Many good economists, like Simon Johnson and Paul Krugman for example, have said something about permanent productivity differentials and optimal currency areas I simply do not understand. (Lots of other people say the same thing, but when good economists say it and I don't understand it I get worried.) Maybe they are making some implicit assumption that I'm just missing. Or maybe I am misunderstanding what they are saying. Or maybe, just maybe, what they are saying doesn't make any sense.
{Update: Hmmm, on re-reading both those economists a third time, maybe they are saying something different from what the others are saying. But it's still not clear to me.)
This is what I think they are saying (I could be wrong):
If two countries have a permanent difference in productivity levels, (or a permanent difference in productivity growth rates, or do not converge in productivity over time), then that is one reason why those two countries do not belong in the same Optimal Currency Area. Unless there are fiscal transfers from the high productivity country to the low productivity country.
That's what doesn't make sense to me.
I understand why asymmetric shocks, including asymmetric shocks to productivity, are one reason why two countries do not belong in the same OCA. Because real exchange rates may need to adjust quickly in response to asymmetric shocks, and nominal wages and prices might be slow to adjust, and nominal exchange rates can adjust more quickly.
And I think I understand why fiscal transfers from the country experiencing temporarily high productivity to the country experiencing temporarily low productivity might help alleviate the problems a fixed exchange rate creates in the presence of those asymmetric shocks. Because fiscal transfers might mean the real exchange rate doesn't need to adjust as much in response to asymmetric shocks.
But I don't understand why the exchange rate regime matters for permanent productivity differentials. And so I don't understand why fiscal transfers would make the exchange rate regime matter less. You can't make something matter less if it doesn't matter at all.
Assume that Canadians are permanently only half as productive as Americans. Always have been and always will be. It's something in the water.
Does that mean it would be better to peg the exchange rate at 50 cents US rather than at par, just so that Canadians could feel good about having the same dollar incomes as Americans, even though we are getting paid in different dollars that are worth only half as much? Would it make any difference if our dollars were the same, but we only got paid half as many? I can't see why it should make any difference.
And sure it would be nice if the rich Americans gave us poor Canadians some fixed fraction of their income every year. But it would be equally nice whether we convert their dollars into the same number of Canadian dollars that were worth the same amount, or into twice as many Canadian dollars that were only worth half the amount.
Maybe, just maybe, there is indeed some sort of permanent money illusion, so that Canadians would insist on being paid the same as Americans only if we call our currency by the same name, even though we are only half as productive. So we suffer permanently higher unemployment that could be eliminated if we switched to calling our dollar after an aquatic bird so people stop making the comparison with American incomes. But if that's the case, maybe we should also pay lower productivity workers in cents, rather than in dollars, so they are satisfied getting the same million cents salary as those who get a million dollars.
I don't think this is what good economists like Simon Johnson and Paul Krugman would be assuming. There must be something else. Some other hidden (to me) assumption they are making. What is it?
Maybe they are assuming that permanent productivity differentials cause asymmetric shocks? That if the Greeks and Germans became equally productive then the Greeks would start building BMWs and the Germans would start growing olives, so that any shocks would hit both economies more equally? But if that's the case, then the relation between productivity and OCAs could go either way. That's because the main benefit of a common currency is that it's supposed to make trade easier, and if two countries became more alike they would tend to benefit less from trade.
Maybe there's some sort of link between permanent productivity differentials, balance of payments deficits, and exchange rate regimes? But I can't figure it out. The link between permanent productivity and the balance of payments isn't obvious, and the link between those two and the exchange rate regime is even less obvious.
Anyway. I just want to try to make sense of this argument. There are lots of other arguments against common currencies that do make sense to me. But this one doesn't. What am I missing?
[This post is an attempt to be clearer than I was in my previous post on the same subject, where lots of good commenters didn't get my point, which means I wasn't making it clearly enough.]
Worthwhile Canadian Initiative 
Christiaan: “I think your confusion is based on the fact that you ignore two important facts. One is that if two countries have a productivity differential, all other things equal, it’s not that the [real NR] exchange rate will settle at a level different from one, but rather will change at a rate different from zero.”
I edited your quote to add the word “real”, and adding that one word makes all the difference. First, while the level of the productivity differential may affect the level of the real exchange rate (a la Balassa-Samuelson, for example), I don’t see why it should affect the rate of change of the real exchange rate. But even if it does affect the rate of change of the real exchange rate, a small difference in inflation rates across the two countries could create that changing real exchange rate, just as easily as a slowly changing nominal exchange rate.
The problem with fixed nominal exchange rates is when the real exchange rate has to change quickly from one level to another, or change direction quickly from increasing to decreasing. Because price and wage levels, and inflation rates, cannot change quickly.
Of course, the whole question of this post is really about the long-run neutrality (and super-neutrality) of money, just under another guise. Just as the long run level of the money supply doesn’t matter for real variables, nor does the long run level of the nominal exchange rate. It’s the same thing. And if we are talking about permanent productivity differentials we are talking long run. But I carefully avoided the words “neutrality of money” because I knew if I said them it would bring all sorts of people and arguments out of the woodwork.
