Sunday, 14 February 2010

Is the euro doomed?

There's a meme around which says that the euro is destined to break up because countries like Greece are fundamentally less productive than countries like Germany. A strategist at Societe Generale has put his name to this idea, as has the director of the Open Europe (anti-EU) think tank.

This argument supposes that the only way to become competitive is to devalue one's currency.

But surely this applies within countries too? The southern half of Italy is much less productive than the north, while the reverse is true in Britain. But there are no calls for a London currency and when the lira existed, it was never under the threat of an Italian breakup. Different states in the US are just the same - with widely varying fiscal problems as well as the same diversity of competitiveness.

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.

So there's no fundamental argument why devaluation must be necessary at a country level.

But as a practical matter, devaluations are a useful coordination mechanism. They instantly enforce a price and wage cut across a region, making everybody more internationally competitive at the cost of reducing their ability to buy things from other countries. They serve the same coordination role as inflation. The drawback is that people or firms who are internationally competitive get penalised for the benefit of everyone else (just as with inflation, people who have more wealth in cash or other currency-denominated assets are penalised). This provides a disincentive to invest in becoming competitive, just as inflation is a disincentive to save.

If there were other mechanisms for making these cuts (say, agreements between government, labour unions and large employers) then devaluations would not be necessary. Conversely, if devaluations and inflation are not available, people will be forced to find those other mechanisms - though there may be a lot of pain in the meantime.

The Daily Mail (which does have an agenda on this subject) says:
Countries that are highly uncompetitive are normally able to slash interest rates and devalue their currencies to prop up their economies.
But this is not possible within the euro, given its one-size-fits-all economic governance.
The implication is that weak, peripheral eurozone members will have to suffer years of painful deflation and tumbling living standards, as well as draconian budget cuts, in order to adjust.
Of course with a devaluation, they'd still have the deflation, tumbling living standards and budget cuts - but all at once instead of gradually.

The "one-size-fits-all" argument is a revealing one, because of course there has to be one-size-fits-all economic coordination at some level. The question is whether it's at the level of Europe, of an 80-million person region like Germany, a 12-million person region like Greece, a one-million person region like Amsterdam or a one-person region like my apartment.

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.

However, a stable currency does strengthen the incentives for less competitive regions to save and to invest in productivity, both of which are prerequisites for long-term growth. Perhaps the unusual circumstances of the last ten years have allowed Spain, Greece and Portugal to get away with less productive investment than they would have if the euro had started at a different time.

Or perhaps they have been investing - in long-term projects such as education and infrastructure, rather than capital equipment - and the returns just haven't started to come yet. If so, it would be a tragedy to throw all that away, destroying the returns for those who have chosen to invest, and condemning the Mediterranean population to decades more of second-class economic status in Europe. So my instinct is: stick with it. A few more years and the results will start to show.

p.s. A good way to achieve many of the same goals as a devaluation, with less of an investment penalty, is the IMF's proposal to have a higher, but still stable, inflation target. This gives much more room for relative wages to adjust in different countries, but also across different industries or even different people. Paul Krugman has a good explanation.

Update: Bluematter has a good post on the same topic which comes to a less equivocal pro-Euro position than mine.


Min said...

"However, a stable currency does strengthen the incentives for less competitive regions to save and to invest in productivity, both of which are prerequisites for long-term growth."

And how has that worked out for, say, the south of Italy, the north of Britain, and the southern states of the U. S.? Having grown up in the U. S. South, I know that it has been dirt poor since the end of the Civil War. I also know that Mississippi, for instance, has had a Balance Agriculture With Industry program since the 1930s, and it is still dirt poor. Southern states have "right to work" laws that keep wages low, and give tax breaks to attract industry. Yet progress, to the extent that it has come at all, has come at a snail's pace. A stable currency does not seem to have helped much.

Leigh Caldwell said...

Fair points Min.

I don't have a convincing answer; though I'd point out that there are important non-monetary factors involved in all those cases, and it could be that the stable currency has made things better than they'd otherwise be.

Productivity in the north of England and the south of the US is almost certainly higher than in Portugal, partly because of investment from the richer regions of those countries. But I certainly accept that the right answer here is not obvious.

PunditusMaximus said...

Yep. There's no difference in labor mobility within and between countries.

PunditusMaximus said...

Less snarkily, the case for higher inflation is very strong, the more diverse and less labor-mobile a given currency zone is.

Min said...

Thanks, Leigh. :)

If I knew what to do I might move back there and run for office. ;)

I have been wondering if maybe the right to work laws have not been such a good idea. As you point out, saving is important, and if wages are depressed, people can't save much, eh?

PunditusMaximus said...

The Right to Work laws are a great idea, if you want a poor and poorly educated populace. So they're a good fit for the South.