Permanent productivity differentials and Optimal Currency Areas

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.]

Comments

[Kevin Donoghue]

genauer: "Do you know anybody who ever tried to make this paper comparable to any kind of real world data ?"

It took me about 2 minutes to find Frankel and Rose, Currency crashes in emerging markets: An empirical treatment, one of 3,131 papers listed by Google Scholar which cite Krugman 1979b. It does what it says in the title.

Simon van Norden’s “Perhaps if you used the internet, you could find some too” isn’t a “cheap point”, AFAIAC, it is a perfectly proper suggestion that you do your own homework.

I didn't suggest that pseudonymous "physics PhDs" whose comments don't measure up to their level of education were just "here around" as you put it; they show up on many a blog.

[Nick Rowe]

Part of the problem is that there's a partial division of labour. The people who come up with theories, and the people who test theories, aren't always the same people. And even when they are, they don't always do it in the same paper. You have to look at economics as more of a communal enterprise.

You can't usually figure out the marginal productivity of one paper just by looking at that paper alone. You have to know where it fits in with the rest.

[Gusgutoski.wordpress.com]

Hi Nick. I haven't read all the comments; apologies if someone has already tried this explanation.

Suppose Germany is more productive than Greece at producing ANYTHING. If you want, you can even assume that Germany is EQUALLY more productive than Greece at producing anything so as to remove concerns about comparative advantage, but that extra assumption may not be necessary. Suppose further that Germany can produce enough of everything to satiate demand in both Germany and Greece.

In a fiscal union, no one would ever buy anything from the Greeks because there's always a German who can undercut any Greek. Greeks still need to consume, so the effect is that all the money would flow from Greece to Germany as Greeks buy goods more cheaply in Germany than they could ever be produced in Greece. Eventually there's no money left in Greece, so the Greeks can't buy anything at all. (Poverty, starvation.) Moreover, if ever a Greek happened upon a stray Euro, he would have every incentive to spend it in Germany.

By contrast, if Greece and Germany had separate floating currencies then Germans would accept Drachmas in payment for their goods only if there was something worthwhile to buy with them in Greece. In order to induce a German to buy something in Greece we require a favourable exchange rate between Drachmas and Deutschmarks to compensate for the extra cost of the under-productive Greek economy. The result is that the exchange rate adjusts so that Greek goods and German goods have equal "price".

To Greeks, the expensive Deutschmark removes incentive to spend their money in Germany. If ever the Deutschmark becomes just a hair too expensive, it will be cheaper for Greeks to spend their Drachmas in Greece. The result is that Greeks can still sell their goods, implying that Greece has a functioning economy. (Poverty, starvation averted.)

Any thoughts?

[Lord]

Krugman does have a way of stating the obvious which why he is usually right and this is also true of his paper on the euro. If it is to proceed, it will have to do most of what he says, but if it wishes to retreat it can ignore it. It should realize though that both paths will be painful for everyone, there are no easy ways out which is why they are so intent on deferring it.

[genauer]

Kevin,

Well, apparently in contrast to you and several others here, I am actually able to read papers, analyze them, and then I am able to attack or defend them.

The Frankel 1996 paper mentions Krugman 1979b as “classic”, yes, I can read, but then take look. Where is anything mentioned, Krugman was specific about, exchange of foreign and domestic money over time, the dynamics of a speculative run?

In contrast to that Frankel et al. investigate empirical factors, under which countries could be vulnerable, namely:

1) Foreign variables like northern interest rates and output;
2) Domestic macroeconomic indicators, such as output, monetary and fiscal shocks;
3) External variables such as over-valuation, the current account and the level of indebtedness; and
4) The composition of the debt

Is there any mentioning of the speculative dynamic by Frankel? No.

Any mentioning of the stuff Frankel sees as important, most notable the foreign variables, and domestic credit by Krugman? No.

That means the only thing the Krugman and Frankel paper have in common is the general subject “currency crashes”. This is ZERO empirical vindication of Krugman’s paper.

@Nick
In physics people are normally able to describe in a few specific sentences why key papers are regarded highly across the community. As an admirer of Krugman you should be able to find at least one paper, where you can do this, and not have to resort to some general blah “where it fits in with the rest.”

In General: why did Krugman trot out his wild speculative dynamic ideas in a Journal like “JOURNAL OF MONEY, CREDIT, AND BANKING” with a fairly low reputation, and catering to whom? Speculators? See the wiki page. Was he trying to sell his warez to speculators?

@Kevin
In Germany young students get the advice, if you cite a paper, you have better read it, and, if you are able to, even understood it.

[Kevin Donoghue]

"Is there any mentioning of the speculative dynamic by Frankel? No."

Seriously? You actually read the paper (available here for anyone who is interested) and found no such mention?

[genauer]

Kevin,

if you take the version

faculty.haas.berkeley.edu/arose/Ccrash.pdf

you can do a search for the keywords "dynamic", "dynamics"

Please slow down a little bit and read a little bit more carefully.