Damn! Now I just said those words!
Noquis: I read your post, and I disagree. Why should permanent productivity differentials cause a balance of payments deficit/surplus (why should the poor country always borrow from the rich?) and even if it does, why should flexible exchange rates help solve that?
But if you read BSEconomist’s and Simon van Norden’s comments above, you will see that they do in fact sketch out an explanation for why this might be so. Basically, differences in initial capital/labour ratios cause productivity differentials and also cause balance of payments deficits. And BP deficits have a tendency to do a “sudden stop”. And flexible exchange rates can handle the shock of that sudden stop better than fixed.
Theirs is a good and logical argument. I’m not 100% convinced, but it’s not implausible. But if their argument is correct, it means that only some sorts of permanent productivity differentials (those caused by different capital/labour ratios) preclude an OCA. Plus, what they are really saying is that two countries that have different natural rates of interest for whatever reason do not belong in an OCA. Their argument has nothing to do with productivity per se.
I’ll mention again the notion that permanent productivity differentials favour different regional policy preferences, which then generate the asymmetric response to general recession. Then one can invoke the standard OCA insight. No need to invoke exotic theories of capital crises.
Are there even any general theories relating financial crisis to OCA?
@Simon van Norden
Mundell recognized the tradeoff, not me. But all macroeconomic goals are political ones, ultimately, are they not?
I do wonder whether the element of labour mobility is less about resolving labour market disjunction and more about the propensity of each region toward nationalist separatism. Strong federal governments provide a safety valve, really, a la Rodrik’s trilemma – when jobs seem to flee across the border, one either champions stronger local policy or global regulation.
@Jon
As Lord points out, Germany will bail out German banks but not Greek banks. So there’s the imperfect capital market, since now capital is no longer treated identically.
In my opinion, the BSE/SvN argument, for why countries with permanent productivity differentials do not belong in the same OCA, is a good argument, and is the best I’ve seen. Now I’m going to get really picky, and dump on that argument.
1. The association between permanent productivity differentials and balance of payments deficits is weak, both empirically and theoretically. Differences in marginal returns to capital due to different capital/labour ratios are only one possible cause of permanent productivity differentials. And this is only one possible reason for running a current account deficit. It would be much better to say that countries which have differences between national savings and investment for whatever reason, so that one wants to borrow from the other, should not belong in the same OCA.
2. The theory of “sudden stops”, and their impact on the equilibrium real exchange rate, is only sketched. It may be that sudden stops do not always require the real exchange rate to depreciate quickly. It may be that sudden stops are only associated with certain types of balance of payments deficits, and that balance of payments deficits associated with permanent productivity differentials do not (for some reason) cause sudden stops.
Yes, I’m being picky.
All in all, a very good comment thread.
Hmmmmm. Why can’t there be a “sudden stop” inside a country, where the lenders all suddenly stop lending to the borrowers? Is a “sudden stop” just the cross-country equivalent to a “Minsky moment”? Is there something that monetary and/or fiscal authorities can do if a sudden stop happens inside one country that they can’t do if it happens between two countries with a common currency? Is this really just another way of saying that countries with a common currency have problems in creating a LOLR for national banks and governments?
Kathleen: Certainly the mechanism I talked about, with factors moving across regions, is part of standard Balassa-Sameulson modeling (which I had drummed into me as a young lad by one of Robert Mundell’s best students.)
“I think your confusion is based on the fact that you ignore two important facts. One is that if two countries have a productivity differential, all other things equal, it’s not that the exchange rate will settle at a level different from one, but rather will change at a rate different from zero. This is something you cannot of course do in a currency union.”
I do not understand these “facts.” I would have expected a relationship between productivity differentials and the level of the exchange rate, or between a productivity growth differential and the change in the exchange rate.
I also think that real exchange rates move in a currency union. But why believe me when you can check for yourself? (1) download the CPI (all items) for your favourite Canadian cities. (2) Calculate their ratios. Those are indices of real exchange rates between those cities. 😉
“Are there even any general theories relating financial crisis to OCA?”
Yes. No. It depends [I’m channelling my inner Nick this morning.]
I don’t think there’s a general theory on the break-up of currency unions just because they are usually broken up for political reasons (states disintegrate — think of the collapse of the Ottoman empire or the USSR.)
On the other hand, there’s a vast literature on the collapse of fixed exchange rate regimes (PK was perhaps the seminal modern contributor and I think it was mentioned by the Nobel Prize committee.) And the literature on the collapse of the gold standard is big enough that it could physically crush us all!
@Nick Rowe
This is true of many regions in unified nation-states with one currency, however. Structural industrial change and demographic shift happen all the time, with ensuing investment and disinvestment. One only has a problem when bets go wrong, politicians start arguing over who gets to realize the loss, and suddenly ancient nation boundaries become relevant as possible fracture points.
Maybe instead of an optimal currency area, we should call it an optimal banking insurance area.
David:
Yup, we’re all paying homage to/ripping off Robert A. Mundell (and his teachers and students.)
