Take any country. Or rather, take any normal country, with its own currency.
Suppose some people in that country are less "productive" (defined however you want) than other people in that country. That's normal. Now let's call the less productive people "Greeks" and the more productive people "Germans". Does calling them different names suddenly cause a disaster?
Let's slip a time-derivative. Suppose some people in that country have productivity that is growing faster than other people in that country. That too is normal (young and old, for example). Now lets call those with slower productivity growth "Greeks" and those with faster productivity growth "Germans". Does calling them different names suddenly cause a disaster?
Presumably not.
Yet Simon Johnson says:
"The underlying problem in the euro area is the exchange rate system itself – the fact that these European countries locked themselves into an initial exchange rate, i.e., the relative price of their currencies, and promised never to change that exchange rate. This amounted to a very big bet that their economies would converge in productivity – that the Greeks (and others in what we now call the “periphery”) would, in effect, become more like the Germans."
Look, I am no friend of the Euro, but this "productivity differential" or "productivity divergence" story of why the Euro is fundamentally flawed is seriously incomplete.
What's in a name? A rose and a skunk, by any other names, would also smell very differently too.
Maybe it's physical geography? The "Greeks" all live and work in one place, and the "Germans" all live and work in another. But why would physical geography matter? Does it matter because of transportation costs, so that "Greeks" trade mostly among themselves, and "Germans" trade mostly among themselves? Maybe, but if so, can someone spell out why exactly that matters? Is the implicit story here just a slightly less extreme version of the story I told in my old post, about a world with international finance but no international trade?
If that's not the underlying story, then what is it?
Just asking. Because this is frustrating me.
Worthwhile Canadian Initiative 
OGT: thanks, yes. If Simon Johnson had said that permanent productivity differentials are what cause asynchronised productivity/competitiveness shocks (because low productivity means you are stuck producing olives rather than BMWs, and shocks to the olive harvest are not well correlated with shocks to BMW production??), then his story would at least be complete.
While waiting for Nick’s reformulation of the issue, in defense of Simon Johnson, let it be noted that Johnson’s views concerning productivity differentials at the root, is widely shared in IMF publications including Blanchard,the OECD, central banking – see Gov Carney’s speech of yesterday in Halifax and the think tanks e.g. VoxEU.
For example, see “The Eurozone’s May 2010 strategy is a disaster: Time to pay up and end this crisis”, Charles Wyplosz, 20 June 2012 – http://www.voxeu.org/index.php?q=node/8117
Or see any of Ambrose Evans-Pritchard’s columns
Or Munchau at EuroIntelligence
Or, gasp, Martin Wolf’s latest columns.
Nick: I do remember that old post, since it was really interesting. I got some other things and since comments are closed, I would add just last comment to that post. We already know that all money in the world would end up in the country with higher interest rate and that in the other country people would expect permanent deflation.
In the discussion I already mentioned wealth effect as possible reason that could interrupt the whole bond purchase process, that was not formulated well enough. So lets do it again – we know that if the first country expects deflationary spiral, sooner or later prices would be so low that any individual could use proceeds from bonds to buy the whole real product monopolizing it and dictating whatever price he wants. So if people expect that this will happen in the future, they would not start buying those bonds in the first place. Now this strongly reminds me of backward induction proof of why fiat money should be worthless by Earl Thompson. Except that your model does not recognize any authority that would ensure redeemability of these essentially worthless bonds into someting (like CPI basket of good etc.).
So my take is, that if there are permanent productivity (and real interest rate) differentials between “countries”, they cannot remain in a tradable sector forever. They may exist in nontradable sector, but since I think that I proved that your model with common curency for countries that cannot trade are not affected by purely financial transactions, any such transactions should reflect just that part of the economies that are tradeable.
But all this really means is that differences in productivity are not the reason for crisis (financial or otherwise). This is why I would define “country” as the largest entity that is potentially able to manage nominal shocks (by monetary policy, by fiscal policy, by factor mobility etc.). So you are right, it is strange that people so loudly speak about difference in productivity between Germany and Greece, while even bigger difference in productivity like that between Germany and Slovakia is overlooked. And by the way, Slovakia is supposed to have highest GDP growth in the whole Eurozone.
Ian: You are definitely right that Simon Johnson is very much not alone in stating that view. It’s very widely held. But I pick on Simon because he’s…whatever is the opposite of a strawman. And someone I usually agree with.
JV: I think we are on the same page.
Hmmm. Paul Krugman says that productivity differentials are about the same in the US as in the Eurozone.
But in his last 3 paragraphs he says that it’s fiscal transfers in the US that make the difference. Why? If we are talking about productivity differential shocks I get the point. But if we are talking about long run non-convergence, I just don’t see it.
There are macro arguments for automatic fiscal stabilisers to handle shocks. And there are micro arguments for transfers to the permanently poor. But I don’t see him making a macro argument for transfers to the permanently low productivity regions.
Nick – I am looking to you for the answer to this macro question – which I have puzzled over.
