailed by the kind of currency appreciation that would follow an interest rate rise, or even a really credible commitment to hold inflation down. And given the difficulties of handing out explicit haircuts, a modest amount of inflation seems likely to be a low-risk way of easing debt burdens without endangering the (largely German and French, and also UK) banks that hold a lot of the debt.

I am somewhat curious as to how closely connected German monetary policy preferences are to its Mittelstand economy. I would hazard that most Mittelstand are too small to effectively hedge against significant currency and interest rate changes, and thus there’s a fundamental, instinctive conservatism in that regard. Given that they generally have quite some degree of market power, better exchange rates might present a smaller boon for Mittelstand than otherwise.

I would welcome anyone who knows more than I do on the subject (that’s….most of you) to correct my assumptions.

I would sneer here, but I live in the USA, where that’s almost written into the Constitution.

In the 60’s, Michigan had incomes that were something like a quarter (1) above the national average. An two-bedroom apartment on the Upper East Side, meanwhile, went for $50,000 in 1971 (2), probably much lower in real terms than many had paid for them. It’s really hard to look at both (the Cold War-financed Michigan juggernaut of decades ago and the Wall Street juggernaut of today) and not be reminded, simply, of Ecclesiastes 9:11: “…but time and chance happeneth to them all.”

ft1: the only data I could find at the moment referred to Michigan having incomes 15% above the national average in 1955.
ft2: I think I read this in the book about KKR, but not sure.
ft3:…

21

Myles 01.24.11 at 12:24 am

Just as the US’s financial problems were a combination of bad business from both the top-down (Wall Street sharks) and bottom-up (Main Street suckers), plus morally hazardous government bank rollers wrapping the whole thing together.

(Completely off-topic…) As the commentators on a recent B&T thread noted, the worst suckers are the people who thought they are the evil geniuses. Case in point: AIG Financial Products….

Of course, this accords with your general point..

22

Matt McIrvin 01.24.11 at 6:22 am

Didn’t the real-estate crash put a big dent in US labor mobility, for groups likely to own homes? I know the potential difficulty of selling my house in the current market made it much harder for me to consider moving when I was looking for work. And of course the most depressed areas will be the hardest to sell a house in.

23

Oliver 01.24.11 at 9:15 am

That is true, but it is a transient issue, which means that the US is closer to an optimal currency area than the Eurozone.
In addition, the problem exists in the US only as long as your are not foreclosed. After that lower rents increase mobility.

24

Martin Bento 01.24.11 at 10:03 am

The notion that the main street suckers were anywhere near as much to blame as the bank sharks requires supposing that the suckers should have known that home prices would not continue to escalate for a few more years as they had been for a few years previously. After all, all the bad deals – the interest-only’s, the ARMs, even the neg am’s – were perfectly manageable with prices going up 20% a year. Manage your teaser rate for five years, and you would have enough equity to either refi to something more reasonable, or sell and get a very nice capital gain. Should the average nurse or bus driver have understood that the party could not last and about when it would stop? The titans of Wall Street evidently did not realize it, and they are still getting huge bonuses for being so brilliant. Realizing things like this is job of the financial industry and the academic experts, not the job of the lay public. It is amazing that the technocrats claim in this field claim such vast wealth and power on the premise of their superior understanding, but still feel no more responsible than those who do not claim and are not rewarded for such understanding.

25

Matt McIrvin 01.24.11 at 4:29 pm

I certainly thought all that stuff was crazy before the bubble popped, but I’m paranoid about these things.

26

piglet 01.24.11 at 5:19 pm

“There he neglects to mention that the US has labor mobility. The Eurozone doesn’t.”

Well he doesn’t “neglect to mention” it, he explicitly warns not to “overestimate labor mobility in the U.S. and underestimate it in Europe”. And I guess his point is that if labor mobility really were so much more of a factor in the US, why are the regional differences comparable?

27

Sebastian 01.24.11 at 5:46 pm

I’d suspect that the impact of labor mobility in the US might be overestimated, but I doubt the impact of less labor mobility in Europe is not underestimated. Adding language (and maybe even a sense of nationalism) to the mix isn’t likely to do anything other than make the problems of labor mobility worse.

