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- there is permanent Club Med,
- and this will cause relative political instability,
- and this instability will increase the variance of ideal exchange rates,
- and therefore the costs of not having a flexible exchange rate vis a vis their major trade partners increase

It only makes sense if you interpret 'uncompetitiveness' to refer to other reasons besides low productivity for why a country might be considered hostile to business...

You remembered the conversation we had on neutrality quite a while ago! =]

You're right of course. You can also see this as an implication of the Balassa-Samuelson effect: equilibrium real prices are systematically higher in high-productivity regions, compared to low-productivity ones. (This holds both across countries and for differing regions within a single country, e.g. capital city v. rural areas.) This suggests that the real exchange rate does adjust in the long run to offset differing productivity. (It may not adjust effectively over short-run fluctuations; if a region has idiosyncratic business cycles or fluctuations in productivity, then they will probably benefit from a separate currency. But that's not the same as being consistently less productive.)

Nick, when you talk about these issues what model do you have in mind? the standard optimal currency area model (http://homepage.ntlworld.com/peter.micklem/euro/OCAs.htm) seems to me that it doesn't include the factors one hears about more often: financial flows and money itself.

What's the best way to think about this?

PD: an alternative view could be proposed by chartists, I presume. starting from the fact that money is a creature of the state.


"(I have a memory like a sieve, but I don't think I'm making that up, am I? Anyone got good examples?)"

"Saving Imbalances and the Euro Area Sovereign Debt Crisis"

... recent article and its from the Fed.

** I meant chartalists


When Argentina broke the peso-dollar link in January, 2002, the country saw a marked real devaluation and an increase in GDP. Yes, there was deeper problems such as fiscal federalism and corruption, but the currency board made it all the more challenging for Argentina to cope with its problems. The US dollar, to which it was linked, appreciated over the mid-to-late 1990s while its main trading partners (Brazil, Eurozone) saw their currencies depreciation against the Argentine peso. In the case of Brazil, it had a massive real appreciation in 1998-1999. So the currency board was choking Argentina by the late 1990s.

Now having its own currency hasn't fixed Argentina's underlying structural problems, but its real growth did accelerate for several years after the break up of the currency board. The point is that importing the wrong monetary policy can make a bad situation worse, at least for some time. I think that is argument I have made for the Eurozone.

I think another issue is that when we talk abut non-neutrality of money we do so for a given monetary shock. But what if there are multiple monetary shocks? Thus, the Eurozone periphery got a series of positive monetary shocks when the currency union was formed (i.e. monetary policy more appropriate for sluggish core than hot periphery) and now has been hit with a series of negative monetary shocks with crisis of the past few years. This non-neutral effect of these shocks build on themselves.

"All I hear is that the Club Med countries need permanently looser monetary policy to let them stay competitive in international markets. Which doesn't make any sense."

I broadly agree, but let me play devil's advocate. Suppose a country has a long history of buying off labour unrest by granting inflationary pay increases. In steady state, this country has high inflation, high nominal interest rates and a currency which depreciates steadily. Then along come a bunch of know-nothing Eurocrats, who say: if you can just keep a lid on inflation for a few years we'll let you join a monetary union with Germany. You'll have much lower interest rates and your economy will bloom! You don't have to picture the sequel. You're looking at it.

The moral is that changing the monetary regime doesn't change attitudes anything like as quickly as freshwater economists would have you believe. In a way, it's a replay of the early 1980s. Volcker and Thatcher announced that they were going to get inflation under control. And by God they did! But it took some pain -- pain which a freshwater economist would not have foreseen.

Nick: Like you say, inflation is a tax on money (as is growth). At equilibrium you can think of it as nominal rates being a tax on money. When nominal rates are low, the low cost of getting money produces a large expansion of credit and the money supply. As the system becomes more and more leveraged it becomes increasingly unstable and requires increasingly sophisticated and disciplined regulation and risk controls.  Some countries may be more or less successful at managing such an economy than others. But the risks are big, and the downsides of a crash with high amounts of nominal liabilities can be very high as we have seen. I think it makes sense that some countries run higher inflation with higher rates than others.