My question is not rhetorical.
Did Canada establish fiscal equalization to the poorer provinces – because they had lower productivity and thus generated less economic activity including jobs (that pay taxes) and thus could not provide the same level of social services as those provinces had lower budgetary income w- used to finance social goodies?
Updated to southern Europe: Do the permanently lower levels of productivity – acceptable with e.g. the drachma (as the drachma depreciated to compensate for lower productivity) – now produce increasing unemployment as the Greek firms could no longer compete via a depreciated currency – within a common Euro currency, as their goods were now more expensive than Dutch or German or Austrian goods and the cost of visiting Greece as a tourist became more expensive than Turkey?
In turn, was it this factor that caused sovereign borrowings to increase to compensate for declining govt income from higher unemployment?
I recently read an interesting paper (Harvard economics?) trying to explain why current account deficits often occurred in tandem with government budgetary deficits.
I think – but not sure – if I am puzzling over the same question you are asking.
What is the relationship between permanently lower productivity levels in a country (in a common currency) and the deficit and sovereign total indebtedness?
Not looking for concrete steppes. Just trying to understand the relationship – if any – between permanently lower productivity and sovereign deficits, between micro and macro.
Ianlee mentioned the productivity differences over centuries re the north and south. I’ll ask again why EU can’t just force Germany to take in more labouring immigrants the way the north forced USA students to learn at parity in the South. It creates a demand for language instructors and such. I wanted Canada to build wind turbines instead of the holosands; the company I googled for California was a German tool-and-die maker. It has been hypothesized Greece has bad transportation compared to german intra-city trading.
This suggests some inequality is not fixable and there should be city planning. ie) Grecians forming a new “Canberra” between German cities insteas of prolonging the bleeding. Is like the manufacturing vs resources thread a few weeks ago. Either build cities in the tarocaust where I presume Mulcair died of terminal cancer, or be prepared to invest in manufacturing (including hightech “services”) where cities are now (assuming past efficiencies of locations still stand). But it seems like everytime I rationally criticize AB/petro/CPC the room goes silent. CPC can’t be efficient and greedy at the same time. When you give money to parasitic petro or neutral banks, you take away from researchers, from $5/day geniuses, from pretty much most future humans who will be hunting and gathering their way out of AGW…
Ian: if the A’s have permanently lower productivity than the B’s, then we would expect the A’s to have permanently lower real wages than the B’s. If, for some reason, the A’s insist on having the same real wages as the B’s, then the A’s will have a higher unemployment rate than the B’s.
Permanent fiscal transfers from the B’s to the A’s could offset the lower incomes of the A’s. Permanent fiscal subsidies to A’s employment, paid for by taxes on B’s employment, could also help offset lower real wages and/or higher unemployment for the A’s.
If there is a temporary shock to productivity, so that A’s productivity falls quickly relative to B’s, then maybe A’s wages can’t or won’t fall quickly enough to compensate and keep them competitive. In this case, giving A’s and B’s different monies, and devaluing the $A against the $B, could help. Devaluation can happen more quickly than nominal wage changes. But if there is a permanent difference in productivity, a permanent devaluation of the $A against the $B could only help if there is some sort of permanent money illusion, or permanent nominal wage stickiness. It’s like saying: “The Japanese need to have a Yen worth only one hundredth of a dollar, because Japanese productivity is only 1% of US productivity.”
Along the lines of several comments above, a “country” is a set of arrangements for, inter alia, generating and distributing the joint output of a group of people. This obviously requires a whole complex set of institutions, commitments, allegiances, accommodations etc. Taking these for granted, what might “shock” such a set of arrangements? Well, one things might be changes in access to external resources by one group; another might be a growing connection with other groups whose arrangements are very different. Easy to find examples of the first include, say, when landlords find it easier to get state military or political support (the tenants find their share diminishing. See also recent Western experience as state pressure has been brought to bear against unions). The second will pose choices about how far and how fast arrangements can be renegotiated. It will also be vulnerable to perceptions about the degree and permanence of the external support. So the shock might come when people see some change in the creditworthiness of the lenders or borrowers. The Greek (and Irish, Italian, Spanish) experiences have both flavours. It wasn’t Germany lending to Greece, it was some Germans (confident in the support of German arrangements) lending to Greeks (confident that German patrons would behave as Greek patrons) finding out that German arrangements are not Greek arrangements, and then trying to reach some new deal where other Germans, or other Greeks, or someone else entirely, paid for the damage.
Nick, those productive people and less productive people are all mixed up in your example. They don’t have balance of payments problem. If anything, the less productive people will earn less, but I don’t think that is the story. Productivity has everything to do with the society. Let’s take 1000 American laborers to some poor African country and let them work there. And let’s take 1000 of that country’s workers and let them work in America. You know what is going to happen to their productivity right? Sorry if this has been talked about in the comments already.
And you know you can’t have that kind of ‘equilibrium’ in EZ ever, or in any monetary zone.