Second Post on Europe: History and Choices

In my previous post, I described how balance of payments problems can arise in the abstract and a few ways they can be resolved.  In this post I will be slightly more specific and describe my view of the situation in Europe.  As a reminder, I am not an economist, so take all of this met een grote korrel zout.

You can think of the euro as a bunch of currencies that have "fixed" exchange rates.  This is literally the case with the euro and the Danish krone, but it is conceptually the case throughout the eurozone.  So even though the euro is one currency, we can think of German euros as "foreign" currency for the rest of the world, including the rest of the eurozone.  It's just that while the exchange rate between German euros and U.S. dollars (and even, in theory, Danish kroner) can shift, the exchange rate between German euros and Spanish euros absolutely cannot.

After the euro was adopted, investors from "northern" Europe (Germany, Austria, the Netherlands) poured money into investment assets in "southern" Europe (Spain, Italy, Greece) and in Ireland (for simplicity, I will use "southern" and "northern" for the rest of my post).  A lot of those investment assets were related to real estate—mortgage loans, that kind of thing.

Now recall that investment assets compete with tradeable goods for foreign currency.  The huge hunger for southern European investment assets made it cheap for southern Europe to borrow but difficult for southern Europe to export tradeable goods.  The northern European euros were all flowing into investment assets and there weren't many left for southern European tradeable goods.  As a result, southern Europe's tradeable goods sector shriveled, but its labor markets still did well because (A) in some cases, real estate speculation led to construction booms, and (B) in other cases, governments took advantage of cheap financing to run large deficits, generating fiscal stimulus.  In fact, southern Europe's workers did so well that labor costs rose faster than labor costs in northern Europe.  That is, southern European workers' productivity (on a per-euro basis) lagged northern European workers' productivity.

Then the asset bubble burst and suddenly southern Europe faced huge trade deficits that it could no longer pay for by selling investment assets.  So how will the balance of payments be restored?  Well, as we discussed, there are several ways to do this:

1.  Devalue southern European currencies relative to northern European currencies.  This is what Switzerland and Sweden did when they faced balance-of-payment problems.  Sadly, this is impossible for the southern Europeans because they are on the euro.

2.  Run a higher rate of inflation in northern Europe than in southern Europe.  As discussed in my previous post, this basically amounts to a slow-motion devaluation.  However, here we run into a dilemma.  On the one hand, you could achieve a decent inflation differential by running high (~5%) inflation in northern Europe while running low (~1%) inflation in southern Europe.  This would be an effective and relatively painless way to restore balance to Europe.  The problem is that northern Europeans fucking hate inflation with the passion of a thousand supernovas.  And the northern Europeans control the European central bank, for largely sensible reasons that have stopped making sense in this particular situation.

On the other hand, you could achieve the necessary inflation differential by running low (~2%) inflation in northern Europe while running severe (~2%) deflation (that is, -2% inflation) in southern Europe.  In fact, this is what we are doing, or trying to do.  The problem is that severe deflation can generally only be brought about by severe recession.  Basically, you make the labor market so terrible that workers will acquiesce in savage wage cuts, year after year.  This requires insanely cruel levels of unemployment.  Even as the southern European economies collapse, deflation has not been severe enough to restore balance (this is because prices are "sticky," particularly in the downward direction—deflation is fucking hard).  To achieve the necessary deflation, unemployment will have to go much higher.  Southern Europeans really really don't want this (and neither, honestly, do the northern Europeans, whose exports to southern Europe would collapse), but the southern Europeans do not control the European central bank.

In my next post, I will examine whether there is a better way to achieve deflation in southern Europe.  But the answer is almost certainly no.

3.  Improve the productivity of southern European workers.  This is what prostitutes whisper to German policymakers to get them really turned on.  The idea is that southern Europe should increase the skill of its workers and the flexibility of its labor markets so that its exports can compete with northern European exports.  The problem is that no one really knows how to improve the labor force's skills, and anyway it would take years.  And as for labor market flexibility, that has no real traction in a depressed economy.

Now, on top of the balance of payments problem, you have a sovereign debt problem, and it is really ugly.  But most of southern Europe would be okay (not great, but okay) if eurozone inflation were 3% higher.  Note, however, that in addition to alleviating the balance of payments problem, inflation would lower the real debt burden of southern Europe.  And to whom is that debt burden owed?  Northern Europe.  So part of the problem is that increased inflation would constitute a redistribution from north to south, as some portion of the debt would be inflated away rather than paid.  But it would be a mild redistribution, and far less disruptive and painful than the alternative.  Just note that northern Europeans tend to think of inflation in moralistic terms, and so even this mild redistribution pisses them off much more than it should.