“…all macroeconomic goals are political ones, ultimately, are they not?”
Sure, but “political goal” is such a broad term it can include damn near anything!
“I do wonder….disjunction…propensity….trilemma….one champions…”
You write like a bureaucrat!
A mortal insult!
Nick;
“…the BSE/SvN argument, for why countries with permanent productivity differentials do not belong in the same OCA, is a good argument…”
1) You’re slipping a differential aren’t you? Because I think you mean a permanent productivity GROWTH differential.
2) I was trying to be positive, not normative. I tried to stop short of saying that they don’t belong in the same OCA. Instead, I suggested that it might make voters in one region quite upset. The frictionless long-run solution suggests that we maximize efficiency by transferring resources to the more productive region. Fiscal transfers help prevent that….and suddenly we’re talking about Harper’s EI reform.
Nick: “It would be much better to say that countries which have differences between national savings and investment for whatever reason, so that one wants to borrow from the other, should not belong in the same OCA.”
Now you’re making me think!
Okay, so here’s my model;
– Cities are filled with young folk who work.
– The countryside is filled with old, retired folk.
– Folks are net debtors when young and net creditors when retired.
– No productivity growth or shocks.
We’ll obviously want the countryside to run a trade deficit with the city (financed by all the interest payments they get on the capital account.)
Why is a common currency bad in this case?
Let me be clearer…..No productivity growth and no productivity shocks.
David: “A mortal insult!”
I was just making a positive observation, with no normative implications…. o:-)
Well, I don’t know really. Now I see te BS argument in Kathleen’s post a necesary condition to my argument. I’m truly confuse, because the (growing) diferencial between Spain and Germany is so evident, that I cannot see how they don’t play a role in this story
Sorry, me another time.
Perhaps it is necessary to introduce a higher saving rate in te more productive country. Al diferencial in productivity plus a diffrencial savings rate. All other things equal. I tihink that Saving tate diferencial is not sufficient condition.
Perhaps Johnson and Krugman make the assumption (which turned out to be true) that lenders would fail to factor the increased country risk (increased, because borrowers would not have the exchange rate instrument for dealing with shocks) and instead look only at lower exchange rate risk. This error led to excessive lending and permitted borrowing countries’ wage and price structures to get out of line with those of their currency union partners. With borrowers’ real exchange rates out of line and no way to adjust nominal exchange rates, lenders were in a bind. Likewise perhaps they assume that ECB woud fail to raise average Eurozone inflation to levels that would permit borrowers’ wage and price levels to slowly come back into line without big reductions in nominal wages and prices.
Really we are constantly bombarded with both argument: we (Spain) must save more and be more productive.. Both. Perhaps one is redundant?
There were certainly suddenly stops in the US predating the Fed, and I would be surprised if there wasn’t in the 30s though I haven’t looked at the pattern of bank failures then. Even a LOLR doesn’t assure they will act as one. Regional tensions, cross of gold speeches, quite a familiar scene, even to how much respect a “foreign” bank was due.
Paul Krugman’s latest on OCAs and the Euro is very good IMO. No mention of permanent productivity differentials in the list of problems. Fiscal transfers only help in the presence of asymmetric shocks.
For one of the preeminent market monetarist blogs in the econoblogosphere, why is there no mention of nominal GDP growth in this entire thread?
Productivity growth rate differentials matter because they can translate into nominal GDP growth rate differentials via Balassa-Samuelson and elastic aggregate demand curves. This then creates the pressures on exchange rates that gets translated into internal devaluation. As Scott often reminds us, “You decide whether a currency is under or overvalued by looking at whether aggregate demand is at an appropriate level.” And what measures aggregate demand? Nominal GDP. Note that this nominal GDP differential persists no matter what the central bank does. Because all the European states are bound by the same currency, there’s no way to effect a monetary contraction in some regions while expanding in others. Monetary policy can raise mean growth, but cannot selective expand and contract individual countries.
By refocusing on nominal GDP, a lot of the questions Nick and others are asking become much clearer. A permanent differential in productivity growth matters because it implies a permanent differential in NGDP growth, which causes pressures for an exchange rate to change. But because the euro pegs the exchange rates all together, the pressure manifests itself as internal devaluation, which carries very severe negative consequences on count of sticky wages/prices and safe asset shortages. A permanent differential in productivity levels doesn’t matter as much because if productivity growth rates are the same, there is no differential in nominal GDP.
Fiscal transfers work because they affect regional NGDP growth. Fiscal transfers are a crude way of “taking” aggregate demand in one region and putting it in another. But when one country has permanently higher real growth and nominal GDP growth, that country will be permanently paying transfers to the others. This is the political problem to which Krugman and Johnosn refer. These permanent NGDP differentials necessitate a one-sided transfer union, which we do not have. As a result, we see the painful process of internal devaluation in periphery countries.
A narrative in terms of nominal GDP also subsumes discussions about unit labor costs. By the New Keynesian business cycle model, lower nominal GDP growth rates arise because of higher real wages or labor costs. So the lower nominal GDP growth in the periphery raises the real wage, rendering the periphery uncompetitive. This is then a more concrete reason why internal devaluation is the only option in a world without transfers or national currencies. Unit labor (and capital) costs need to adjust.
