Arnold Kling  

Devaluation and the Real Exchange Rate

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John Cochrane writes,


If the Drachma goes from 1:1 Euros to 2:1 Euros and Greek prices and wages double, nothing happens. On the other hand, if prices and wages don't change, then Greek goods are cheaper and Greece will produce and export more.

If domestic wages and prices do not change by the full amount of a currency devaluation, the real exchange rate depreciates and net exports should increase. That seems true enough. Cochrane then argues that an anticipated devaluation is more likely to be accompanied by wage and price increases. That is standard macroeconomic thinking of the rational-expectations sort. I have never cared for it.

It seems to me that if the rational-expectations theory held, then Greece would not be in its current pickle. Wages and prices there would have fallen in order to make its tradable sectors more competitive.

One way to frame my disagreement is that given a choice between rational-expectations macro and old-fashioned Keynesian macro, I am afraid that I pick the latter.



COMMENTS (10 to date)
andy writes:

Why should have greece people wanted to have their industry more competitive? As long as you have ample public services, social benefits, unemployment benefits, there is no reason to do anything about your situation.

david writes:

@andy: you're espousing a Great Holiday theory of recessions?

Mike Hammock writes:

I don't understand why sticky wages in Greece imply a lack of rational expectations. One is neither necessary nor sufficient for the other.

david writes:

You do need both some source of stickiness plus ratex to get New Keynesianism out. With stickiness alone it's just old Keynesianism.

Charles R. Williams writes:

It seems that each price has a degree of stickiness. The euro/euro "exchange rate" is at one extreme of the stickiness continuum. At the other extreme there are pure commodities traded daily in free markets and floating currencies. Going to the drachma would result in instantaneous adjustments to exchange rates. Wages and entitlements in Greece may be sticky, some contractural obligations may be fixed. There is no doubt that leaving the euro would affect relative prices throughout the Greek economy, probably in a helpful way. Provided Greece is not torn to pieces by violence.

But Cochrane has a point too. How did wages, entitlements and "rents" get so far out of line? This must represent some kind of political power. If the politics doesn't change, then the uncompetitiveness will re-emerge. And surely the parasites on the Greek economy are making contingency plans for a devaluation at this moment. Those plans probably include strikes, slowdowns and violence.

Ken Hirsh writes:

I was pretty surprised by Cochrane's post. Why doesn't he consider recent examples of devaluations that produced dramatic decreases in real wages, e.g. Argentina? Cochrane seems to show biases that are uninformed by recent history and/or knowledge of institutional dynamics in Greece. I'm not an expert on Greece either, but I think it is naive to assume that a significant devaluation would be met by close-to-equivalent wage increases.

mick writes:

Sovereign labor cartels usually block the fall in wages. In this case the devaluation causes a contraction of the labor supply instead of a fall in wages.

Craig writes:

Andy is correct.

There was little reason for wages and prices to fall under the Euro. So, they didn't.

Under a drachma, that would change. The Greeks would have to earn their keep instead of living in the glow of the Germans' reputation.

Mark Michael writes:

The post doesn't mention it, but much of the Greek debt is denominated in euros. If Greece goes back to the drachma and devalues it by half, they double what they owe those holding Greek debt in euros. If they can't pay the interest on that debt today because it's so large, think of what those interest payments are after the drachma reinstitution & devaluation.

Of course, they'll default on some of that debt, but I'd think it would be much larger if they leave the eurozone.

Bloomberg Businessweek, Jan. 9 - 15, 2012, p 12, "Don't bring back the drachma" editorial made a lot of sense to me. One of the first adult, sensible discussions of the pros and cons of Greece leaving the eurozone, and from an unlikely source!

It starts by giving the usual arguments for leaving, then says this: "The trouble is, leaving the euro would be an even bigger economic disaster. It would cause a run on Greek banks as depositors rushed to move their euros abroad before the balances could be converted to drachmas. And Greek borrowers would still owe euros to foreigners. B/c the new drachma would instantly depreciate, the borrowers would have diminished capacity to service those debts, causing new waves of of bankruptcies.

"Difficult as it may be, debt restructuring plus 'internal' or 'fiscal' devaluation looks preferable. Explicit wage cuts, and the recession needed to induce them, don't have to carry the whole burden of cost adjustment. A combination of increased value-added tax and lower payroll tax (Greece could easily do both) mimics a currency devaluation by raising the price of imports relative to the price of exports, lowering real wage costs by stealth....

"In theory, persistent cost inflation can be smoothly offset by a steady devaluation of the currency, but many countries have found controlled depreciation hard to achieve...a floating exchange rate might look helpful, but in practice it would be a mixed blessing.

"Inside the system, the peripheral countries have learned a harsh lesson: They must hold growth in wages to the euro area's rate of inflation plus any increase in national productivity...."


Joss Delage writes:

Not to mention that Greece doesn't really produce anything export-worthy to start with.

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