28

Sebastian 01.24.11 at 5:46 pm

Ugh, thats what I get for editing the sentence midthought, incorrect double negatives. ;)

29

James Wimberley 01.24.11 at 6:37 pm

Oliver in #18: “the US has labor mobility. The Eurozone doesn’t. All legal equality doesn’t remove language barriers.”
Er, am I imagining the long history of South-North and now East-West Europeam migration? Italians and Spaniards went to Germany in the 1960s, lon gbefore there was an intra-EU right of settlement. Somehow, tens of millions of pretty uneducated Turks, Pakistanis, Poles, Algerians etc have managed to overcome language barriers and find jobs abroad. The same is true of Mexican immigrants to the USA today.

30

Oliver 01.24.11 at 7:52 pm

True, but that isn’t full mobility. Those migrants disproportionally became members of the underclass. Language is a serious problem, not an unsurmountable problem.

31

piglet 01.24.11 at 8:23 pm

“True, but that isn’t full mobility.”

??

32

Lemuel Pitkin 01.24.11 at 8:55 pm

Not to mention, US mobility is a lot less than people think. I’ll try to look up the exact number later, but a large majority of American adults live in the same state they were born in.

33

Steve LaBonne 01.24.11 at 9:04 pm

Re Lemuel @32: the folk belief that lots of Americans are frequently on the move is, I think, a product of the fact that the media are based in large coastal cities in which many inhabitants (including the mediots) have in fact moved from elsewhere. When I moved to Ohio some years ago, I was indeed struck by the very high proportion of people who are living near where they were born. I guess I shouldn’t have been surprised but then I’m originally from the East Coast myself (and a former academic, a profession in which long-distance moves are usually a career necessity), so I too was prone to this misconception.

34

Martin Bento 01.24.11 at 11:51 pm

I’m with shah8 on who would want deflation and don’t know why Delong and others seem to think there is no logical constituency for austerity. It may result from thinking the rich look at what benefits the rich as a class more than what benefits specific currently-rich people and maintains their status relative to others (since accrual of wealth beyond a comfortable middle class level is primarily a status game, and status is relative and therefore zero-sum).

35

piglet 01.25.11 at 1:19 am

Lemuel : “a large majority of American adults live in the same state they were born in”

Steve: “the folk belief that lots of Americans are frequently on the move”
“When I moved to Ohio some years ago, I was indeed struck by the very high proportion of people who are living near where they were born.”

And there’s nothing wrong with that! Why shouldn’t they stay in their community?

I am uncomfortable with a certain view – which may not be yours but which comes up a lot in these discussions – that (mass) migration is a good thing per se that should be encouraged. Keep in mind that (mass) migration is an incredibly inefficient process that destroys a lot of capital – material and social – and strains the communities at both ends of the trajectory. Sure, it also enriches communities and promotes cultural diversity. Nevertheless, economic mass migration is not something to be welcomed and should not be seen as an easy way to solve economic troubles. It isn’t easy, even when the cultural barriers are low, and it doesn’t solve the economic problems that are pushing people to leave. And it undermines the health and stability of communities. To expect the economic imbalance in either Europe or the US to be “solved” by masses of people being shuffled around on the map – millions of Spaniards moved to the Netherlands, Michiganders to the Dakotas – seems foolish to me. This isn’t molecules in a chemical diffusion experiment.

Now let’s get a bit more specific about the US. There is clearly a difference in attitude compared to Europe. The idea that you can always vote with your feet, move away if you don’t like where you are is clearly more prevalent. Again I don’t necessarily see this as a good thing. This attitude has contributed greatly to increasing economic segregation, urban flight and the neglect of the cities, and it has significantly contributed to the housing bubble. Economists who interpret mobility as an equalizer of economic conditions are having it backwards: To a large extent, internal mobility in the US is motivated by the desire to escape diversity (e. g. Bill Bishop, The Big Sort). A lot of that mobility doesn’t cross state boundaries. Even when it does, is there evidence that “voting with the feet” promotes economic stability and resilience? Consider how Americans in past decades have voted with their feet for places like Nevada and Florida, which now find themselves among the states worst hit by the crisis. I hope Nevadans like it in North Dakota.

36

hix 01.25.11 at 2:03 am

Very important point piglet.

Lower mobility also helps to encourage long term investment into a region. Unlikely that Americans would build something like Gotthard tunnel . Rather we see ugly downwards spirals until a crisis that would have been managable in Europe leaves a city with huge crime rates and unmaintained public infrastructure. At that point, no one invests there anymore, no matter how cheap real estate and wages get or how good the skill base from old industries would be for some new one.

37

Positroll 01.25.11 at 10:38 am

Particularly in GDP terms, Germany’s recovery has not been that strong”
That’s a joke, surely?