I think I just figured out a common misperception. Some people say that easy monetary policy was the original cause of our current troubles. What they really mean is that we had historically low nominal rates, but they are wrong to describe it as easy given that inflation was well contained. What they really should be saying is that equilibrium low inflation caused an unstable accumulation of debt/money. Equilibrium high (e.g. 4-5%) inflation is safer.

Kevin Donoghue,

That's true if we're talking about the standard modern freshwater economist. Friedman, on the other hand, was always keen to say things like that the pain of disinflation came first and the benefits later (and, vice versa, the benefits of expanding the money supply come first and the costs later). That was also why he opposed, at least in the case of the US, a "shock therapy" approach.

Funnily enough, the "short-run non-neutral, long-run neutral" position used to just be called "monetarism", IIRC...

your point about neutrality pertains to the general price level. But when you think of the exchange rate as a relative price, and not just ANY relative price, but THE relative price that relates domestic costs to international prices, the general price level is not what really matters.

Of course, as a relative price, the exchange rate (and it's evolution in time) reflects the relative evolution of Spain's productivity (and it's concomitant domestic costs) relative to those of Germany. Now, I don't need to think that Spain's productivity (or its growth rate) is always lower than that of Germany. All I need to assume is that they are no correlated. Once they diverge (and it could even be the case that Spain's productivity grows faster than Germany's) the exchange rate has to adjust relative to all other domestic prices. If you don't adjust the exchange rate (either because of a currency board, or a monetary union) then you lose one degree of freedom. Hence, I'd rather have my own currency and allow it to freely move reflecting productivity growth differentials, instead of committing to an exchange rate that might not be realistic at some no so distant future.

So here let's assume that Greek productivity is the same as French productivity but for whatever reason Greek inflation accelerates because they are more willing to take on debt. (Is this right? I think that's what basically happened.) Now Greece finds out their investments were bad and have to default, at the same time their wages are uncompetitive -- their current account would likely be reflecting their non-competitiveness as a deficit. Pre-Euro they would default on the stealth by devaluing, with everyone taking a pay cut across the board in terms of trade terms. But much of their costs are based on locally-paid labour so in terms of PPP the adjustment is muted. Post-Euro, the only way of defaulting is bond haircuts and falling wages that are notoriously sticky -- we get unemployment and a lack of demand leading to deflation which is much more painful. The difference, then, pre and post, is how fast the band aid is pulled. Greece is woefully uncompetitive because of sticky wages.

Is this correct? I don't think a currency union with productivity gaps is the problem, look even at disparity between states in the US or even between provinces in Canada. The problem is how to resolve bad debts and the fastest way is through currency revaluation.

1) Labor mobility and a central treasury. You don't have that in Europe.

2) I can look at US states or Canadian provinces, but what I can't look at is at the counterfactual of how individual states or provinces would fare WITH exchange rate flexibility and WITHOUT a central treasury. That didn't historically happen so we can only guess what were the costs and benefits for each province for joining a federation.

3) Now, if Germans are willing to pay European taxes to be spent in Europe (and not necessarily in Germany), just as Californians don't have the slightest clue where in the US they federal taxes are spent, the monetary union might work, just with Greece being the European Alabama to Europe's California.

"all believe inflation is a bad thing."

I can give you a real-life example of the problems with higher inflation that can provide some justification for this "belief". Imagine you are a manufacturer and you build widgets. You require whatzits to build the widgets and have sourced a supplier of whatzits. The supplier sells based on his fixed and variable costs -- building, labour, input costs, -- and margin, and gives a quotation, which is valid for a certain amount of time, which I accept. I sell my widgets using a similar model to customers.

Our costs will go up a bit with a small amount of inflation -- wages and maintenance will go up a bit ahead of inflation due to wage growth. As the whatzit supplier gets better at making whatzits by improving productivity, his production costs will go down to offset this inflation. Generally he won't have to re-negotiate pricing for a while, if ever. I've seen this in my line of work where the price of a part won't change all that much over time. Tooling gets amortized, processes optimized, and new manufacturing methods are discovered that all manage to produce more whatzits.

