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What is damaging is the threat itself that Greece could withdraw from the Euro--rewrite contracts, impose capital controls.

Thus there is a local shortage of liquidity in Greece. The ECB could expand the money supply endlessly to meet Greek demand, none of that money will stay in greece. Sure there might be a way out if the ECB moved so massively that there was faith that the Greek government wouldnt seize all of the euros--but now that the work understands that Greece is one of the last command economis in the world, they aren't going to believe easily.

The best thing the EU could do now is state that the treaties have no exit clause and any attempt by the Greek government to exit is an attack on liberty and will be enforce against as the criminal act that it is. Greece cannot abandon her euro liabilities; the sovereign could though start a parallel currency without redemption.

One thing: Greeks can not move "very" easyly to Germany and if they do i am not confident they will get 1)a "warm" welcome 2) Greece will go over very fast ( they'll probaby do anyway).

Jon, Marc: you guys just aren't high enough on the autism spectrum! What is this thing called "Greece" and "Greeks" you are talking about? And how is it related to the assumed productivity difference between "Greeks" and "Germans"?

Jon: Why should a shortage of liquidity across individuals be correlated with low (or falling) relative productivity of those individuals? And if there is such a correlation, why wouldn't it also appear within Canada?

Marc: it's also not easy for a high-school dropout to "move" to become a brain surgeon.

Maybe look at the problem from another end: why do various provinces in Canada never see CAD-exit as core to their recovery? It looks to me like it's many factors:

-provinces have, and historically had, weak or nonexistent money-supply controls. There's no Bank of British Columbia* to regulate the money supply and set interest rate targets. There never was a BC drachma. This has practical and mood effects: our province doesn't think of our currency union as some contingent thing, but as the only thing.

-fluid mobility. The diasporas out of the have-not provinces are famous and massive, and much more fluid than immigration from Greece to Germany. There is a language and culture barrier. Yes, Canada is a multilingual country, like many countries, but even so, language is often a hard barrier for diasporas (and like a lot of multilingual, multicultural countries, ours seems to have some natural fracture lines on those language boundaries)

I wanted to say "history," too, but that seems less of a barrier to separations like this, if the incentives are strong enough. But it may count for something that people across Canada are used to the present arrangement by dint of generations of history, unlike Eurozone members. The contingent nature of the EZ is only emphasized by its irregular, not-even-EU-congruent boundaries.

*there once was a Bank of BC. HSBC bought them.

I assume that Greeks trade mostly among themselves and Germans trade mostly among themselves, so monetary disequilibria are mostly localized to Greece and Germany, with litle interaction among them (because price stickiness mostly occurs in the local, non-tradable sector). Thus, a union of Greece+Germany is not an optimal currency area, although Greece and Germany may each be OCA's, taken separately.

Prof. Rowe,

Maybe it doesn't matter assuming those with higher and lower productivity are in the same country and regularly interacting with each other. But when there are thick national borders separating regions and preventing various important varieties of economic interaction, it matters a great deal.

...which is a fancy way of saying that if we assume laissez faire, there is no problem; but we are not in a laissez-faire world, so the problem is terrible.

@Ryan: "Maybe look at the problem from another end: why do various provinces in Canada never see CAD-exit as core to their recovery?"

We have equalization payments between the provinces. EU does not.

Not precisely on topic, but I sometimes wonder if debtors and creditors might not be in the same OCA. I feel like this is related to an old post of yours (or maybe SRW) on the price of debt and maybe giving a central bank a knob to adjust that.

anon: OK, so are you endorsing (a slightly watered down version of) my crazy model of international finance with no international trade? But in my crazy model, what drives the disaster is differences in natural rates of interest, rather than difference in productivity or productivity growth. And why did it take some no-name macro blogger like myself to actually write down the model (or did someone else do it first)?

Ryan: OK, but where do productivity differentials appear in that story? And why is it provinces that are the unit of analysis, rather than collections of individuals living anywhere?

fmb: "Not precisely on topic, but I sometimes wonder if debtors and creditors might not be in the same OCA."

I was wondering that too. And that's the key point in my old crazy model, where it's natural rate of interest differentials, rather than productivity differentials, that drive the debtor/creditor differential and cause the non-OCA result.

Good question, Nick. My answer is that there is no fundamental difference between economic performance disparities between countries, firms, individuals, or any other subsets of society. In my opinion, there is nothing conceptually wrong with EMU as it was set up and remains, and no need for transfer union, fiscal union, debt union, banking union etc. All that is required is the understanding that, just like subsets within currency areas, if you don't perform well, you either improve your peformance, live with less income, take what transfers are volunteered by your compatriots, or, ultimately, default. Basically, the euro is a default union. The trouble with EMU has been that, despite the best efforts of the Germans, the euro dreamers and schemers, especially the French, always believed that, when the crunch came, they could change or bend the rules and either put off the problem indefinitely by borrowing more or get the prudent to pay.