I explicate on this topic a bit more on my personal blog here.
[edited to embed link NR]
Yichuan: welcome!
Suppose you agree that NGDPLPT is the best policy. (Not everyone does, and I wanted this post to be a more general discussion about productivity and OCAs). You want to NGDP growth rate to be constant. But does it really matter a lot what the precise number for that constant growth rate is (as long as it’s not far too low or far too high)?
If two roughly equal-sized countries shared a common currency, and one had 2% productivity growth, and the other had 1% productivity growth, and both had the same 2% population growth, then if the central bank were targeting 5% NGDP growth, one country would have 4% NGDP growth and the other would have 6% NGDP growth. (Roughly). No big deal?
“For one of the preeminent market monetarist blogs in the econoblogosphere, why is there no mention of nominal GDP growth in this entire thread?”
Yichuan,
You’re mistaken. I mentioned eurozone nominal GDP growth last night:
http://worthwhile.typepad.com/worthwhile_canadian_initi/2012/06/permanent-productivity-differentials-and-optimal-currency-areas.html?cid=6a00d83451688169e2016767cdc8e8970b#comment-6a00d83451688169e2016767cdc8e8970b
By the way, I’ve been reading your blog and recommended it to others at a recent post on NGDPLT at Economist’s View.
@Mark
I apologize for my oversight. I actually read your comment before writing my post, and I guess I should have been a bit more precise. My point was not that nominal GDP hadn’t been mentioned, but rather why hadn’t differentials in nominal GDP growth hadn’t been zeroed in on as a possible cause for currency imbalances. Your post seemed to be more of a general comment on the collapse in average nominal GDP, whereas what was intriguing me was why the variance in nominal GDP hadn’t been identified as a possible explanatory factor for why the Euro can’t stay together. Thanks for reading, and I appreciate the support!
@Nick
My point is really not about the efficacy of NGDPLT. My argument was that even in an ideal world of NGDPLT at a certain k percent (agreed that the percent is not that important), differentials in nominal GDP growth are still problematic. I like to think about this from a steady state situation, and then add a few shocks.
So we start with two equal sized economies, A and B, both with real growth of about 2% and inflation at 3%. They are governed by a central bank that controls the total money supply of the currency union. A positive shock to real growth rates kicks A up to 5% real growth and 2% inflation, while B stays put. The central bank, observing the increase in NGDP, contracts the money supply such that A is at 4.5% real growth, 1.5% inflation, while B falls down to 1.5% real growth and 2.5% inflation. B has now fallen into a recession, with all of the attendendant transition problems. Note that this shock doesn’t even have to be in different directions for different countries. Once a positive productivity shock hits one country, immediately we start having problems in differentials.
You assume that the economies start out from different real growth rates, so the differential in nominal GDP growth shouldn’t matter as much. But as soon as there’s a shock somewhere, the above steady state analysis still applies.
One possible adjustment mechanism is if B returns to its natural rate of 2% faster than A gets back to 5%. This way, the central bank tightens as B gets closer and closer to a higher nominal GDP growth rate, which lowers A back down closer to B. However, this is very unlikely as the higher productivity countries are usually the ones with more flexible labor markets that would permit the faster adjustment. If shocks were symmetric, there would also be less of a problem. But it also seems unlikely that Greece would get as many positive productivity shocks in its service industries as Germany would with its high end manufacturing.
In a sense, a lot of the problem arises from adjusting to the productivity differential and then adjusting to the different nominal growth rate. But in a world of highly leveraged banks and sovereigns with large debt burdens, these nominal readjustments can have highly non-linear effects. This is a large reason why a robust system of transfers is important, as they can readjust as soon as the productivity shocks hit and then raise expectations of future nominal growth in the lower productivity areas. As we can see from Europe, large mosaics of heterogeneous economies bound by one currency are highly fragile, and transfers go a long way torwards protecting against those fragilities.
This is not hard.
If exchange rates float, a country’s consumption will eventually always be brought in line with its production.
If the exchange rate is fixed, or abolished, one country’s consumption can rise while another one falls. Greeks buy more stuff than they make. They buy it from Germans, who sell them stuff. They use the money to buy Greek debt. The private sector no longer does this, so Germany et al now lend public money through various bailout schemes. They’ll have keep doing this as long as the production/consumption gap persists. The ‘crisis’ is the simple fact that this is necessary.
The EU has been trying to get Greeks to consume less, by cutting government spending, laying off workers etc. However, this also makes them produce less, since a laid-off worker is not productive (strange how that sounds).
The Germans have some vague ideas to raise production, which they call “structural reforms”, but frankly I doubt any of these will work in the short term.
Krugman et al are saying that, as long as it stays in the eurozone, Greece must be provided with the extra cash to consume more than it produces, and it makes more sense to give it rather than lend it, as it’s spent on German goods anyway.