Contrasting a high inflation environment, this goes all to pot. The supplier has to continually renegotiate rates because his costs are going up faster than productivity is improving and it adds a whole new layer of uncertainty and overhead trying to renegotiate pricing all the way up and down the supply chain and people get justifiably nervous. The "inflation expectations" is much more than confidence, it's looking at the bottom line on business balance sheets.

So in my view, coming at it from this side, there is a big difference between 2% inflation and even 5% inflation in terms of operations management and stability of supply chains. It's way simpler to fix a price and ride the productivity train than the alternative and the implications of leaving this comfort zone should not be underestimated. This ignores currency differences, of course, but that's another issue; we can look at a solely Canadian-based supply chain to see the inherent problems with inflation markedly higher than productivity growth.

Pablo: "so we can only guess what were the costs and benefits for each province for joining a federation"

We do have the example of Newfoundland but I don't know how applicable it is in this context. Newfoundland has a large out-migration.

Labour mobility is a big difference but I think a significant effect would happen over years, not months. Perhaps here Quebec is a more apt example -- is labour mobility in and out of Quebec that high? Without getting too political, Canada provides some interesting parallels between what a sustainable currency union between Germany and Greece would look like. And, frankly, I don't think it would be palatable in the long run for those who haven't grown up with it.

"That's a problem (by assumption). But can having your own currency help alleviate the symptoms of that problem? "

Sure. The less developed countries do not have well-developed bond markets. Actually, almost no one has deep private sector bond markets. That is the purview of a handful of rich countries.

Everyone else uses bank loans to finance capital investment, and bank interest rates are set administratively.

A common development technique is to have low real rates to support a less productive capital stock, and this leads to higher levels of inflation.

Low real rates are a tax on consumption and a subsidy to investment, and this is an easy way for less productive nations to try to compete with more productive nations. If they didn't do this, they would see large capital outflows.

If you are less productive, then you have a real problem. There are many ways of trying to deal with this problem -- capital controls, export subsidies, forex currency intervention, import tariffs, low interest rates for domestic investment.

The last of these is often the easiest to do without incurring the wrath of the global financial police (e.g. the IMF/World Bank).

@W. Peden,
I quite agree. Friedman wasn't freshwater. In Hall's classification -- "Sargent corresponds to distilled water, Lucas to Lake Michigan, Feldstein to the Charles River above the dam, Modigliani to the Charles below the dam" -- I guess Friedman was closer to Feldstein than to Lucas.

rsj: A common development technique is to have low real rates to support a less productive capital stock, and this leads to higher levels of inflation"

Except that you can't set the equilibrium real rate. If you set the real rate low you don't get "high" inflation; you get runaway inflation, which sucks as a development technique. If you manage to contain inflation at a high level you may indeed get an equilibrium lower real rate. But only because high inflation is increasing risk premia and damaging the productive potential of the economy. I think that preventing excess leverage is the only good justification (even then there are better ways) for running high levels of inflation.

david: your argument makes sense. But I see it as a variant on the "asymmetric shocks" argument in optimal currency area theory. Which is valid given short run non-neutrality. Just that the shocks are political.

Niklas: sometimes my memory works, and other times it doesn't.

anon: Agreed, but I sort of see it the other way around. Models of the Balassa Samuelson effect are usually either barter models, or models where money is neutral.

JCE: any open economy macro model which had long run neutrality of money would work for my argument. ISLMBP with vertical LRAS would be fine.

Ramanan: thanks. Yes, any argument saying they need their own currency because of permanent savings imbalances is equally problematic.

David: the Argentina case has always been a bit of a puzzle to me. The immediate cause of the breakdown is not a puzzle. Asymmetric shock with fixed exchange rates plus no lender of last resort is a recipe for disaster. But the long real appreciation in the years leading up to that crisis is more of a puzzle. Self-fullfilling currency crisis model? Only here its output prices and wages that keep rising, because they expect the peg to break, and because P and W keep rising, the peg does break???

Kevin: I'm trying to figure out the underlying model you have in mind there. Vertical LR Phillips Curve? But with a lot of very long-lasting underlying inflation inertia, which was only temporarily suppressed to join the Euro? Maybe.

K: if inflation (and high nominal interest rates) is a tax on currency, you would expect to see higher inflation leading to a bigger banking sector, since banks produce a product (chequing accounts) that is a substitute for currency.