I have always been sceptical of the idea that it is efficient to shift the whole price array of a currency area because of the difficulties of one or more of its subsets. And I would apply the same reasoning to inflation and its effect on borrowers and savers.

Rebel: if "countries" are things that act as Lender of Last Resort to banks, and to themselves, then I can see why countries having their own money matters. But the LOLR function doesn't have anything to do with productivity, AFAIK.


Well, it didn't when we called the "Californians" and " Alabamians". And the comparison is interesting, because while American states are all part of one country, the have many of the same attributes of EU states - i.e., they have their own domestic laws (so could, in theory, re-write contracts), they are part of a broader monetary union. That said, the differences are also telling, the US states share a common language and, to a degree, common identity, making mobility between them far easier. They're also part of a fiscal union. And they're subject to a common set of binding laws with respect to property rights (would re-writing debt obligations be a violation the Bill of Rights?)

"The best thing the EU could do now is state that the treaties have no exit clause"

The problem, of course, is that the EU Treaty DOES have an exit clause - Article 50 of the Lisbon Treaty, which permit member states to unilaterally exit the EU. What's problematic, from a Greek perspective, is that so long as its in the EU, its can't exit the Eurozone unilaterally (subject to an important caveat, that I'll come back to). So it either stays in the EU and keeps the Euro, or it exits the EU and can do as it pleases.

The caveat to is that treaties are a weird form of law in that they purport to bind sovereign entities - i.e., states. What's tricky is that a "sovereign" state, almost by definition, cannot be bound by external sources of authority (at least so long as they remain sovereign). So, for example, in Canada (and the US and UK), in order for treaties to be effective, they have to be enacted into our domestic law by way of an ordinary statute. As enacted, yes, they are legally binding, but like any other statute they can be repealed or amended by parliament at will. In other words, they're legally binding on Canada, but only so long as Canada chooses to be so bound. IF we pass a law that's inconsistent with or renounces our treaty obligations, that law takes precedence. That action might be illegal under international law, but it's quite legal under our domestic law.

The point of this digression is that, while it may be "illegal" under the European Traety for Greece to unilaterally exit the Euro zone, it may not be illegal under greek law to do so. Moreover, there's no mechanism under the European Traety to kick a member state out. Unless the EC intends to end Greece's status as a sovereign state (i.e., send in the storm-troopers), the European Treaty doesn't have any legal bite.

Nick, I'm not sure I want to endorse your crazy model, because (IIRC) the crazy result was driven by lack of trade in goods, which is an unrealistic asumption. But I'm sure that the OCA literature has explored these issues in depth, including what happens when natural rates of interest diverge (due to diverging NGDP growth perhaps?).

The problem isn't that the Germans are more productive or that that their productivity is growing faster; it's that their wages are too low, or conversely, Greek wages are too high. This happened because there was a boom in Greece that drove up wages, and the boom collapsed, leaving wages too high. This happens within individual countries, too, e.g. Texas in the 1980's. Texas had a bit of a recession in 1986 after the oil boom collapsed (as I discovered by looking at city-by-city help wanted advertising data when I was working on my thesis circa 1992), but most macroeconomists didn't notice. Why not? It wasn't a big deal, for couple of reasons (and probably a bunch I haven't thought of):

(1) If you lose a job in Texas, it's pretty easy to move to California or Massachusetts if there are jobs there. The language is the same; the customs are similar; there are no bureaucratic problems with moving; you aren't regarded as a foreigner; etc.

(2) If you lose a job in Texas, or if the debtors of your Savings & Loan in Texas default, you get bailed out by the Federal government automatically. No need for a lot of difficult negotiations with uptight officials from more productive states; programs like Unemployment Insurance and the FSLIC just come in and do the bailout with no questions asked. (Actually there was a deliberate Savings and Loan bailout, but that was not too difficult to negotiate, because the US would have been on the hook for most of it anyhow, so it was just a more efficient way of doing what had to be done.)

Now if the Germans were willing, without complaint (and I didn't hear a whole lot of complaining in the US back in the late 1980's -- and as I recall, none of the complaining I did hear was explicitly regionalist: the S&L bailout was not considered a "Texas" bailout), to come in and do a truly gigantic bailout for the PIIGS the way the way New York and California and Massachusetts did for Texas -- and do it in a timely fashion rather than always waiting until things are on the brink of total disaster and then doing the bare minimum to forestall that disaster -- and if they all learned to speak Spanish and Greek and Italian and to treat PIIGS citizens as compatriots, maybe Europe could get by with a single currency. But we're a long way from there.

Nick, I don't agree with Simon. There is no reason the productivities have to converge and I don't see why that is precondition for stability.