[Nick Rowe]

genauer:

PK put imperfect competition into international trade. That's a big deal. Among other things it resolved a puzzle of Ricardian trade theory: why do similar countries trade a lot of similar goods?

Put Krugman in the search box top right, and you will see a lot of my stuff on Krugman, including my review of his paper with Eggertsson. Remember though, that's a very biased sample. I mostly write about PK in those rare cases I think he's wrong. It would be a waste of my time to write loads of posts saying "PK is right again".

Oh God. Look, I don't work for you, and I don't have to spend my time writing an essay justifying my belief that PK is a good economist to some anonymous guy on the internet. I have other things I think are a better use of my time.

[Kevin Donoghue]

genauer, just because a paper doesn't actually use the word 'dynamic' doesn't mean you can say there is no mention of the speculative dynamic. In a nutshell, the speculative dynamic, as it operates in the FX market, is just what that paper is about. (You won't find the word 'democracy' in the Gettysburg Address either, but when Lincoln refers to "government of the people, by the people, for the people" what do you think he is on about?)

I'd suggest that anyone who is tempted to take you seriously click on the link I provided and verify that your argument is without merit.

[genauer]

Kevin,

if you can not distinguish between " empirical factors, under which countries could be vulnerable" and "dynamics of a speculative run", as I explained at length above, then it is really bad.

P.S. my link is a factor of 10 smaller, better readable AND searchable : - )

[genauer]

@Nick,
my original question was:

“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”

My expectation was that this could be done in less than 5 minutes. Apparently not.

That competition is imperfect, everybody outside academia knows that.
“why do similar countries trade a lot of similar goods” ? My first reaction was, where is the problem?
Because of negligible trade, transport, transaction cost, like in central Europe? If this question has no meaning between the German provinces Suebia and Bavaria, why should it now have between Germany, Netherlands, Poland, Czech. This is just one tightly integrated economic space.

Krugman “solves” “Problems” nobody in the real world has.

I looked at the Eggertson Paper, and your comments, and I am at a loss, what this is saying. Many wild assumptions (“sudden debt limit shock”, huugh?) many excuses, yeah it is just a little simple model. And what again is the conclusion? That we should continue to pile up unsustainable debt?

This Emperor Krugman has no clothes!

The main problem is, that the economics profession in the US doesn’t see it,
because it has become a cargo cult (see also Deidre McCloskey)

[Stephen Gordon]

genauer, I would greatly appreciate it if you could move on from your anti-Krugman campaign. If you want to disagree with him on a point of analysis, fine. But this is not the place to go on and on about how bad an economist he is.

At least, it isn't any more.

[genauer]

Stephen

I have no problem to end this here. I am completely done with Paul Krugman. I got everything I wanted. Sometimes it is necessary to escalate things a little bit, to make sure that nothing is overlooked or misunderstood. Putting a clear end to certain things simmering.

I do not “disagree on a point“ with Krugman. I am long through with this. Japanese Budget and Balance sheet, Irish bond yields and CDS, etc., etc. , ALL papers from him, I was pointed to and looked at. I say it is all garbage.

In former times I was on the slow side of making hard judgments, especially about people. This post is a sort of “coming out” for me. If anybody is interested why I think so, I am available, but we can also leave it with that.

[Mandos]

I looked at the Eggertson Paper, and your comments, and I am at a loss, what this is saying. Many wild assumptions (“sudden debt limit shock”, huugh?) many excuses, yeah it is just a little simple model. And what again is the conclusion? That we should continue to pile up unsustainable debt?

This is the key here. Ordinarily I would agree with genauer about economists (heh), but genauer's dismissal is post hoc, having decided that he doesn't like Krugman's current recommendations, because genauer believes a particular story about sovereign debt.

[Oliver]

I stopped reading the comments about half way through, but from what I have read I agree with the assessment that PK and SJ are not using the word productivity properly and should be talking about changes in unit labour costs or wage inflation rates instead. This seems to be the common mistake behind all the PIIG bashing too.

Here is Heiner Flassbeck with his theory of diverging inflation rates within the EZ:

http://www.laits.utexas.edu/eur/session_2.html

That, and what RSJ said.

[genauer]

Mandos,

I know that my active English is not perfect,
but I started with "I am at a loss, what this is saying",

crtized the classical Krugman approach "Many wild assumptions", "many excuses" and the unclear, unquantitative "result"

I wondered what kind of conclusion that is (first question mark) and for the unsustainable debt another question mark.

To interpret this as a post hoc dismissal, this I find pretty stretching.

P.S. Maybe some readers here are interested in, that in Science there are valid "post hoc dismissals". Powerful. If somebody comes with a new proposal for a perpetuum mobile, I do not listen at all about the inner workings of it. If a tropical rainforest has no humus underneath, it is not a significant sink for CO2, no matter how often Greenpeaces says so.
The carbon must be deposited somewhere.

And to annoy Kevin a little bit, mastering the argumentation with these conservation laws gives physicists perfect grades : - )