W. Peden: "Funnily enough, the "short-run non-neutral, long-run neutral" position used to just be called "monetarism", IIRC..."

Yep. I remember that too. It was highly controversial when Milton Friedman said it. 20 years later it became part of the New Keynesian mainstream, and "monetarism" now meant "that old false doctrine that said follow a k% rule for the money supply".

Pablo: "your point about neutrality pertains to the general price level. But when you think of the exchange rate as a relative price, and not just ANY relative price, but THE relative price that relates domestic costs to international prices, the general price level is not what really matters."

The *nominal* exchange rate is the relative price of one money in terms of another money. The *real* exchange rate is the relative price of one country's goods in terms of another country's goods. If Canada measures meat in kg, and the US measures meat in pounds, then 2.2 pounds per kg is the nominal exchange rate. But if Canada devalues the kg by a factor of 10, the nominal exchange rate would now be 0.22 pounds per kg, but the price of Canadian meat would now be 10 times as much per kg, so the relative cost of a side of Canadian and US beef would be unaffected.

"Except that you can't set the equilibrium real rate. If you set the real rate low you don't get "high" inflation; you get runaway inflation, which sucks as a development technique."

I would say that this is true only in certain "knife-edge" models. It is not true in the real world. Not even close. Many nations -- all the east asian nations, brazil, etc. have set the real rate low and have kept it low for decades. Moreover, you can even do this -- if you have the right repressive tools -- without accelerating inflation.

This really boils down to the faith-based assumption that savings demands must increase with the rate of interest. But this is only true of one very specific source of savings demand. There are many other sources of savings demands, for example, saving for retirement, or buffer stock savings. In that case, the savings demands increase when the real interest rate falls, because you need to save more to meet your retirement goals or to maintain the appropriate buffer.

So it is not true that in all cases inflation must be accelerating when the real interest rate is too low. Moreover, even when this is the case, you may be able to keep the game going for several decades, with inflation increasing only slightly each year.

rsj: if you were right, about AD being positively related to r, and if you also thought of monetary policy as setting a rate of interest, then you would have to conclude that all central banks have been getting it wrong. That if you want to reduce inflation, the central bank should lower the rate of interest, not raise it. And that it is a total miracle, that the Bank of Canada, which believes the steering wheel is connected up the other way around, hasn't steered the inflation targeting car into the ditch decades ago.

Remember there's investment as well as saving. Remember the substitution effect as well as the income effect. Remember what generally happens to income effects in aggregate.

OK, I didn't say AD was positively related to r.

I said that savings demands can increase if real rates decline. They may not increase. Investment demand will always increase if r is lowered, cet. par. But at the same time, as more investment occurs, MPK will decline.

So all I really need is an argument that you do not always get *infinite* inflation if the real rate is too low. You can get accelerating inflation if the real rate is too low, but you don't need to.

And the empirical evidence for this is clear. Japan, China, Korea, Malaysia, Signapore, Hong Kong, Brazil and others. And then there is the U.S. which kept real rates substantially below MPK from the end of WW2 until the late 70s, with accelerating inflation only at the end of that period.

Many, many nations adopted policies of low interest rates in order to create investment led booms. Those booms often ended in deflation (e.g. Japan). And some ended in inflation.

A more complete model should allow for both cases, and should also allow a long period of time -- e.g. 20-30 years, before the interest rate effects start to really bite. During that intervening time, you do get seemingly effective GDP growth.

Btw, I am not advocating for this policy, only pointing out that you do not get instantaneous infinite inflation if rates are too low. A horribly unproductive capital stock a la Japan with deflation is also an option. Or more of a soft-landing scenario such as in Brazil is also a possibility.

RSJ and Nick, AIUI the general consensus is that AD is negatively related to short-term rates of interest, yet it is positively related to long-run rates. The former relationship reflects how the convenience yield of money balances is affected by changes in the money supply; the latter is due to the Fisher effect as well as more AD increasing profitability of business expansion.

But all of these factors are confined to the short run, whereas RSJ was supposedly addressing long-run growth. Yes, you may be able to keep interest rates low by taxing domestic and foreign investment ("financial repression"), but what's the point? If you mean for the low rates to stimulate growth, it's a wash.