The Greek problem is that there is a robber baron in that part of the world. He is presenting three choices: let me steal from everyone outside my land by defaulting, let me steal from everyone inside and out by repudiating any contracts in euros, or let me steal from the people who live in My land thru ruinous taxation.

The US works as a single currency zone because there is no way out. A state cannot abrogate debts, a state cannot seize everyone's dollars. A state can default but that's different because Europe has target2 and a treaty which requires government debt to be treated as risk less.

The US national government fought a long, bloody civil war proving the point that leaving isn't an option. That's the difference.

"if "countries" are things that act as Lender of Last Resort to banks, and to themselves, then I can see why countries having their own money matters"

I strongly disagree, Nick. The LOLR is really a fiscal function. In my opinion, a government bank regulator, ideally detached from the monetary authority, should be the LOLR, although I would concede that it might be useful for that institution to have a short-term credit line from the monetary authority to allow it to react quickly without setting up market borrowing first.

Like promoting real economic activity, the LOLR is another of the things that central banks have been called on to do since the financial crisis not necessarily because they were the best state institutions to do them, but because governments preferred not to explicitly raise resources or introduce structural reforms for the purpose. Central banks have allowed themselves, no doubt partly because their senior officials enjoyed the appreciation, to become the slush fund bucket that has so far allowed the public to avoid facing the full cost of the financial crisis.

A "country" to my thinking is a geographic zone where real public expenditure and real tax income are required to balance over some (arbitrary & shifting) time horizon; ie real debt must be zero in some sense.

US states do not face this constraint/definition due to programs like those highlighted in anon's comment above - public expenditures in Texas or California can be very broadly separated from their tax incomes. Imagine, for example, if Florida had to finance its own Medicare or Social Security payments - it would be Greece in a heartbeat and I imagine selling off those little valuable islands would be demanded by the young productive financiers of New York quite quickly.

Massive fiscal union (superstatism) breaks this rule for the jurisdictions it contains by providing transfers that are mutually beneficial but could not be accomplished by trade because of long-term multilateral commitment problems. For example, New York would like military protection but its own youth are better served going to school and getting good jobs; they'd prefer to employ the relatively unproductive youth of Middle America to keep the peace; and in exchange they pay out more in taxes which end up being Florida's Social Security benefits for the retired (ex-productive) New Yorkers who financed the educations of the current New Yorkers, and so on and so forth.

Superstatism also prevents inefficiently competitive (or adverse-selective) policy adjustments such as cutting taxes or increasing benefits to attract more desirable residents. More importantly, mutualization of debt means lower borrowing rates, longer terms, and legitimate (non-default) ex-post changes in repayment obligations for all members of the new debt-union ("country") - thanks perhaps to the availability of emergency transfers or of a central bank that acts in the "general interest" as represented by federal finances and so can smooth interest rates at low cost over time. But in Europe, superstatism has not yet evolved to solve these problems, since the transfer system and the debt mutualization system are not in place.

oops, I meant those programs highlighted in Andy's comment - names below comments really throws me off, sorry!

This is very interesting post, similar to recent Scott's post regarding implications of NGDP targeting in China. Scott's argument (as I understood it) was that productivity growth (in tradable sector to offset Balassa–Samuelson effect) means different pace of change in relative price level that means different changing real exchange rate and thus also difference in real interest rates. Now this is not bad as this disequilibrium should rebalance by capital flows. In your model the real interest rate was given and set, it is not so in real world. Hell, this was the promise of European Union - free flow of capital was supposed to bring "convergence" aligning economies closer.

So to sum it up I totally agree with you. It is not about different productivity and stuff. It is about different "countries" being more susceptible to different shocks. I can even imagine that the Crisis could go the other way around - if crisis would that global demand for machinery and cars produced by Germans dropped and vacations in Greece would be highly attractive maybe we would see things unfold in a different way with Germany asking ECB for more monetary easing to accomodate this shock that would be blocked by southern countries.

So for me and in this discussion the word "country" is really just a placeholder for a largest unit that can be source for asymetric shocks. And I do not mean just economically but taking into account the whole institutional frameworks. So for instance there can be several Canadas economically out there (resource extraction, services, manufacturing etc. or regional differences in productivity) but if they are held by fiscal transfers, labor mobility or other factors than they can be viewed as a Country in this sense.

The Greeks will never leave the EU or Eurozone voluntarily. They are probably the most pro-european europeans around. The Greeks think of themselves as european first and Greek second. Germans the opposite. The Greeks came to the eurozone party uninvited and Germans were just to reserved to bar their entry, they are definitely not going to pay their cab fare home now.

The problem with the EU is there are no supra national taxation and no equalization payments or social cohesion.

Perhaps I'm not answering Nick's question because I'm not autistic but I'm mildly ADD, which means I don't always read the question patiently. I suspect the issue is political and socialogical and not economic.

