Euro Dilemmas and the Specter of the Gold Standard

Simon Johnson and Peter Boone present a lucid analysis of the Greek and other « PIIGS » (Portugal, Ireland, Italy, Greece and Spain) adjustment problem to the great recession in the Wall Street Journal:

“If Greece (and the other troubled countries) still had their own currencies, it would all be a lot easier. Just as in the U.K. since 2008, their exchange rates would depreciate sharply. This would lower the cost of labor, making them competitive again (remember Asia after 1997-'98) while also inflating asset prices and helping to refloat borrowers who are underwater on their mortgages and other debts. It would undoubtedly hurt the Germans and the French, who would suffer from less competitiveness—but when you are in deep trouble, who cares?

Since these struggling countries share the euro, run by the European Central Bank in Frankfurt, their currencies cannot fall in this fashion. So they are left with the need to massively curtail demand, lower wages and reduce the public sector workforce. The last time we saw this kind of precipitate fiscal austerity—when nations were tied to the gold standard—it contributed directly to the onset of the Great Depression in the 1930s.”

What the authors do not explain, however, is that membership in the eurozone, that the recession puts at risk, was also, during boom time, a main source of the present difficulties of these countries. In a common currency, the centralized monetary policy is necessarily divorced from national economic conditions (one size cannot fit all), and moreover it exerts a pro-cyclical effect on national economies. Those countries that are growing more rapidly, and thus with more inflation, than the others during boom time benefit from lower real interest rates than countries with less inflation, since the nominal interest rates of the ECB are the same for all. This exacerbates the boom as was clearly the case of Ireland and Spain, and that premium explains in large part the extraordinary real estate booms in these countries.
By a theoretical “Austrian” mechanism, bad investments will be the magnified where the real interest rate is lowest. Thus the deeper will be the necessary correction in the recessionary phase.

Moreover, since no national currency depreciation is possible in a currency union, as explained above by Johnson and Boone, the only other way to cushion the recessionary shock is through government deficits, and precisely these are made easier by the “strong common currency” vehicle, which means relatively low interest rates for governments to pay on their borrowing, at least up to a point, which Greece has now reached.

Thus the euro, by itself, magnifies the business cycles in member countries, contrary to what was advertised by his promoters (see my 1998 book: L’erreur européenne, and my 2002 paper “Les promesses de l'euro: tout était faux" here).

Johnson and Boone advocate four measures to try to remedy the present problem: first ask the IMF for help (but that would amount to recognizing a failure of the eurozone policies and system); second, Europe must soon create a multilateral funding system that ensures that adequate finance is available to each nation that adhered to these conditional programs (but this amounts to progressing in the direction of a central federal financial and fiscal system, a known requirement of non optimal monetary zones, such as the eurozone, which is unlikely to be adopted in the current political state of the European Union); third, “the European Central Bank needs to adjust its policies, lowering interest rates further and allowing higher inflation throughout the currency union. If such looser money policies are not palatable to the Germanic core, then Berlin/Frankfurt should get on with the task of admitting that the euro zone itself is a failure”; and last but not least, the European Union needs “living wills” plans – plans for countries to exit from the euro zone, (a basic requirement indeed, but also again a recognition, if used, of the non-optimality of the zone and of the euro).

The euro has been launched on the vain premise that where there is a political will, there is necessarily an economic way of reaching whatever governments define as their objective: the primacy of politics over economics. Now European politicians are confronted with economic difficulties that they find difficult to ignore, but will find even more difficult to solve.

A Miles Tax Is a Bad Idea

“One of the most ridiculous policy proposals I’ve read in a while” writes Andrew Samwick in Capital Gains and Games.

"Compared to a higher gas tax rate, a tax on miles driven ignores the amount of fuel used to drive those miles. Highway travel is taxed the same as city travel. Gas guzzlers are taxed the same as hybrids. Neither change makes any sense from an environmental perspective. Nor is it necessary to raise issues of privacy involved in collecting a tax on miles driven in the ways suggested in the article by monitoring the history of the locations of the car (as opposed to an annual fee based on an odometer reading collected at a state inspection).

Many cities are experimenting with congestion taxes, which are based on miles driven at particular times in particular locations. Those are worthwhile policy measures to relieve congestion and are different from a uniform tax on miles driven."

Hat tip: Alex Tabarrok (Marginal Revolution).