1) 3,6% is the biggest gain for Germany since 1992 … Please take into account that the German population + workforce is currently stable, while the US grows at 1%. So German growth of 3,6% (2011: 2,5 predicted by Ifo; might be even higher) produces the same growth / capita as a growth of 4,6% (2011: 3,5%) in the US.

2) In Germany, the number of workers on “short-work” peaked at 1,5 mio in mid 2009. They are now down to 300.000. Unemployed numbered 5 mio in 2004. They are now at 3 mio, with further reductions forecasted. As the continuation of the recovery of the world economy isn’t a sure thing yet, many manufacturers only hire back those (few) people they had to let go during the crisis. For the moment, they prefer paying overtime to hiring people from the service sector or foreigners that need to be expensively trained (as happened with the “Gastarbeiter” in the 50s / 60s).

3) Also, the service sector itself is expanding and hiring. But there aren’t that many “service jobs” in Germany compared to the US, that could be filled by southerners. Many restaurants are run by families. Paid parental leave means way less nannys. People do their own lawnmowing + laundry as they need to work less hours on their day job. After heavy losses, Walmart fled the Germany market when they found out that in supermarkets Germans prefer lower prices to better service (and surely don’t want other people packing their stuff into bags) …

That doesn’t mean I disagree on the main point. A somewhat higher inflation for a short time (e.g. 2 years) could do a lot to improve the situation of the GIPS-countries while not endangering long term stability. Personally, I’d prefer a one-time money drop by the ECB to all member states (according to population) that would have to be used to pay back debts of the memberstates.

38

piglet 01.25.11 at 5:09 pm

“Unlikely that Americans would build something like Gotthard tunnel.”

Well there were some big infrastructure projects earlier last century – Hoover dam, TVA, of course the interstate system. It seems that nothing comparable has happened in about the last 40 years, or am I wrong? Even the Obama stimulus was mostly dedicated to catching up on maintenance rather than new future oriented projects. The current state of affairs is symbolized by the New Jersey governor’s decision to pull the plug on a transit tunnel to Manhattan that was widely seen as necessary, and that already had most of its funding.

39

Steve LaBonne 01.25.11 at 5:12 pm

And there’s nothing wrong with that! Why shouldn’t they stay in their community?

I didn’t intend any implication that it’s a problem, only that the reality about mobility in the US is at odds with elite / media perceptions.

40

Lemuel Pitkin 01.25.11 at 8:35 pm

What Steve said.

By the way, the number turns out to be around two-thirds of American adults who live in the same state they were born in. Which presumably is a bit lower than Europe, for what it’s worth.

41

Jack Strocchi 01.25.11 at 8:55 pm

Phil Armstrong @ #8 said:

I’m not sure skiving Greek tax-payers are entirely to blame: they haven’t changed their behaviour at all, it’s just that a bunch of European banks decided that the advent of the Euro clearly meant that the Greek attitudes would change overnight & it was obviously now safe to lend them huge amounts of money at a far smaller premium over German bunds than was sane.

Okay your explanation of the EU financial crisis makes more sense to me because it still allows for both elite top-down and populus bottom-up factors in the deals that went wrong. In both the US and EU, the Masters of the Universe dealt with the Greater Fools which ended in tears before bedtime for the taxpayer.

Interesting that in both cases it was mostly “Northern” bankers making bad business with “Southern” borrowers. Thus in the EU GFC, greedy Big Three (UK, FRA & FRG) bankers recklessly lent money to impecunious and dead-beat borrowers in the PIGS nations. This is analogous to the US GFC situation where greedy Wall Street bankers recklessly lent (or guaranteed and derived securities) to impecunious and dead-beat borrowers in the Sand States (CA, FL & NV).

And in both cases the “federal” government (FRB & ECB) had to step in to bail out the banks that were too big to fail. Although in the EU’s case the administration of the bail-outs was out-sourced to debtor nations who had to cut their spending in order to help with the financing.

Also in both cases, the federal governments responsibility for bailing out financial institutions meant that less funds were available for spending on the more general fiscal stimulus. Which was particularly bad timing because the credit crisis and construction bust had put both economies in a hole.

The conservative moral of the story is that society needs to impose more authoritarian controls on both greedy lenders and lazy borrowers or else society’s agencies wind up paying the cost. This fact punches another hole in the post-modern liberal fairy tale of freedom.

42

piglet 01.25.11 at 9:38 pm

Understood, Steve and Lemuel. I’m just saying that often, mobility is discussed as if it were desirable for its own sake, the more the better.

Comments on this entry are closed.