It is pretty obvious that the Euro area is not what economists like to call “an optimal currency area” – a region that is sufficiently similar so that having a common monetary policy is beneficial rather than counterproductive (imagine how crazy it would be to have interest rates in Australia set to match economic conditions in the UK, for example).
Economists figured this out by playing the Sesame Street “one of these things is not like the other” game and then applying their skills to Europe (especially Greece and Germany), which makes Torrens wonder whether Sesame Street was as big in Europe as it was in the English speaking world.
In fact, the Euro area has so many misfits that unless something dramatic happens to turn the Euro area into a true federalist fiscal union with a single market for goods and labour, it seems quite plausible that some countries will be compelled to leave to in order to secure their nation’s economic prosperity.
This leads to the fundamental question, one that TH has been struggling with for months – how do you break-up the euro area without causing Armageddon as Mr Kilmartin calls it? TH wants to believe that it is possible. After all, countries have made the switch from fixed to floating exchange rates in the past – and quite often without anyone noticing. Australia and New Zealand , for example, did it almost effortlessly in 1982 and 1985 and have never looked back.
To answer the question, you first need to understand the problem that Greece, Spain, Italy (etc.) are facing.
The fundamental problem is, in fact, surprisingly simple. First year economics tells us that the best outcomes occur when relative prices (i.e. the price of one good relative to the rest) are allowed to freely adjust to balance demand and supply. For international macro issues, such as this, the key relative price is the price of traded goods (like TVs that get shipped across international borders) relative to the price of non-tradable goods (like haircuts and restaurant meals that are consumed where they are produced). In the euro periphery, the problem is that the market price of tradebles (relative to nontradeables) is too low in countries like Spain, Portugal and Greece and too high in Germany and Austria and that frictions in the market are preventing these process from adjusting freely.
When the relative price of tradables is too low, a country imports too much and exports too little, which induces countries to borrow to make up the shortfall between national income and expenditures. In Europe’s case, banks were willing to finance the trade deficits on such European countries such as Spain, Portugal, Greece and so on because they believed that the benefits of currency union membership would boost productivity and export competitiveness in the future. But they were wrong. So when the GFC happened and banks were forced to reassess lending practices, the uncompetitive Euro area countries were ones that banks (except the French) were first to reassess. As banks cut off the funds, the trade deficits couldn’t be sustained, and something has had to give.
Unfortunately, in the Euro periphery, it was businesses and jobs that gave way as the contraction in foreign financing translated into a fall in demand for goods and services in the peripheral economies.
Getting back to that key relative price, since the price of traded goods are set on world markets , the fall in demand doesn`t directly affect their price, but since they are determined domestically, the price of those non-traded goods will fall. This causes a decline in profitability in these sectors, which in turn leads to lay-offs and firm closures. In short a recession – exactly like what we are seeing in the euro periphery right now.
If, on the other hand, these uncompetitive countries had had a flexible exchange rate, the very first thing that would have happened when the funding started to dry up is that the exchange rate would have depreciated. As the exchange rate depreciated, it would have caused the relative price of tradeables to rise making imports more expensive for domestic residents and boosting the price received by domestic exporting firms. Either way the profitability for firms operating in the traded sector would rise inducing them to expand and create jobs offsetting the loss of jobs in the non-traded sectors.
So, the answer to the periphery`s problems is to break free from the euro area and let their currencies depreciate. But this is not necessarily easy. Some fear a catastrophe. Nevertheless, before getting bogged down in the much harder question of whether countries like Greece, Spain and Italy could leave without destroying the world’s banking systems, Torrens wonders what would happen if Denmark (which technically is not part of the Euroarea, but does have a hard peg to the Euro) broke its peg and floated? The answer, according to Torrens, is nothing. Torrens would be happy to know if you think otherwise. But for now, the point is that under certain conditions, a country could easily leave. The harder question is how far you could go. Could Italy leave?
This topic is for the next post.
Incidentally, distinguishing between these two types of goods in this way was first done by a couple of Australian economists (Salter and Swan) who really should have won the Nobel Prize for their work. And the model that is used to analyse this type of economic situation was called the “Australian” model by Rudi Dornbusch – one of the world’s greatest economic minds – to reflect the contribution made by the Aussie thinkers Salter, Swan and later Max Corden. (It is also referred to as the dependent economy model – not really sure why).