Even in Portugal where I was from there are "greeks" and "germans", typically the greeks live in south and germans in the north. The theories are various, the cooler northern climate forces people to work harder to store provisions for winter thus the different in productivity. The hotter south disways people from working too hard. But why don't germans move south where there is more and better land so they could say double their production and why don't greeks move north where they could increase the amount of their labour?

For me its subsidies(gov interference) and group identity that keep people from moving and thus equalizing productivity.

Nick: prices levels are sticky. Esp. downwards. And Germans target stable prices.

So here's a way I've been trying to understand the current crisis in Europe that's different from the Krugman/Johnson view of productivity differntials and misaligned exchange rates that Nick links to above.

We're seeing a Balance of Payments crisis, not entirely unlike what we saw in '97 with the Asian Crisis. Remember that one? A number of countries ("Asian Tigers") were industrializing; starting from low levels of productivity, wages and infrastructure, they experienced high levels of growth and attracted lots of foreign capital. Some people look at such inflows as a sign that a country is a great place to invest (think Ireland.) Others look at such inflows and the current account deficits that they imply as a sign that a country is living beyond its means (think Greece.) While the proximate causes differ from one crisis to another, each one features a "sudden stop" as the inflow of foreign capital abruptly turns to an outflow.

Those reversals broke many exchange rate pegs in 1997 Asia (Hong Kong was one that survived IIRC.) The capital outflow (and worries about devaluation) also strains the banking system as deposits leave. So governments face some nasty choices.

Problem #1) Capital outflows imply that the economy must consume less than it produces. If production is falling, private consumption must fall faster, or the government has to quickly shift from deficits towards surpluses. But the fall in domestic demand tends to hurt production, exacerbating the problem. Some governments try to buy time by using capital controls to reduce the outflow. That option is not available in the Euro zone.

Problem #2) Capital outflows cause the values of domestic fixed assets (e.g. real estate, physical investments) to fall. This in turn makes banks' loan portfolios lose value, even as the domestic banking system is losing deposits. Worse, banks may have borrowed from abroad to extend loans domestically; a devaluation may technically bankrupt them overnight.

Simon: OK, but still: what's a "country"? Is a country a group of people who trade mostly with each other, and have very low trade volumes and low trade elasticities with other groups of people? If so, then you are in the world of my "crazy" model, except slightly less extreme (my crazy model assumes zero volumes of trade and zero trade elasticities across countries).

If so, we are on the same page. The underlying problem is: a difference in natural rates of interest (however caused); low trade elasticities; a fixed exchange rate/common currency.

It's not productivity differentials, it's saving/investment differentials, plus the low trade elasticities.

Andy: "The problem isn't that the Germans are more productive or that that their productivity is growing faster; it's that their wages are too low, or conversely, Greek wages are too high."

OK, but what is it about people *living in the same country* that would cause one group of individuals all to have wages high relative to productivity, and a second group of individuals to have wages low relative to productivity? In other words, why is there a correlation between: wages/productivity; where you live?

There is at least one very important difference, although I agree with you that the problem is not a "productivity gap" precisely. The problem is politics. The German government and the German CB, by which I mean the ECB, is not the Greek government or the Greek CB and yet the Germans are now calling the shots when it comes to growth in Greece.

Why on Earth would politicians elected in Germany care one bit what happens to Greek people? That's the reason this problem is so intractable.

We're all economists, we understand (or think we understand) that the ECB could end this thing tomorrow if it were so willing.

To push the question: how can 2 countries be more different than germany and Burkina-faso? They share the same currency. Franc CFA, french-speaking subsaharan africa's currency, is pegged to the euro: monetary policy is determined in Frankfurt. Franc CFA was devalued once in last 20 years, in 1995. There is no common budget, no worker migration, etc. And no one imagines a fiscal union. And greece is way less corrupt than Burkina, etc. So, how and why does this arrangement work, and the euro doesn't?

What would happen if you moved all the Germans to Greece and vice versa who would be more productive then? Maybe it's about capital. Maybe instead of investing in Greek productivity the banks in the EU bought sovereign government bonds and mortgages to maximize returns to their capital (Basel requirements?). Crap capital allocation. Maybe the reason they don't build BMWs in Greece is because there is no BMW factory there. Maybe the reason Albertans make more money than people in PEI is because PEI don't sit on top of a bunch of oil. Probably I'm too simple to understand but that seems more to the point to me.

Thats not to say that the Greeks did whatever they could to foster productive investment. They may have done the opposite.

Nick: "why is there a correlation between: wages/productivity; where you live?"

Productivity depends on things like physical capital and natural resources that typically exist in a particular place and are difficult or impossible to move. The relative productivity of labor working with different kinds of capital and natural resources is affected by shocks. Wages ratchet up as productivity rises, but they don't go back down in response to an adverse shock.