In Canada, Northern Ontario produces less than Southern Ontario, because of long-term structural and geographical factors. The Ontario government does not lecture the region about “structural reforms”. It provides the north with extra cash, in the form of public services, which are mostly handed out per head of population, not per unit of per capita income. We don’t often hear southerners complain about lazy northerners; they’re our people and we provide them the schools, hospitals, etc. they need. Germans, however, don’t think of Greeks as their countrymen. Hence largely mythical stories about Greeks retiring at 50 that dominate German tabloids.
If Germans aren’t willing to do fiscal transfers, they should let Greece exit the euro. Then Greek consumption will fall to match production, as the drachma price of everything will rise sharply. There is no easy way to do this.
It is both a strange and a funny feeling when I see you all talking about “productivity differentials”.
I had yesterday promised a “Ordnungspolitik view” and “determinant” already knew that it is wrong, before I spent a single word on it : – ).
Then I thought I first try to describe a little bit the reality outside, and then come back to what different models of the world (Krugman, Ordnungspolitik) have to say about it.
Then I realized that maybe your “reality” is actually different from mine, with respect to what we talk about here.
And then I was coming back to the fundamentals of the western productivity revolution.
First, if somebody is able to produce 2 bushels of wheat instead of 1, with the same input and some “new technology” (like slaves, cough, in the Roman case), then his productivity goes UP, but for the normal farmer next door, he gets his “PRODUCTIVITY DOWN”, because of the price drop due to the competition. Productivity is measured in DOLLAR / hour, and not bushels or gallons (of beer : -) per hour.
This is the very basis of all western progress, produce something cheaper than before, and that means that the traditional is LOOSING, to the benefit of the customer.
That way we shrank our agricultural workforce from 80 % to 1% in the last 200 years (2% relative per year, this number is actually very typical for “productivity change per input”), outputting of textiles and related, textiles during the 60ties, coal in the 80ties, porcellaine in the 80ties, a lot of manufacturing in the 90ties.
During this process, both employers and employees always have the choice to accept shrinking wages (or nominally stagnant, with 2´% inflation), shrinking (zero) profit margin. Or to call it quits, when some significantly better alternatives arises. Nothing new under the sun.
In areas, (and those are only loosely correlated to currency / state boundaries !!) via the so called Ballasa- Samuelson effect wages rise (typical correlation around 0.5), somebody earning 100k is more willing to pay 20 for a haircut, than somebody earning 20k. That can lead to the “dutch disease” making other industries uncompetitive, because of wages too high.
And I think the “greek disease” is, that the state and state / union controlled companies have a way too large share, and with endless EU subsidizes, debt financed just destroyed, not only hampered their private sector, resulting in the dismal export fraction. Paying fantasy wages.
Now, finally coming to the more detailed present day reality (in my place) and the overarching Ordnungspolitik.
Reality:
In Germany we have 489 “tariff contracts”, regulating wages and conditions across 16 “Länder” and about 14 business sectors (metal, chemistry, construction, baking, public service, you get the idea)
Entry level wages in the baking industry can vary between 8.05 (NRW) and 11.92 (BY), that means 48% difference.
In the metal industry, (ERA EG5, other levels look very similar, I was not “data mining”) base wages can vary from 2835 per month in Osnabrück / Emsland to 2167 (NRW) (31% difference in adjacent highly populated regions !!)
In Dresden the wage level in semiconductors did vary by 20 % between 2 factories just 1 mile apart.
In good years people get a 10 – 20 % profit sharing, in bad years none. In very bad years (2009) wages are cut 10 % (Kurzarbeit)
When I buy the exact same kind of canned tomato from the same grocery chain (LIDL)in Dresden the price is cheaper by 30 % compared to north Italy (and that is typical, and not just for tomato, although the tomato are surely not from Germany, canning can be done everywhere, and transport costs are negligible (maybe 2%).
Bottomline, in reality:
There is no “law of one price”,
no “law of one wage”, they vary from local region to adjacent, within 1 mile, from year to year, from business sector to business sector, with age and experience.
Industries, which are dying, first reduce wages, then the most unprofitable companies die, one after the other, until usually only some token remains, which can sell at fantasy prices to a few aficionados. That is the way of life, and the very core of the western productivity revolution.
In all this, there is NO need nor use for the interference of the Government, the Central bank, all kind of Europe agencies, or the usual do-gooders and busy bodies at IMF, worldbank, BIS, OECD.
Greece has got humongous subsidies over the last 30 years (20 Marshall plans) , and is the poster boy that this primarily provides a massive moral hazard to develop a deeply parasitic mindset, this sense of entitlement to permanently feed on other people.
In (my) reality all this silly (Paul Krugman and acolytes) hyper simplified theories have no relevance. Borders, currencies, OCA do not appear (significantly). People make all the time their own choices, which very often include a lot more than just a wage (level). There is neither need nor room for reality distorting transfers. Prices and wages, and their differences direct people to more profitable / amicable alternatives. Period.
Funny stuff like NGDP ? Why on earth should real GDP grow just to a simple exponential fit curve? What use has some artificial number like NGDP?