The Current State of the Euro Union

David Beckworth (Macro and Other Market Musings) posts an excellent and comprehensive survey of the current Greek and Euro problem, as seen by journalists and professional economists such as Carmen Reinhart, Simon Johnson, Barry Eichengreen, Tyler Cowen, Paul Krugman: “The Eurozone: Déjà Vu Argentina 2001 & Other Thoughts”.

Among other considerations, this excerpt:

« I couldn't help but think of Argentina's crisis in 2001-2002. It too had a sovereign debt problem, an overvalued real exchange rate, and was effectively part of a currency union that did not meet the optimal currency area criteria. It too tried to cut wages and prices but found the deflationary price too high. Ultimately Argentina defaulted and broke the peso-dollar link, even though the currency board linking the two currencies was almost a decade old and considered an important institution. It seems possible some of the PIGS could go the way of Argentina. »

NB: "PIGS" stand for Portugal, Italy, Greece, and Spain.

I agree. A must read.

Economics as a "Normal" Inexact Science

Daniel Little comments in his blog Understanding Society
on a book by Daniel Hausman, The Inexact and Separate Science of Economics (Cambridge University Press).

Economics is far from being alone in that category, hence the qualifier "normal" that I use in the title. It follows that the criticism of economics helps define the limits of its uses, not its scientific status that it shares with Galilean mechanics or Darwinian theory.

Excerpts:

« To say that a social or economic theory is true is to say that it correctly identifies a real causal process -- whether or not that process operates with sufficient separation to give rise to strict empirical consequences. Galilean laws of mechanics are true for falling objects, even if feathers follow unpredictable trajectories through turbulent gases.

Second, how can we reconcile the desire to use economic theories to make predictions about future states with the acknowledged inexactness of those theories and laws? If a theory includes hypotheses about underlying causal mechanisms that are true in the sense just mentioned, then a certain kind of prediction is justified as well: "in the absence of confounding causal factors, the presence of X will give rise to Y." But of course this is a useless predictive statement in the current situation, since the whole point is that economic processes rarely or never operate in isolation. So we are more or less compelled to conclude that theories based on inexact laws are not a useable ground for empirical prediction.

Third, in what sense do the deductive consequences of an inexact theory "explain" a given outcome -- either one that is consistent with those consequences or one that is inconsistent with the consequences? Here inexact laws are on stronger ground: after the fact, it is often possible to demonstrate that the mechanisms that led to an outcome are those specified by the theory. Explanation and prediction are not equivalent. Natural selection explains the features of Darwin's finches -- but it doesn't permit prediction of future evolutionary change. »

The whole paper is illuminating and well worth reading here. I did not read the book yet but plan to do so shortly. Here is an editorial comment:

"...challenging and stimulating...[this book] does reflect an insightful familiarity with the nature and uses of economics. Its criticisms of the discipline are not to be lightly dismissed. It is definitely recommended reading for academic economists and advanced graduate students." Social Science Quarterly.


Hat tip: Mark Toma (Economist’s View).

What European Centralizers Think

The New York Times publishes an article ”Is Greece’s Debt Trashing the Euro?”.

Here is an excerpt reporting a centralizer’s diagnosis and “quitte ou double” dilemma: does the euro survival now compels Europeans to merge their diverse polities into one?

“We have a centralized monetary policy, but we allow budgets and wages to move in different directions,” said Paul De Grauwe, an economist in Brussels who advises the president of the European Commission, José Manuel Barroso. “Without a political union, in the long run the euro zone cannot last.”

That was the hope of the federalists from the start. But the remedy would prove to be worse than the disease in this decentralizing, post-imperialist era. In a choice between creating a continental super-state and a return of some member states to an autonomous national monetary policy, the latter option is clearly the lower cost and higher welfare improving strategy. But centralization means more power for political decision makers, and better career prospects for bureaucrats. It is thus the preferred solutions of European elites, while voters, when clearly asked the question, tend to reject it.

Deficits Don’t Matter

At least that’s what John Cassidy writes in the New Yorker, The Return of the Rosy Scenario. Winston Churchill, Dick Chesney, and Victor Zarnowitz also professed a benign neglect for projected deficits, and rightly so.

The reasons? Deficit forecasts are notoriously unreliable (the Cassidy thesis). Reagan proved that deficits don’t matter (the Chesney thesis). Dire deficits forecasts are a necessary part of any political adjustment process (the Churchill thesis). And all forecasts are acutely sensitive to the economic assumptions that underpin them, especially the economic growth rate (the Zarnowitz thesis).

The punch line: enjoy.

Banks and Populism

Simon Johnson clarifies the debate on the meaning (or absence of meaning) of "populism".