A couple of examples (the same as my examples above) of shocks that affected the productivity of labor:

1. Southern European real estate boom/bust. The value of labor in construction in Southern Europe was affected by overall aggregate demand and credit availability. When those factors disappeared in 2008, the labor became less valuable, but wages didn't go down. In Northern Europe, by contrast, the value of labor was not as strongly affected by these factors, because there wasn't much interest in building a lot there in the first place. So the relative value of that labor went up when the crisis hit.

2. Texas oil boom/bust. When OPEC constricted supply and raised the price of oil during the 1970's, oil extraction labor in Texas became more valuable because of the natural resources that were physically located there. Wages went up. Then in 1986 OPEC lost its cohesion, and oil prices went down. Oil extraction labor in Texas became less valuable, but wages didn't go down, so they experienced a local recession. But, as noted, it wasn't a big problem, because of outside support and labor mobility.

"OK, but what is it about people *living in the same country* that would cause one group of individuals all to have wages high relative to productivity, and a second group of individuals to have wages low relative to productivity? In other words, why is there a correlation between: wages/productivity; where you live?"

Well, in part it has to be a function of different policies in each country. National boundaries may be arbitrary, but the different policies in different countries are sure to have an impact on levels of real wages and productivity in each country. In other countries, those differences can be ignored because the exchange rate mechanism will adjust the real price/productivity ratio between the two countries. (I.e, Greek wages may be high relative to their productivity, but if the Drahma falls, the wage/productivity ration in Deutchmark terms stays the same).

"To push the question: how can 2 countries be more different than germany and Burkina-faso? They share the same currency. Franc CFA, french-speaking subsaharan africa's currency, is pegged to the euro: monetary policy is determined in Frankfurt. Franc CFA was devalued once in last 20 years, in 1995. There is no common budget, no worker migration, etc. And no one imagines a fiscal union. And greece is way less corrupt than Burkina, etc. So, how and why does this arrangement work, and the euro doesn't?"

Does the arrangement work? Does it even matter? Apparently 80% of Burkino-faso's population lives on subsistence farming. That population might be quite indifferent to monetary policy, since they may mostly live in a real economy - they eat what they grow, and barter for the difference. You could link their currency to the value of moon rocks for all the difference it makes. Also, if I had to guess, I suspect that wages are probably not that sticky in Burkino-faso, the protection of workers rights not being a big aspect of a lot of third-world countries. Maybe they can adjust internally better than, say, Greece can.

Moreover, while Burkino-faso doesn't have a fiscal union with Germany, it does get injection of foreign aid from international donors equal to 15% of its GDP, which amounts to the same thing. If the Germans were willing to give Greece an amount equal to 15% of Greece's GDP, we wouldn't be having this discussion.

And while there isn't worker migration between Burkino-faso and Germany, there is worker migration between burkino-faso and other neighbouring countries (and those workers make significant remittances back to Burkino-faso).

What is a "Greek" -- it's not someone subject to a certain interest rate policy, it is someone living in a certain society with specific institutions, bank regulation, eco systems of production, credit relationships, and social bargains that make the economy work.

These differences require differences in monetary and fiscal policy. Greece historically has had a difficult time taxing its population, and so relied on the inflation tax to fund itself. That option was removed. Greece emerged from a dictatorship not too long ago with massive levels of inequality vis-a-vis Germany (or the rest of europe). The Greeks expect that increasing real wages, rather than transfers, would chip away at the third-world levels of inequality. In Germany, unions agree to real wage cuts combined with a progressive tax scheme and explicit fiscal transfers. German social benefit payments are much higher, as a share of GDP, than Greek benefit payments (prior to the crisis, of course).

One nation may experience a property bubble whereas the other does not, due to differences in bank regulation or relative outlooks for future income growth. Changes in external demand for goods may cause expansion in one nation and contraction in the other, etc.

At the end of the day, all of that is bundled up into one figure "productivity", but if Greece were allowed to strike its own economic bargains and its own policies, rather than being forced to act as if it was adhering to Germany's bargains, then Greek productivity would be much higher, because the economy would at least be functioning.

I still don't get why they aren't talking about stimulus, at least where labour intensive and where fixing market failures, isn't part of the EU conversation. If you don't free up money for stimulus when interest rates rise, it makes you richest backers, potentially all the way to the USD, more broke post-bailout. And it just makes rich banksters richer and more likely to mess up again.
Marc Labbe, why doesn't the EU finance labour migrants? Why not hire more police to prevent racial beatings or whatever German backlash you are alluding to. With Canada a neocon craphole and stupider (more like AB minds) human capital each election, I'd love to see some area of the world takeup the torch for efficiency. Racism and lack of immgration kills the Germans here despite unmatched technical expertise.
The is a Pareto distribution effect, where rich get richer without higher taxes or some other socialism adjustment. At highest efficiency, you'd probably have wealth always being restributed from Germans or Swiss, too the rest of Europe. The key is finding the optimal redistribution. Eventually when rich people get too rich or too wedded to a dinosaur industry, Romney and Harper prove they get inefficient and start building moats around their landlocked wealth instead of creating more. I like that Harper's ship contractor is oil. I hope every oil player finds another industry to succeed in, with fed help if necessary. Of course there are issues on the EU left too, with much of the debt prolly racked up by Communist politicans.