Real economicy is an eternal up and down. For Germany, when the Chinese decide, they don’t need as much shiny german production machines or BMW, first we reduce overtime, no bonus this year, use up Arbeitszeitkonten, do not increase wages, do not hire new workers, do Kurzarbeit (including training workers on new stuff), layoff temp workers, find new business fields, lay off “Stammarbeiter” , close a whole factory, …..
We have been through this in varying degrees, several times. That is live !
Nick,
since I think Krugman is 100 % garbage, since ever completely removed from reality,
and eaten up by the typical physics envy,
how about you come up with some piece from Krugman, you think has relevance for predicting or at least understanding reality, and explain your good opinion about Krugman in a few sentences?
genauer :
Here’s one contribution.
“Krugman has also made important contributions to the analysis of international monetary
economics. A framework of analysis that set a new standard in the study of currency crises
was proposed in Krugman (1979b). Here, he assumed that a government is trying to maintain 18
a fixed exchange rate despite some fundamental imbalance (for instance, the country has a
higher long-run inflation rate as compared to the rest of the world) that makes such a peg
impossible to maintain in the long run. By buying and selling currency in large amounts, the
government can maintain the fixed exchange rate in the short run. Krugman analyzed how
the expected future depletion of the government’s currency reserve would be taken into
account by rational investors, so as to ignite a speculative, early attack on the country’s
currency. Krugman’s simple model captured the essential mechanism of currency crises in a
way that has inspired considerable later research.”
You can find the original at http://www.nobelprize.org/nobel_prizes/economics/laureates/2008/advanced-economicsciences2008.pdf
I expect there were those against the euro and if they had prevailed they would probably be better off now, but having it, must face the problems it created. The question is not how much aid will be given to the periphery, but how much private creditors will be bailed out by their governments, both of which are in the core. If creditor bailouts are not desired, it is really necessary to prevent them from getting into trouble in the first place. The only other possibility is to let the first creditors fail and bailout the the second, otherwise the economy implodes with debt, deflation, and default.
If California, Massachusetts, and New York have permanent productivity advantages over Mississippi and Alabama, why does our currency area work better than the Eurozone? Because of fiscal transfers and actual (as opposed to nominal) labor mobility.
For most of the history of the euro, interest rates for the debtor countries were 4% below the Taylor rule. People borrowed a lot of this free money and given the limits to productive investment, a lot of it went into asset inflation. The countries assumed a great deal of debt (counting individual, corporate and national together).
Worse, European banking rules allowed the banks to treat all sovereign debt as riskless. Since the returns were somewhat better for the debtor countries, banks bought lots of their debt, which caused the rates to converge, so government borrowing was very cheap.
Large quantities of debt make a country vulnerable to speculation against its bonds, and 2007-2008 made investors very skittish. The problems in Greece supplied a shock, and the long default drama gave the contagion time to spread. The ECB did little to stop this, and here we are.
It really isn’t about productivity. Only Portugal is suffering from low productivity, and I see no reason that would have been a problem with suitable monetary policy. The ECB, however, was setting rates according to the needs of Germany, which was in recession after the dotcom crash.
Greece’s problems involve social and political issues, rather than productivity. The productivity that is needed is in tax collection and government administration, For instance the lack of reliable correct public records of land title is a drag on investment.
Italy has had problems for years, but they were under control (by Italian standards) and finances looked relatively good until their debt came under attack.
In all cases the weakness of the banks has worsened the problem, and this weakness isn’t confined to the debtor countries. It’s not clear where the enormous sums needed to recapitalize the banks are going to come from, and the sovereigns and their banks are joined at the hip (Spain, Ireland, Belgium…).
So the real issue isn’t productivity. It’s bad monetary policy and worse bank regulation. Recapitalization will take trillions of euros, and the ECB balance sheet is enormous and packed with questionable assets.
I think their argument is less to do with permanent productivity differences, and more to do with permanent societal/cultural/language/population differences that make them more prone to asymmetric economic shocks.
Greece will always speak Greek, and Germany will always speak German. Probably.
And it’s more than that. Even regions that are relatively similar will have asymmetric shocks from time to time and would need proper transfers in a shared currency union. Look at Florida and its housing bubble, for example.
genauer,
You wrote:
“What use has some artificial number like NGDP?”
If anything it is RGDP that is the artificial number. NGDP is simply current dollar (or euro or yen or pound etc.) GDP.
RGDP is derived from NGDP by estimating aggregate price level changes, which are always problematic, especially given changes and innovations in technology.
In defence of Krugman:
This is why I listen to Krugman. He’s right.
Demand collapse? Well, there was this avionics manufacturer in my home town I worked for in the summer of 2004. I wanted to go back there. (leaving aside their weirdness in 2005). I checked their website. It was stale, all the jobs were from 2010 and closed in 2010. Little unprofessional, that. Then I checked the local newspaper website. Their main US customer had disappeared in the Crash of 2008, then the firm laid of 1/3 of its 200 person staff and still hasn’t recovered. That explains the stale website.
