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).

5 thoughts on “Diagnosis

  1. TH: Like you, I would like to think that members could exit the eurozone without precipitating “Armageddon”. That being said, we need to distinguish between the potential exit of Greece and that of a much larger partner–Italy, say, or Spain. The reason why is simple: for another “Lehman moment”, there would need to be some systemic shock that triggers the kind of dysfunction in financial markets that was evident in the fall of 2008. I don’t think the exit of Greece would create that effect. The potential exit of a larger partner could.

    What is the difference? In the case of Greece, there would be no threat to the euro–if the exit was managed effectively (admitedly, a big “if”). But if a much larger partner were to exit, people would likely begin to question whether the euro could survive. And, if they did, the result could be pervasive uncertainty about the value of all existing contracts denominated in euros. In such an environment, the flight to cash could become a stampede, inter-bank lending freezes, and individuals and firms exercise the option value of waiting.

    1. Well hello Mr Haley. Welcome to the Specie Flow. Thanks for your comment. You strike at the fundamental problem with breaking up the Euro zone. It is the existential question. What exactly is a euro if it isn’t used in Italy or Spain? For some reason a country can join the Euro area and we don’t worry about that, but if a country were to leave, then it raises the question, what is a euro?

      It comes down to the fundamental question of why people our willing to hold worthless pieces of paper as a store of immense value. People are only willing to do so for two reasons. One is fiat: the government tells people its worth someting (at minimum they can pay taxes with it); second is that people believe someone else will be willing to hold it in the future. The government fiat argument is “interesting” because in Europe there is no federal treasury to support the ECB, so the Euro is only valuable because national governments tell people that it is. I suspect that there isn’t much confidence in government authorities so the fiat case for the currency could be fragile. And ceratinly, if a break-up of the euro area led to a crisis of confidence in the willingness of people to hold it, then we would have Armageddon! At that point the US dollar would truly be the world’s reserve and boy would we be pea green with envy of China.

      That being said, the literature on breaks from fixed exchange rates suggests that governments often wait too long, and then we get a disorderly exit. What I want to suggest is that there could be a mechanism that would allow for an orderly exit.

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