I'm trying to figure out the underlying model you have in mind there. Vertical LR Phillips Curve? But with a lot of very long-lasting underlying inflation inertia, which was only temporarily suppressed to join the Euro? Maybe.

Something like that, yes. I’m thinking of governments (specifically the one I know best, the Irish government) being on their best behaviour in the late 1990s in order to meet the Convergence Criteria for EZ membership. Backsliding at that stage would have triggered an FX-market crisis. But once you’re in the club, discipline is more relaxed. Also, France and Germany were the first to break the fiscal rules, such as they were.

Meanwhile, in the private sector, the idea that property is rarely a bad investment dies hard in an economy with a history of inflation. From the time Harold Wilson devalued sterling to the time Ireland adopted the Euro, it was practically unheard-of for anyone to take a loss on selling a Dublin property. With hindsight, it’s really quite obvious that low interest rates will create a property bubble in an economy like that. Indeed it was pretty obvious to me even at the time. What wasn’t obvious, alas, was that the banks were getting carried away in the euphoria. Even Morgan Kelly didn’t see that until quite late in the day.

I’m pretty sure that somewhat similar considerations apply to the Club Med countries.

I think there is a lesson here: don’t take rational expectations too literally. A builder in Galway doesn’t have the same model of the economy as a banker in Frankfurt.

Nick: "K: if inflation (and high nominal interest rates) is a tax on currency, you would expect to see higher inflation leading to a bigger banking sector, since banks produce a product (chequing accounts) that is a substitute for currency"

Sure. If demand for money was totally inelastic, that's what you'd get. But people do care about nominal rates so when they are high they feel *less* inclined to borrow = hold cash.

Thanks Nick for the interesting rebuttal of this argument, basically the same I just made here here (in French).

I'm not convinced by your explanation though. I do not claim to understand the deep mechanisms of monetary policy, but here's some food for thought. The eurozone as a whole does not have a trade deficit or trade surplus. Inside the eurozone this is not the case: basically the high productivity countries (Germany, Finland, the Netherlands, etc.) are running trade surpluses whereas the deficit countries (PIIGS and more) have seen their relative productivity deteriorate since joining the monetary union. A lot of the latter have seen important asset bubbles (and total relative debt levels rising much more rapidly), whereas the former didn't. These bubbles, in turn, generated a positive feedback loop on wages, deteriorating the relative productivity of the rest (non-bubble sectors) of their economies. Thus the economies of Europe failed to "converge" and diverged instead. I'm not saying I have the right mechanism to explain this but this divergence is a fact.

Now this might have to do with financial misallocation but there might be something deeper going on, perhaps how the capital account surplus are distorting investment (malinvestment?). And I certainly can't claim that surplus countries are immune to bubbles, they're not. I'm certainly not saying that productivity is permanently lower in some countries and that it's an inescapable destiny, I'm just saying is that sharing a common currency could be responsible for this productivity divergence.

I'm sure you can put that in more elegant terms and/or correct me.


Low rates are not a tax on domestic investment, they are a subsidy to investment.

Moreover, the long run correlation between rates and growth is not causation from high rates to high growth.

In any case, you cannot have ever-increasing inflation in the short run and deflation in the long run, yet we've seen deflation as the end game for nations that keep rates artificially low.

So there is something missing from the models that assume that ever increasing inflation must be the result of low rates -- those models are not capturing some important effect that reverses the conclusion in some cases.

Nick, The problem is differnce in cycle.
And now just to joke a little:
Junkers, president of the ECOFIN:

El presidente del Eurogrupo, Jean-Claude Juncker, admitió que existen "leves diferencias de criterio" entre Estados Unidos y Europa en torno a cómo solventar la crisis. Washington apuesta por nuevos estímulos keynesianos a la coyuntura, mientras Europa, con Alemania a la cabeza, prefiere seguir la escuela de la austeridad fiscal a ultranza.

Guillame: good article, even though, yes, you and I are saying essentially the opposite things!

How can we reconcile what you and I are saying? Dunno. Vague thoughts:

1. Maybe what you are describing is all short run, and I am talking long run? (The "long run" is longer than the existence of the Euro)?