Further to the demand collapse idea, I attended an interview in 2008 a three hour drive from my home. The interview ended with “We like you, we’d like to hire you, but our customers don’t have any bank credit anymore (customers overseas) and have cancelled their orders. We can’t hire you.” They gave me gas money as a gesture of apology.
The Great Recession was transmitted to Canada through the Export deterioration. It surely exists. That’s why I agree with everything Paul Krugman says. He accurately described the reality I have observed.
Nick and Stephen’s views (sorry Stephen, but I honestly disagree with your conclusions) do not reflect the reality I have observed. This is why I’m the resident Lefty.
cough cough
Simon
Your Krugman 1979b Paper:
Short form:
It is the classical Krugman 4 step process:
a) Stating the obvious
b) Making many (mostly hilarious or at least questionable) assumptions
c) Derive some “result” from the assumptions equations
d) Never ever compare to any reality and make sure that the “result” is not testable / falsifiable by real world testing
Works like a charm, so many people fall for this anti-science approach.
Long form:
a) It is first stating the obvious.
If your exchange rate is mismatched and you therefore run a current account deficit, (the opposite case is called bad mercantilism, and is buuh, bääh) and when your accessible foreign reserves are used up, you can’t pay anymore for imports. Bang.
That’s why you have flexible exchange rates since the end of Bretton Woods, because certain countries (erm, like the US) were not able or willing to keep their inflation under control.
That is why some folks like TE “The economist” follow those numbers since many, many years:
http://www.economist.com/markets-data
and therein http://www.economist.com/node/21557357
This was certainly not new at this time.
When this game is drawing to an end, it obviously invites speculators to sell overvalued currency, to make a profit, and to profit faster, the faster the game comes to an end.
Wow, who would have thought that.
b) Strange assumptions, drawn from thin air
Then Krugman makes a couple of completely false assumptions:
Zero nominal interest
Total real wealth just consists of domestic and foreign money (typically this is first real estate, second stock, third long term financial invest, and only fourth cash (equivalent)
“Under a flexible rate regime, since neither the govemment nor foreigners will trade domestic money for foreign, there is no way for domestic residents to alter the composition of their aggregate portfolio” Harumph ? The volume of international foreign exchange dwarfs everything else!
“A convenient, if somewhat artificial, assumption is that the govemment adjusts its expenditure so as to keep the deficit a constant fraction of the money supply “ The problem is, that they don’t control their expenditures until brutally forced by the markets.
And so it goes on and on …..
Any evidence ever to the inputs? Of course not, a Krugman doenst need reality.
c) plays with some equations
more strange assumptions: “private savings is in tum a function of private wealth, with dS/dW= – C2 < 0”
well , Simon, what would you see as a “result” of the equations gymnastic ?
d) does Krugman every compare to real world data ?
do you know anybody who ever tried to make this paper comparable to any kind of real world data ?
@ all professors here at WCI
Just show me one Krugman paper, you think has any positive value, and explain in a few sentences, why you believe that
@Mayson
Mentionable transfers to Texas came only long after the civil war, establish firm federal control over the states.
Germany has always stated that if there would be effective financial central control, one could talk about many things, but not before.
Too much “labor mobility” in Europe would be actually very bad. The folks, who are moving are the highly paid, active, intelligent, taking their taxability with them and the remainder are the brooding masses. This is actually one of my long term fears. IQ differences are already now up to 10 points.
See for example Florida “the creative class”
@Peter N
We don’t believe in Taylor rules. Inflation targeting only, please, we are Germans.
“It really isn’t about productivity”
Right ! it is all about lacking adaption processes in these countries.
@Peter N second part
“The ECB, however, was setting rates according to the needs of Germany, which was in recession after the dotcom crash.”
False, first the dot-com “NeuerMarkt” was end of 1999 about 5% of GDP or 1.5 % of wealth, something within the noise of yearly change, irrelevant for developments in Germany.
Second the Mandate of the ECB was for Euroland HICP, which includes of course Germany. If the ECB would cater to German interests, Rates would be at 4 -5 % by now.
Banks are always as good as the government standing ultimately behind them.
There is no reason that everybody else bailed out there own banks, but Spain gets some extra favour (barely hidden transaction)
genauer;
Just a short note on some of your remarks on Krugman (1979).
A) Yes, it is obvious. It is the statement of the situation he seeks to analyse. Did you think someone was claiming otherwise?
B) Krugman, like many good modellers (Lucas, Sargent, Samuelson, Solow, to name a few) presents highly simplified models. These strip away much that is inessential to make a specific point. Yes, many of the assumptions are false. In fact, all economic models are false. However, some are useful.
C) You’re probably the first and last person to complain that Krugman is too mathematical.
D) “Do you know anybody who ever tried to make this paper comparable to any kind of real world data ?” Yes. Perhaps if you used the internet, you could find some too.
“@ all professors here at WCI
Just show me one Krugman paper, you think has any positive value, and explain in a few sentences, why you believe that.”
I think my previous quotation from the Nobel prize committee did just that. If you followed the link in my previous post, you would find more of Krugman’s work that the committee cites. (Yes, the committee is made of professors.) They also explain, briefly, why it is valuable. Actually, they explain it twice; once for economists and once in non-technical language.
