First Post on Europe: Balance of Payments

I am going to try to explain what is going on in Europe.  I will start with a post explaining, in very simple terms, balance of payments.  I am not an economist, so take this all med et stort gran salt.

Here is the basic idea.  Imagine two countries that trade with each other a lot.  Each country has its own currency.  So a cross-border transaction consists of two parts:  the conversion of the buyer's currency into the seller's currency, and the transfer of the purchase price from the buyer to the seller.  (Why does the seller insist on being paid in his own currency?  Because that is what he must use to pay his workers, suppliers, etc.)  So there is a "goods" market and a "foreign exchange" market.

You can think of the price of importing something as consisting of two parts.  First, there is the price of buying the seller's currency, determined in the foreign exchange market.  Then there is the price of the goods being sold by the seller (denominated in the seller's currency), determined in the goods market.  Imports can be expensive either because the foreign currency is expensive, or because foreign goods are expensive (or both).

Now we need to add one more market.  Let's say there's a mismatch in the value of goods exported by each country.  The country that is a net importer must pay for the excess somehow.  (I don't mean that the government must pay, just that the country as a whole must pay for the goods it imports.  Throughout this post I will ignore the possibility that one country will simply donate money or goods to the other country for free, as sometimes happens with foreign aid or remissions remittances [UGGGHH I AM A FUCKING IDIOT] or disaster relief or something.)

The way that the net importer pays for its imports is by selling investment assets.  Those investment assets could consist of almost anything:  stocks, bonds, real estate.  They could just consist of loans:  a loan is an asset from the perspective of the lender.  People in one country could borrow money from people in the other country.  This amounts to selling an investment asset.

And so a country obtains the required amount of the other country's currency by selling goods and investment assets, and so you can see how things balance.  Each country will export the same value of (goods + investment assets), but the mix could be different.  In a sense, financial assets compete with the export sector for foreign currency.  Some people think the U.S. runs a persistent trade deficit largely because the quality of its financial assets is so high that they out-compete its export goods in the market for foreign currency.  We will return to this possibility later.  I will note that one particularly important type of asset is sovereign debt—notes issued by the government when it borrows money.  If a country's government runs a large budget deficit, it will flood the market with its notes, which will compete with the country's export sector for foreign currency.  This helps explain the "twin deficits" phenomenon, in which large budget deficits cause large trade deficits.

But back to the mismatch.  Let's say that Country A has cut its labor costs somehow (so it can make more stuff per hour worked [EDIT: or more stuff for the same amount of money]).  This could happen any number of ways.  It could be improvements in technology, improvements in education, fewer labor market distortions from bad policy.  But it could also be something like a simple decline in wages, maybe because unions have been disempowered.

Whatever the cause, when a country's labor force produces more stuff per dollar unit of currency [oops], the country's goods become relatively cheap.  This boosts Country A's tradeable sector while hurting Country B's tradeable sector (the tradeable sector is just the sector of the economy consisting of things that can be traded across borders—cars are tradeable, haircuts are generally not).  Country B experiences increased unemployment, while Country A has a boom.

Remember, though, that the relative price of goods is a function of both the price of goods and the price of each currency.  Country B could devalue its currency relative to Country A's currency, with the result that the trade balance would shift back in Country B's favor (partially or entirely erasing the earlier shift in favor of Country A, or maybe even over-shooting).

So a devaluation of Country B's currency cools off Country A's tradeable sector and heats up Country B's tradeable sector.  But it also benefits consumers in Country A, because they can now buy stuff from Country B for a lower price.  It hurts consumers in Country B, because they have to pay more for imports from Country A.  You can think of it this way:  Country A is going to get some kind of benefit from its increase in productivity.  It can take that benefit in the form of a booming export sector (if the currencies do not adjust), or in the form of increased purchasing power for its consumers (if Country B devalues its currency).  As a side note, for many years China "took its benefit" in the form of a booming export sector, angering its trade partners.  Now its currency has appreciated considerably, to the benefit of its consumers and the delight of its trade partners, but to the detriment of its export sector.

If the nominal exchange rate does not adjust, then eventually Country A's booming tradeable sector will lead to inflation, while Country B's depressed tradeable sector will result in deflation (or at least lower inflation).  This will have roughly the same effect as a devaluation of Country B's currency relative to Country A's currency.  As Country A's currency inflates faster than Country B's, its relative labor costs rise and the trade balance shifts in favor of Country B.  Note that Country A's purchasing power still increases relative to Country B's, because while Country A's currency is inflating, the nominal exchange rate is staying the same.  Basically, the price of everything except imports from Country B is rising.  You can see why that would improve Country B's trade balance.

Alternatively, of course, Country B could try to imitate Country A and increase the productivity of its workforce.  If Country B's workers can become as productive as Country A's, then trade can be balanced without any need for currency adjustments or relative inflation.  We'll return to this, but for now just bear in mind that it may be difficult, painful, or even impossible to do this.

What I just described in the last two paragraphs is essentially what has to happen if Country A and Country B use the same currency.  In that case, there is no such thing as "devaluation," and so adjustments must be made in other ways (relative inflation or relative productivity gains).  But this post is long enough, I will describe my view of the European situation in the next post.