Arnold Kling  

The Euro and Armageddon

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Michael Pettis writes,


In my opinion the current set of crises, beginning with the sub-prime crisis in the US and spreading throughout the world, is not a short-term liquidity crisis like LTCM, the Asian Crisis, or the Mexican crisis of 1994. I think this is likely to be one of those big events, one that represents a major re-adjustment in the world during which time the massive imbalances that had been built up during the long globalization cycle that started around the late 1980s and early 1990s are finally worked out.

Pointer from Tyler Cowen. Pettis says five things.

1. The euro is toast
2. This is the end for the latest expansion of globalization.
3. The trade-deficit countries of Europe will have to reverse their deficits, leading to a big shock in international trade patterns.
4. Greece and probably a few other European countries will have to reschedule their sovereign debts before their economies can recover.
5. Policy makers will pretend otherwise and instead these insolvencies will be papered over for a while in order to try to help the banks that own most of the bonds.

I agree with (4) and (5). I hope that (2) is wrong. I think that new patterns of specialization that increase cross-border trade would be a good thing. Leaving aside sovereign debt issues, I think one does well to keep in mind Don Boudreaux' point that international capital flows are not a collective responsibility. We do not track whether Floridians are running a trade deficit with New Yorkers that is financed by capital flows, and I am not sure that we should wring our hands if this sort of thing happens across national borders.

Point (3) has to be parsed carefully. It is not that Europe as a whole is running such a huge trade deficit. Within Europe, there are countries running trade surpluses and countries running trade deficits, and the question is whether or not that is acceptable with a common currency. In that sense, (1) and (3) are linked.

I see Greece as a sovereign debt crisis, not a euro crisis. If Greece were to somehow gracefully get out of the euro tomorrow, they would still have bloated pensions, a bloated public sector, and ineffective tax collection. In other words, it would not really solve their problems. At best, devaluation could make fiscal cutbacks less painful, but even that assumes that devaluation results in lower real wages and that lower real wages result in much higher private-sector employment, which might or might not turn out to be the case.

If market forces really were determined to rebalance trade within Europe, then German wages would be rising. Would that be catastrophic? I guess you could tell a story in which the European Central Bank keeps money tight, so that overall European employment falls as German wages rise. Seems far-fetched to me, although probably not to a lot of macroeconomists.

On the other hand, suppose Germany keeps running a surplus. Then perhaps that shows that surplus is innocuous. Individual debts matter for individuals. Government debts matter for constituents. But what is the significance of aggregate non-government debt of specific geographic territories within a currency union? Why is Germany's balance of trade with Spain more important than Tuscany's balance of trade with Lombardy?



COMMENTS (9 to date)
dWj writes:

If Americans in aggregate run a trade deficit, and I save a lot of money but save it in dollars, if other Americans' behavior ultimately proves unsustainable, does that affect the value of my dollars?

Maybe if Floridians are running a trade deficit with New Yorkers, and it proves unsustainable in some manner, there will be a real depreciation in the currency in Florida relative to New York, i.e. the relative cost of living goes up in Florida.

This is something to which I've given occasional thought, to no real effect.

Chris Koresko writes:

I haven't thought this through carefully either, but it occurs to me that the trade balance between U.S. cities is different from that between nations, because the people involved are much more mobile. In other words, the flow of human capital is much more important between cities in the same nation-state than between nation-states.

Detroit provides an example: it's lost about half its peak population, reputedly due to bad local policy and the economic deterioration that brought.

Rebecca Burlingame writes:

I wonder if the massive trade imbalances are more correlation than causation. As to Pettis' concern about long term readjustment, it seems that everyone really needed those high home prices: federal government for wealth creation in lieu of manufacturing, local governments for the increased taxes, and the individual for increased wealth in the face of stagnant incomes. Plus, everyone needed those once-promising financial instruments for the costs of living that could not be afforded after retirement. As home values continue to deflate, this entire range of realities continues to be affected as well.

Thomas Esmond Knox writes:

dWj: "Maybe if Floridians are running a trade deficit with New Yorkers, and it proves unsustainable in some manner, there will be a real depreciation in the currency in Florida relative to New York, i.e. the relative cost of living goes up in Florida.

This is something to which I've given occasional thought, to no real effect."