If you want more, why not read Robert Feenstra’s appreciation (http://www.econ.ucdavis.edu/faculty/fzfeens/pdf/Paul%20Krugman_2008%20Nobel%20Prize.pdf)
The Nobel Prize committee also mention his textbook (with M. Òbstfeld), “International Economics: theory and policy”, 8th edition, Pearson. 712 pp.
Simon,
what please is the specific point Krugman makes in this paper ?
I have no problems with way more specific math (I am a PhD phycisist with perfect grades in theory, and the max education in “numerik” as we called it..
The point is that his math has no value, because it builts on arbitrary and strange assumptions. There is tremendously more to science than just being able to play with equations.
Your point D) is a cheap copout: “just search the internet” I did not expect such a thing from you.
When I read Krugman 1979a, it is the same reality denying Glasperlenspiel, thats why I asked the WCI professors, where the supposed nugget is there.
the nobel comitee statement is just a lot of general vague statements, a (presumable) good textbook is certainly not relevant for a nobel prize
“The point is that his math has no value, because it builts on arbitrary and strange assumptions”
Yes. It is math. One could argue that all math builds on arbitrary and strange assumptions. When we apply mathematics to the real world, we often find that our models are simpler than the real world. I’m not sure why this upsets you so. I’m not sure why you feel this is Krugman’s fault.
It’s a shame that the various resources I’ve mentioned to you have not satisfied your thirst for knowledge.
@ Simon
The Robert Feenstra Eulogy.
I read this obviously with very different eyes.
This is Feenstra’s eulogy to his admired academic teacher, or in more rude words, a shameless (white) lie. Including the eternal self grandeur of pure macro economy theoreticians taking themselves way too important, especially while ignoring reality.
Just a few examples:
That economic integration with the sole neighbor USA is beneficial for Canada with a 2500 mile border and 75 % of the population living less than 100 miles away from that border, is a non-brainer. You don’t need a little abstract paper for understanding that. The question is more, why it took until 1992 to formalize this.
Many countries outside the western world, like Latin America, India, China tried to develop their own industry by systematically shutting out western imports with at least stiff tariffs.
Central Europe chose a different path by systematically integrating the markets, gaining economy of scales. Montan Union ca 1950, EFTA 1960, EEC ca 1970 (somewhat dependent on your viewpoint)
Did this hurt the smaller countries, like Dutch, Danes, Belgium? I don’t think so. I think it is common sense, that this helped a lot in countries like Ireland, Spain, Portugal, Italy to catch up.
When “Nixon went to China” in 1975 this was also the key Marker, that China realized that this technology autarchy is bitterly failed, long before any Krugman. Other countries needed a little longer for that.
GATT started in 1948, Kennedy round, Tokyo round 1973, all this without any Krugman.
And that the US just 40 years later realized, that being also formally nice to its neighbors Mexico and Canada, and to form a NAFTA 30 years after the EFTA, is then evidence for Feenstra, that this has anything to do with Krugman.
Big stretch in my view.
The same goes for the other claims. Regional concentration of economic activity around centers. Sure an interesting topic. But if you look at what Krugman did, and ask what is new, and you always end up with these “results” which are uncomparable to reality, where people 20 years later write in an NBER paper, that after mangling the data substantially, they get at least, for the first time the sign of the effect right ? What is this?
How terms of trade and exchange rates influence current account flows? An important question, with assets scattered across the world. After I figured that out, roughly for myself (http://www.slideshare.net/genauer/currencies) I realized “silly me” there have to be papers out there for that, stumbled upon Fleming Mundell, who Krugman is careful not to cite in his books, and then there should be the famous Krugman. I looked at the paper, and thought, what do I learn from that, with respect to reality. Nothing.
Maybe there is something out there, which I just overlook. But to find this, I would need somebody who actually read those papers, understood them, and can explain / defend them, talk back, react to questions, like a WCI professor, and not just like a dead bone left over from some anonymous comitee.
Why is it that pseudononymous blog commenters who can’t spell so often have PhDs in physics?
(Muphry’s Law strikes again!)
because they got away with broken english in physics and engineering : – )
how about your spelling (Muphry’s), while typing away? And a lot less than me : – )
Or excessive flexibility in Germany.
genauer,
I spelled Muphry’s Law correctly. It was ‘pseudonymous’ I got wrong, in a confirming instance of Muphry’s Law.
To make sense of your criticism of Krugman’s Nobel, it might clarify things if you told us which other recipients were undeserving in your view and/or which ones truly earned their gongs. Or you could say who should have got one and didn’t.
Kevin,
interesting thing with the Muphry.
my question was not, does Krugman deserve the Nobel,
What I was asking for, is that somebody who is qualified to talk back, shows me one Krugman paper, and tells me why that specific paper has merit.
And I would very much like to stick with that. Therefore it is with great hesitance that I say I like Modigliani, and as much as I like Hayeks “The road to serfdom”, I wondered about his Nobel. But again, I dont want to discuss Nobel prices, but Krugman papers.
and …… what is the name of the other physicist here around?