Saturday, March 12, 2011

Euro-zone collapse? Most unlikely

“It would be technically possible for a member state to leave the euro zone, but politically it is about as likely as a meteorite hitting the Eurotower in Frankfurt” – as Barry Eichengreen nicely put it.

Partly there are significant costs from monetary disintegration. These were massive in the post-socialist transition of the early 1990s, when COMECON and its transferable rouble disintegrated, the USSR and the rouble area split into 15 countries and currencies, Czech and Slovak members of the CSFR split together with the Czecho-Slovak crown and Yugoslavia splintered into more pieces and currencies than its former membership of five. A devastating deep and protracted recession followed, though in fairness this was due not only to such processes of economic and monetary disintegration but to the general move by these countries from planned trade transactions to their sudden exposure to market transactions at world prices and payment in foreign currencies.

Partly, the advantages from dividing the Euro-area would be highly questionable. The weaker countries leaving the Euro-zone and re-introducing a national currency would not lighten the burden of their national debt which would continue to be denominated and serviced in euro or other foreign currencies. They may or may not improve their trade competitiveness via devaluation of their re-introduced national currency – apart from the fact that competitiveness could be improved in many other ways if this is what a country wanted (“domestic devaluation” via wage restraint, investment in productivity increases, greater competition etcetera). Nor would there be any advantage for such stronger member countries as Germany.

In an article for the German Council on Foreign Relations Adam Posen argues that Germany has an intrinsic and direct interest in the prosperity of the eurozone. Germany benefits in terms of seigniorage, transaction cost savings, lower real interest rates available to its companies, a strengthened global influence, and improved shock absorption. These advantages increase with the size and the diversity of the Eurozone, and the German Chancellor Angela Merkel should not make a “competitiveness pact” for eurozone countries the condition for German continued support for the Euro.

All the same, over the last year, the prospect of Euro-area split has been a frequent though intermittent object of discussion. The title of a 2010 book by Hans-Olaf Henkel, formerly of IBM and ex-euro-enthusiast, expresses a widespread feeling in Germany today: Rettet Unser Geld! (Return our money!). Marshall Auerback also explores this possibility in a recent paper, “What happens if Germany exits the Euro?”, Levy Economics Institute of Bard College, 2011/1, though ending with a cautionary assessment not a recommendation.

“On the plus side, given Germany’s historic reputation for sound finances, the country would likely emerge with a strong Deutschmark, a global “safe haven” currency for currency speculators keen to find a true store of value.

But this would likely come at a huge cost: Germany would probably save its banking system at the expense of destroying its export base. The newly reconfigured DM would soar against the euro and become the ultimate safe-haven currency. This would mitigate the write-down impact of the inevitable haircuts on euro-denominated debt, because the euro (assuming it is retained by the remaining eurozone countries) would fall dramatically. Even if the euro itself vaporized, the Germans would simply pay back debt in the old currencies, likely at a fraction of their former value.

But Germany’s external sector would be wiped out. The resultant appreciation of the new Deutschmark, along with the inevitable banking crises in the periphery (which would exert significant deflationary pressures in those countries and therefore reduce consumer demand in the eurozone ex Germany), would engender a huge trade shock: Germany’s growth would slow dramatically, as exports compose such a large proportion of its GDP.

Another interesting byproduct: by accounting identity, a fall in Germany’s external surplus would mean an increase in its budget deficit (unless the private sector began to expand rapidly, which is doubtful under the scenario described above), so Germany would find itself experiencing much larger
[public] deficits.”

This accounting identity is a centerpiece of Keynesian macroeconomics as popularized for instance by the late Wynne Godley, but it is or rather should be part of any macroeconomist’s education. Auerback divides the economy into three main sectors: domestic government, domestic non-government (or private), and the foreign sector. “By accounting identity, the deficits and surpluses across these three sectors must sum to zero; that is, one sector can run a deficit so long as at least one other sector runs a surplus.”

Looking at GDP accounting from the “sources” perspective, we get the identity:

(1) GDP = C + I + G + (X – M), i.e. national income must equal the sum of private consumption and investment, plus government expenditure plus net exports.

From the “uses” perspective, GDP must be taken up by private consumption plus savings plus taxation, i.e.:

(2) GDP = C + S + T. Therefore

(3) C + S + T = GDP = C + I + G + (X – M), or

(4) (I – S) + (G – T) + (X – M) = 0

As a simple matter of double-entry book-keeping, the three balances must add up to zero.