If the price value of housing in Florida has fallen further than the value of housing in New York then the relative cost of housing for homeowners has forced the relative cost of living higher for Floridian homeowners relative to New York homeowners. Recently.

If you own your house and love your house, whether you live in Florida or New York, lose no sleep dWj. God loves all his children, especially those who own and love their houses and have no debt.

MernaMoose writes:

But what is the significance of aggregate non-government debt of specific geographic territories within a currency union?

Interesting question, but is it really "debt" we're talking about here? Somehow the buyer had either money or credit available, or there would be no transaction. When the money/credit runs out, the transactions stop.

There are relatively poor locales in the US, that have been relatively poor since time unknown. Yet people in these locales still have houses, food, cars, etc. By all measures wouldn't we have to say these locales have always run "trade deficits"? Yet business transactions within these locales have continued, albeit at lower volume than other parts of the country.

I'm not an economist so I'm going out on a limb here, but saying "the residents of Lexington, KY are $2 million in debt to the residents of L.A." sounds just a bit absurd.

Why, in fact, does my "trade deficit" with any one trading partner have any significance at all? What matters is the net aggregate balancing of my check book. Seems this should be true from the individual on up through international trade -- ??

NiccoloA writes:

Chris Koresko,


Though european countries aren't as accessible as US states today, it isn't too far off. I think that it is not a very good explanation.

We would travel to Switzlerland or France for weekends from Italy. Much like we now do living in Illinois making weekend trips to Iowa or Wisconsin. Really pretty similar.

endorendil writes:

First of all, the obvious. Trade imbalances (and redistribution of wealth) within the eurozone matter more than those between states because they are more visible. If the US states started worrying about the amount of wealth that is transferred from one state to another, or about whether their population has all the opportunities they should have without leaving the country, you'ld see the same kind of friction and - occasionally - explosions as you see in Europe.

"I think that new patterns of specialization that increase cross-border trade would be a good thing. "

Easy and cheap cross-border trade forces specialization on trading partners. This is fine as long as this specialization is within a homogeneous, democratic country. Alabama has a very different economy than California, but people can (relatively) freely move from one to the other. That allows specialized people to go where specialized industries are, to coin an awkward phrase.

When movement isn't so free, either because of closed state boundaries (Mexico-US comes to mind) or because of linguistic/social/cultural differences (Germany-Greece comes to mind), specialization in local economies complicates matters for the workforce. Even if both economies are perfectly viable, friction in workforce mobility leads to inefficiencies on the combined economies.

In the worst case, specialization can permanently stunt the workforce of a country, especially if it is small and with an immobile workforce. It may make sense for a small undeveloped country to specialize in low-wage manual labor, but it can easily get locked into this specialization. Even when it educates an elite, this elite will be prone to flee the country if allowed to. While there are many arguments to the effect that some work - whatever the type - is better than no work, it's hardly a desirable outcome.

The flip side is also known. The evaporation of low-skill (non-service sector) jobs in the US is a problem for the low-skilled work force that relied on them. If the low-skilled jobs left to another US state, the low-skilled workers could follow it. When they leave to Cambodia, this isn't really an option.

That's why some trade patterns matter more than others. Even if we solve the question of the trade imbalances, we will still be stuck with the problem that workforce immobility in a global economy leads to economic inefficiencies and socio-political friction.

Pietro Poggi-Corradini writes:

"But what is the significance of aggregate non-government debt of specific geographic territories within a currency union? Why is Germany's balance of trade with Spain more important than Tuscany's balance of trade with Lombardy? "

Actually regional differences within Italy, such as the fiscal shape of Tuscany vs. Lombardy are one of the major political problems for Italy. Some regions are more efficient, some are more profligate, some have all the industry, others all the tourism. Healthcare varies wildly from region to region and the respective healthcare budgets are managed differently, etc...Central planners are having a really hard time figuring this mess out.

Gary Rogers writes:

First, I am glad to see that you did not jump on the "Euro is toast" bandwagon. Granted, if Greece, Spain, Portugal or any other Euro country defaults on their debt it will send ripples through the world economy but there is no reason this should destroy the currency any more than having Michigan, California, New York or any state default on their debt would destroy the dollar. The thing that will kill the currencies is flooding the market with worthless money as we have been doing for the last few years.

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