Nick, you should live in Silicon Valley for one year. You will find:

* A huge pool of skilled labor in tech
* Credit relationships -- networks of venture capitalists who know each other and know businessmen
* Businessmen, who know the venture capitalists and can draw on the local pool of labor and their relationships with venture capitalists to form start ups and recruit employees.
* Stored knowledge. Accumulated wisdom that allows older co-workers to mentor younger workers
* Training, conferences, meet ups, universities with strong tech curricula

All of that makes Silicon Valley a destination for both tech workers and tech entrepreneurs. With a 50 mile stretch, you have Adobe, AMD, Apple, Intel, HP, Oracle, Yahoo, Google, Intel, Symantec, nVidia, NetApp, SalesForce, Netflix, Yelp, Twitter, Facebook, Electronic Arts, Asus, Broadcom, RSA, Adaptec, etc. 80 tech companies with revenues of a billion or more.

But there is nothing inherently "techy" about the natural endowments of the region. It is a productive eco-system that is geographic specific.

The eurozone has two crises, which are logically distinct. One is a sovereign debt crisis. It's easy to explain why American states don't have debt crises (very often.) Their debts are an order of magnitude smaller than the national debts of European countries.

The second crisis is the employment/RGDP crisis. Why does the US seem to be more of an optimal currency zone than the EU? There are lots of reasons, and I don't doubt that your commenters have already thought up more than I could.

“What is a country?”
It is what you are willing to die for. Military duty, country, sacrifice.
"Do not ask what your country can do for you, do ask, what you can do for your country"
People who you share a "common destiny" with. Unlimited.
Not a limited liability company.

"Zuerst kommt das Land, und dann kommt lange nichts, und dann kommt die Partei, und erst ganz zum Schluss kommt die Person Erwin Teufel". The first green governor made it a point to meet in approval the “old devil”.

First comes the (father)land.

And then you can demand 60 % tax rates, 10 % cuts in benefits and pensions. Or more, if the fatherlands needs it. That’s were the Iron Crosses grow, and AAA ratings.

Was their ever any discussion about not to share the wealth with our eastern brothers and sisters? Yes, but only by communists like Lafontaine and Flassbeck, a very tiny group.
No, for the > 90 % majority. The pain did start at the top (Solidiaritätzuschlags) and then trickled down. And having been through it makes people feel united and strong.
Do I feel the same for the rest of Europe? No. There is ash in my heart, after what they did in 2011.

And now some people come with some:
“Is a country a group of people who trade mostly with each other,” an OCA?
In what kind of economist ivory tower are you living, that you think that “Glasperlenspiel” has something to do with a real world, with real people, blood and flesh?
In Europe, as in most other areas of the world, safe Canada and the US, the borders of a country are drawn in blood, and not in ink.

Nick: I spent a few years thinking about optimal currency areas and decided that they have little or nothing to do with the frontiers of "countries" or monetary unions. I think part of what makes the situation between German and Greece different from that between Quebec and Alberta is simply a (somewhat) greater political will among the latter to sacrifice for one another in the short term. I'm really not sure whether the trade elasticities are much different (I suspect labour mobility might be.)

But let me see whether I understand your wage/productivity/region correlation puzzle. Am I right in thinking that you're puzzled about what might cause one region to lose/gain competitiveness relative to another? Seriously?

'Now lets call those with slower productivity growth "Greeks" and those with faster productivity growth "Germans". Does calling them different names suddenly cause a disaster?'

Depends on how inelastic the individual country is.
One is assuming that Germany's banking/economy system is without flaws.
Common currency without strong common monetary policy. We've seen what happened to Argentina when they adopted U.S. currency and then tried to come up with their own monetary policy. Or is what happened to Argentina something totally different?

In Europe, as in most other areas of the world, safe Canada and the US, the borders of a country are drawn in blood, and not in ink.

We here in Canada are currently celebrating the 200-year anniversary of the War of 1812, which did draw our border in blood. After 1814, union with the United States was politically impossible. "We're not Americans" has been a core concept in Canada ever since. It was pure emotion, there was no logic in it, and Britain would have gladly signed us over to the US several times in the 1800's. Confederation was to convince them NOT to to that. Anti-Americanism is the oldest, longest and most constant feature of Canadian politics, it's been there with little change since 1783.