At present Germany is running a large positive external balance (X-M), matched by an even larger excess private savings over investment (S-I) minus a modest public deficit (G-T). If, as a result of the reintroduction of an overvalued DM, German external balance were to be substantially reduced or vanish, Germany would have to either contract private savings relatively to investment or run substantial public deficits or both. An abrupt change of gear, which is at odds with the wishes of the German people and leadership. Something for Chancellor Merkel to ponder.

(This is also, incidentally, why the size of a country’s government deficit does not lend itself to be targeted directly, independently of what else happens to the balance of private savings and investment as well as the external balance of the country).


Marcello Colitti said...

I would add that German industry is the terminal of a production structure that embraces the whole of Europe, and not only Europe. The Italian case is well known: our small engineering firms produce components for the Germans, but this concerns the Belgians and the French, and perhaps to a lesser extent the British. To break up the Euro would generate a strong dislocation in these relations, would make them harder to manage, and generate great uncertainties. Why should Germany break up a system that is centered on her, and that has brought her to the highest export levels possible in the circumstances? And I believe that even at a political level the interests of German industry – including the Unions – are much stronger than those of banks, that in Germany have never been as prominent as for instance in England. From this viewpoint my impression is that there can be no doubts about the German position.

D. Mario Nuti said...

I agree, Marcello, thanks.

By the way, today's SPIEGEL ONLINE publishes an article entitled "Off the Mark - Why Ditching the Euro Would Be a Bad Idea" by Sven Böll.

The article recognises that "Even before the current crisis, many Germans dreamed of ditching the
euro and re-embracing their beloved deutsche mark. In a five-part series, SPIEGEL ONLINE responds to the myths surrounding the euro vs. deutsche mark debate -- and shows why they are all wrong.",1518,751483,00.html#ref=nlint

Jacob Richter said...

All macro-economic accounting to date thus far. The GDP model fails to measure productive labour vs. unproductive labour (luxury goods, finance, mass advertising, etc.). While the Material Product System also tracks physical units in the economy, it too obscures the extent of unproductive labour (Soviet defense spending).

There needs to be a macro-economic accounting model that clearly distinguishes between the productive and unproductive sectors of the economy, but of course there needs to be renewed debate on what exactly can be productive (public school teachers) and what can be unproductive (private-sector arms manufacturers for things like military exports).

Jacob Richter said...

Please edit: "to date thus far has failed."

Carmen said...

I am astonished to read in your blog: "competitiveness could be improved in many other ways if this is what a country wanted (“domestic devaluation” via wage restraint,...".

I think it is really cynical to see "wage restraint" as an adjustment mechanism. Clearly economists are lost in their world far away from reality: how much "wage restraint"? would near 0 wages do, if needed? or would negative wages be even better? does one need a wage to live? Can you see around you what "wage restraint" really means?

D. Mario Nuti said...

All I am saying, Carmen, is that a Euro-zone member state wishing that it could raise competitiveness through devaluation - which it can't do as it could with a national currency - can achieve the same result with internal devaluation.

Both external and internal devaluation involve a fall in real wages. Both are just as likely to work or not to work, depending on the net balance of the positive stimulus of lower wages on net exports and investment, and their negative impact on consumption.

It is not cynical to consider the sheer possibility that wage restraint might work; in the latest crisis it certainly worked in Latvia and Estonia. And a lower bound to the wage level is given by efficiency wages anyway. All in the context of the feasibility of external versus internal devaluation.

Of course there may or may not be better ways of raising competitiveness, for instance through greater competition or innovative investment (which I did mention in my post) or enhanced entrepreneurship. But this is beside the point.

Thomas said...

"the positive stimulus of lower wages on ... investment". Is this an established fact or just a conjecture?

D. Mario Nuti said...

Well challenged. In fairness, it is a conjecture. A reasoned conjecture but not an established fact.

Lower wages lower current and prospective running costs, and therefore raise profitability, of any investment project - other things being equal.

But as a result of lower wages two things are not equal: 1) there may be lower investment per unit of new output capacity as a result of substitution by cheaper labour inputs; 2) there may be lower investment due to lower consumption demand if this is not offset by higher net exports. The overall net effect on investment - which I conjecture to be positive, mostly on the strength of recurring lower wages over time, is actually uncertain.