Devaluation and the Euro

"Consider a small open economy with fixed exchange rates. Suppose the central bank announces that it will devalue the currency by 50% one year from today. What are the consequences of this announcement?"

IIRC, the whole point of the Euro was that questions like that wouldn't make any sense, and so would never need to be asked again, and so we wouldn't have to face the ugly answers. It hasn't worked out that way. That same question is back on the exam paper, only in a more ambiguous form.

Nobody knows exactly which assets are denominated in domestic currency units and which assets are denominated in foreign currency units. Maybe bank deposits will be devalued, but bank notes won't. Some debts will be devalued, but other debts won't. Nobody knows exactly how much foreign exchange reserves the central bank has, or can borrow from foreign central banks. The students are raising their hands, asking the professor to clarify the exam question. But the professor doesn't know either, because he didn't write this question.

But there's no choice on the exam paper, so the students just have to do the best they can with what they've got.

The students know roughly what must happen.

People will want to sell domestic currency assets to buy foreign currency assets. The BP curve will shift up, raising domestic nominal interest rates. The central bank will lose foreign exchange reserves, and will seek to borrow reserves from other central banks (Target2). If the central bank runs out of reserves and cannot borrow enough from other central banks, it will be forced to devalue immediately, rather than a year from today. The increased interest rates would cause a recession, which would cause a movement along the Short Run Phillips Curve and reduce the inflation rate. But at the same time the Short Run Phillips Curve might shift up, if firms increase prices in anticipation of the inflationary consequences of the future devaluation. The real exchange rate might even rise, temporarily, thus worsening the recession.

This was precisely what the Euro was supposed to avoid, by making it impossible to imagine a future devaluation. Currency boards were supposed to avoid that too, by making it impossible for the central bank to run out of reserves. Argentina showed that didn't work, because you still need a lender of last resort for the commercial banks; plus high enough real interest rates and a big enough recession will force the central bank to devalue today even if it still has enough reserves.

The same question is back on the exam paper. Currency boards don't work to keep it off. Common currencies don't work to keep it off.

[This post is an attempt to get my economics brain back up to speed after a fortnight in England doing other things. The Euro crisis is the only thing that really matters now. Peter Boone and Simon Johnson are very pessimistic. So am I.]

Comments

[genauer]

Determinant

I checked a little bit the trade numbers of Germany and the GIPSIs, all 5 now account for just 123 / 159 b$ of our export /import, or just 10/ 11 %, pretty similar to the Netherlands alone, and decaying by about 1 % per year. That means, that the Euro did NOT increase (euro internal) trade , actually the opposite. Which many people attribute to the increasing incompetitiveness of the GIPSIs. Leaving the Euro and living their own live might be better for them.
What is more important, each time somebody more or less tries to blackmail me, especially in the open, she destroys her credibility, in part, other people in third countries observe this as well, and draw their conclusions. The Credit conditions of these countries reflect there economic conditions AND their political reaction to that. Trust and patience on our side is of course worn down too, why live in union with criminals and liars? Whom would you lend your money, some racketeers or a rock solid, honest to a fault Germany? An El-Erian calls us now the AAA of AAA.
The second question of course is, do they just think this is a high stakes poker, at which end either the complete destruction of the European Union stands, or complete subjugation of Germany? If they fancy the later, are these people stupid and/or completely amoral?
When you argue that Reunification was Germany’s problem, surely foul Spanish banks, under inept Spanish supervision, giving unjustified loans to Spanish house buyers, being subject to well known extremely socialist biased Spanish judges are of course 100 % the problem of the Spanish government, as with all other banks in Europe, in the last 3 years.

Torrens,

To print scribb is illegal, and ends with the ejection of the European Union. Credit rating Default could be only avoided, if there is some negotiated exit, for which the North is open. Schaeuble made that point over a year ago, in communication to top Greeks (Papandreou, Venizelos, at that time).

[genauer]

Hi Mandos,

Sorry for the delay. I decided to study the southern ways of life first hand, and presently enjoy life at the Garda See, (including eating prosciutto di parma at an extremely competitive price, in contrast to the US, where I had to pay 5x more, Mozarella is actually cheaper in Germany), together with the advantages and disadvantages of a more mobile life style (car based camping :-)

That means I also managed to finish Sarrazin “Europa braucht den Euro nicht” (engl: Europe doesn’t need the Euro). An excellent book, most arguments and numbers are pretty similar to mine, some with more direct statistical references, a few more anecdotes about the never ending Greek malaise. There are so many facts with direct references, all graphs / tables in high quality, not the usual shameless Krugman biases. A Textbook example.
AND, most important, Sarrazin with his Macroeconomics PhD, is not some ivory tower chattering class type, like all these Krugman, Delong, Eichengreen, Sumner, etc, who have never ever been involved in any real world decisions.
Sarrazin narrates 4 in the book real world consolidation projects he was involved in:
a) German Federal Government 1981/82
b) German Railway 82/89
c) German State Rhineland / Palatine 91/97
d) German State Berlin 2002/2009
And I would add
e) German Reunification / Treuhand
In other words, Sarrazin is THE global / state turn around specialist.
The public did not much hear from him, until he had the first 3 under his belt. That is the way it should be!
Having said that, my question to you:
“Mandos, what do you want to change in Germany ?”
was actually intentionally extremely open form !!

Background: about 2 years ago, I spent about 4 full weeks to think, read, explore ways to make a very sensitive online survey (financials) palatable to people like me (tough, very tough : ..)
AND
Being fully aware, that I might not fancy all the possible circumstances of other people, trying extremely hard, to make this (the answers) as open ended as humanely possible.
AND
Give some slight options for those, who just want to get over certain questions.

I will come to more of your post tomorrow.

Today just 2 things:
1. ECB Central bankers were SUPPOSED to be “Central bank boards are unaccountable to the people”. That is the successful Bundesbank model.
Unfortunately this is not true for the ECB. Folks are still primarily aligned to the government of their home country. One good reason to kill the ECB.

2. Your point, “the evidence you're using that the trade imbalance doesn't matter?” I didn’t understand, even after reading on a subsequent day. Could you please rephrase that ?