Second, for a nation that was put together as a dream, for Canada first came the dream, then came the policy: a single, national criminal law (The Criminal Code), national banking (safest in the world), Western Expansion and then two world wars. The First World War pulled Canada together in a way nothing else has.

Determinant: Canadians are definitely not Americans - that reminded me this hilarious joke: http://9gag.com/gag/3784707

But: genauer has a point. A country is first and foremost a polity. Polity and economy are out of alignment. Germany has struck some social/political bargains that cannot be applied to Greece without shattering Greece (as it is), and Germans have at present no reason to change the nature of those bargains, because they don't feel it hurts them to break Greece. This created a huge pressure on one end of the still rather brittle Greek society, and the effects of the warping are obvious. Shattering imminent.

Something like this, I would suggest, is the fate of all economic policy that doesn't have political legitimacy.

Case in point: the easy political target that is the GST in Canada. It's a clear example of putting economic theorizing before political legitimacy. The GST was multiply rejected by the public in all the ways it could express that rejection, and yet still it stands. Does it surprise anyone that Harper can still make hay with it, so many years later?

I would suggest an even more fundamental problem with the mentality implicit in the question of the OP and this whole discussion. There is an implicit belief that economic policy is about Real Things, and that in the hypothetical Platonic world of ideal forms, politics should by nature and right arrange itself around the accomplishment of these Real Things contained in economic thinking.

I would suggest that this is exactly backwards. In fact, if there's any common thread to anything I've ever said in the WCI comments section, it's that.

That's why Nick can ask us "What is a 'country'?", and then talk about trade and productivity. Let me tell you what "Greece" is currently: it's the political truce created at the end of the dictatorship, and nothing but that, and all the economic discussion about it should always have been focused on how that truce could be maintained. Employment, trade, productivity (or lack thereof) are all instruments in maintaining or improving that truce.

The rest of the discussion is besides the point, honestly.

I find the comments as interesting as Nick's very useful post. The real definition of a country seems to one that is prepared to take on specific financial obligations for its citizens only. The Germans are prepared to support implicit and explicit internal support and transfers between have and have-not regions of Germany but see no commitment to do the same for other regions. Possibly because there is no expectation of a reverse commitment.

In Canada, the national ideal has given us a commitment to shared policies and values. However, if we are honest, the CPC seems determined to erode that to a meaningless level.

Nick - As always a fascinating post.

Nick Kalogerakos and I published an Op-ed in the Ottawa Citizen last Sunday channelling my inner Simon Johnson setting out the same arguments:

http://www.canada.com/technology/Endgame+approaches+euro/6796334/story.html

However, the primary sources for our Op-Ed were the remarkable IMF country sustainability reports for Greece, Spain, Italy (and France - which was a real shocker) published in the last 12 months. The reports are models of logical and empirical clarity in setting out and documenting the imbalances in productivity and competitiveness.

You may recall my presentation to EURUS in spring 2010, where I first analyzed the Greece crisis (and predicted its eventual exit as its economy was not sustainable). After providing the productivity differentials between each EZ country - sourced from Eurostats and ECB - I noted there have been very significant differentials in productivity, wealth, economic growth, incomer per capita etc. between the Nordic and Latin countries for a very very long time – dating back hundreds of years. To that end, I invoked Weber's Protestant Ethic thesis, from The Protestant Ethic and the Spirit of Capitalism, occasioning a virulent response from a sociology professor present from a university that is not our university.

Restated, perhaps it is not Germany versus Greece. Might it be northern Europe versus southern Europe? And BTW, to throw in a new acronym, it is the FANG countries (Finland, Austria, Netherlands, Germany) that are opposed to more bailouts for southern Europe - not Germany all by its lonesome.

Restated, maybe it is not the polity or nation state. Perhaps we are asking questions about culture – not to be confused with nationality.

The three historic cultures of Europe - Anglo-Saxons (or is the new fashionable phrase, the Nordics?), the Latins and the Slavs – have very different histories and empirics when you examine the IMF or the OECD comparative data for these countries/regions over long periods. For example, it appears to my untutored eye, that Russia with a thousand years of czarism has a very different history than e.g. UK or Italy.

Therefore, should you not be asking why are there are such profound empirical measurable very long term differences between the countries of northern Europe and the countries of southern Europe – on multiple dimensions - whether productivity or capital formation or new businesses established per 100,000 or GDP per capita (Portugal is about half of Germany per capita) or inflation or ...?

BTW, try googling "imbalances between northern and southern Europe"- the ECB, EC, BIS, IMF are fascinated by this issue.

Quick final point. Last December, the German Govt released a very impressive report in English analyzing the $2 Trillion over 20 years attempt to restructure the former East Germany. It concluded that while progress was made, nonetheless the former East Germany was still far less productive while unemployment is still almost double the average in the rest of Germany. Maybe there is something to the idea of productivity and for that matter, cultural differences?

