Wednesday, March 21, 2012

The Root Cause of the Euro Crisis

It’s not over. While European leaders and media present the euro crisis as a specific Greek problem resulting from exceptionally bad governance, and essentially “solved” by the most recent of several loan programs from “altruist” northern governments, it is in fact, fundamentally, the consequence of a permanent – and growing - trade disequilibrium resulting from the suppression of  the most important price and market in medium sized and open economies: the nominal exchange rate between independent currencies. It is the most important price in these economies because about a third of the GDP is imported and exported in trade with other members of the Eurozone.

A fixed nominal exchange rate does not preclude the real exchange rate (adjusted for differential inflation rates) to vary, and diverge, causing the trade balances to plunge into disequilibrium.

This is shown most clearly in a post I received recently showing that obviously Greece is not alone in that “exchange rate dirigiste” predicament.

Such being the case no financial “help” can solve the problem. Only a return to exchange rate flexibility (see the post on Douglas Irwin’s book) can.

The post I refer to in La Lettre Volée is written in French, but the graphs it contains can be understood by all, even those that do not read French. 

The punch line: after the next Greek default will come Portugal’s turn, and then … France maybe.  

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