2. Something to do with bubbles is not captured by standard monetary theory on the neutrality of money? (Ireland, Spain, etc., had bubbles that are the root of their current problems, and if they had had their own monetary policy they could have pricked those bubbles? Greece is perhaps different, because it ran big hidden budget deficits while Spain and Ireland didn't?)

Nick: I like what rsj is saying right below my comment. I guess I may be talking about one business cycle while you talk about the longer run neutrality. There's also the point And I agree that

I guess it would have to be a two step model. first step is country A (less productive, trade deficit) joining currency union with country B (more productive, trade surplus). Country A enjoys a lower interest rate than it would otherwise have and receives large financial inflows from country B. This leads to a boom in investment but, for a reason or another, much of the inflows are misdirected to bidding up asset prices (and that feeds back into wages). I guess that would be your point #2 and I agree that Greece is an outlier, even though you could make the case that in Greece the government simply took the place of the private sector in misallocating funds.

Step two would be bubble bursting and debt overhang decimating the economy's ability to recover (at least in an acceptable way). But my point would be that even if you reduced every country's absolute debt level (by adding another 0 or by forgiving debt), you'd still end up with the same dynamic because of the internal imbalances of the monetary union (as described above).

Looser monetary policy is what was is needed for step 2 in country A, but a tightening might have reduced the amplitude of the bubble in step 1. So in fact I'm not saying that Club Med countries need permanently looser monetary policy; quite the opposite. It all comes back to a long discussion of the problems of a one-size-fits-all (or fits-no-one) monetary policy.

Kevin Donoghue: and socially Friedman was way to the lefy of current Republicans. See PK's column from last friday.
Jesse: labor mobility in the U.S.is not that high except in the margins, due to high level of home ownership. Mobility is mostly high level university graduates going to the bigger cities and the bottom shifting around.
In Canada there is the same pattern. Mobility between Québec and the ROC was three-fold: high-level anglos shuttling between TO and Montreal (no accent...)during their career, young franco farmers trying their luck in the West, western franco university students going to Montréal or Québec City. The pattern broke in the 50's. Increased growth in the West meant young graduates were sent to develop business in CAlgary, young rural Québécois went to Montréal and Québec City, western franco saw better oportunities in the Quiet Revolution. Don't tell that to the Gazette, they still believ in the 1976 "flight from the rising natives " even if the data don't bear that out.

I believe I read this one on your blog once:

"If the aggressive use of nominal exchange rate depreciation were an effective means to achieve an improvement in a country’s international competitive position,Zimbabwe in the years just before its de-facto dollarisation would have been the most competitive economy in the world."

Zimbabwe's problems are not about the exchange rate. They are about self-destructing their own production. No exchange rate policy could undo the damgae.

I think you are wrong on that. Short-term effects can indeed have very large effects in the long-term. Neutrality of money in the long run is not really true. It is only true in a gedanken experiment. Einstein taught us that gedanken experiments are good because they are not real. They let you know which things can not be real. But they are never proof positive. Money is never really neutral. The question is what kind of relevance it has given the short-term/long-term dynamics it might produce. The gedanken long-term neutraility of money allows you to compare it with the real outcome. Coming from physics I never understood how economics makes this stupid difference between the short-term and the long-term... (and then I guess the medium-term). I quickly got that a lot of economists were normally scientifically illiterate... thanks God I found this place. But I digress.

A short-term shock makes import very expensive and exports cheap. The fact that you have your own central bank allows you to have effects on monetary policy, and more importantly, industrial policy with the printing press. The monetary shock gives a huge incentive to change the investment and labor dynamics in the country. This can lead to an increase in productivity in the long-run given the new stock obtained in the proces of substitution... or to even reduction of productivity if the short-term shock is wasted. I think it is very rare for these shocks to be wasted. Proof: Argentina.

This is why austerity policies are crazy stuff during a recession, you can eliminate the ability to produce stuff in the process of having a lack of demand. I am fully on board with Krugman on that, I have seen this lack of long-term neutrality with my own eyes in Spain.. and between a wrongly understood gedanken experiment in macro and my own eyes, I trust my own eyes.

A pleasure

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