Nick- "OK, but what is it about people *living in the same country* that would cause one group of individuals all to have wages high relative to productivity, and a second group of individuals to have wages low relative to productivity? In other words, why is there a correlation between: wages/productivity; where you live?"

I think the term is asymmetric shock. Generally a change in the terms of trade. In Texas it was primarily the fall in oil prices, then exacerbated by a subsequent fall in RE construction and prices.

Think also of where your neighbors to the south in Michigan would be if they had to pay for their own retirement, most of their banks were Michigan only institutions and it was very difficult for them to move out of Michigan, yet there was still no Michigan exchange rate adjustment mechanism.

So, in terms of what is a country? I think for currency union discussion it's the expected and observed correlation in business cycles, integrated area for social insurance (retirement, medical, unemployment), integrated area for banking insurance, and effective labor . Plus, perhaps a political element of solidarity in a crisis.

By the Thoma has a link to a good post demonstrating the importance of countries in determining real wage rates via a comparison of McWages around the world.

He concludes:

"The key lesson of the figure is that the differences in McWages across countries line up with the overall productivity differences across countries. The main exceptions, in the upper right-hand part of the diagram, are countries where the McWage is above U.S. levels but output-per-hour for the economy as a whole is below U.S. levels: New Zealand, Japan, Italy, Germany. These are countries with minimum wage laws that push up the McWage.

(The author) emphasizes in his remarks how real wages can be used to assess and compare the living standards of workers. I would add that these measures show that the most important factor determining wages for most of us is not our personal skills and human capital, or our effort and initiative, but whether we are using those skills and human capital in the context of a a high-productivity or a low-productivity economy. "

On the other hand I think Simon Johnson was wrong to peg the problem to the absolute difference in productivity, other than that had seemed to be the market's expectations from 1999 to 2007, based on interest convergence and capital flows. Which is why Burkina Faso's peg is not a problem, no one expects any quick convergence.

McWages link: http://conversableeconomist.blogspot.com/2012/05/mcwages-around-world.html

http://dataspace.princeton.edu/jspui/bitstream/88435/dsp01t435gd01h/1/Comparing%20Real%20Wage%20Rates-combined--2-22-2012--final.docx

Nick, Andy Harless has it right, the answer to:

"OK, but what is it about people *living in the same country* that would cause one group of individuals all to have wages high relative to productivity, and a second group of individuals to have wages low relative to productivity? In other words, why is there a correlation between: wages/productivity; where you live?"

is the history of the adoption of the euro. When the euro was adopted, Germany was in a post dotcom slump. It needed the support of low interest rates. The ECB (in which Germany had considerable influence) accommodated it. These rates were much too high for the poorer southern countries and represented negative real rates. I don't know what their economists thought, but the people in those countries obviously liked the idea of low rates.

These low rates had predictable effects.

They created asset inflation. It was like a parachute jump into the latter parts of the Minsky cycle. People bought assets that had appreciated, believing this showed they would continue to appreciate, and the cost of investment was negligible. There were huge real estate booms in Ireland, Spain, Portugal and Cyprus.

Wages began to converge. Not only was business artificially stimulated, but it was in wage competition with the asset inflation business - real estate, construction, finance...

Greece is a bit of a special case. The statistics appear to be unreliable. I have no idea what percentage of the working age population is employed by the government. I've seen figures anywhere from 25% to 50%. I doubt the Greeks know.

All this cheap money made for a lot of debt, particularly non-government debt. The money was then recycled to the lender countries through imports. The European banks financed the whole mess.

When the inevitable loss of confidence came, the debtor countries' banks were insolvent from property loans, and people employed in the boom sectors were out of work. We've seen this in the US.

So, I'd say that differences in productivity rather than being the cause of the euro's problems is one of the the results of them.

Er..."Greeks" are a group of people who pay taxes to a national government based in Athens. Athens takes those taxes, plus whatever money chooses to borrow, and provides services to "Greeks" and is supposed to pay off old debts. "Germans" are a similar group who do the same to a Berlin government.

Greeks make goods and services, and some percentage of that goes to Athens. They also buy goods and services. Suppose they start buying more than they make. They have to get it from another country, let's call it, oh I don't know, "Germany".

Now in olden days "Greeks" had a currency called "drachmas" and "Germans" had "deutschemarks". If Greeks bought stuff from Germans, they would convert drachmas into deutschemarks. That meant the price of deutschemarks would go up. That in turn raised the price (in drachmas) of everything imported from Germany. Then Greeks would have to buy less stuff, enough less, as it happens, so that what they buy had to match what they made.

Then a group of geniuses decided to get rid of drachmas and deutschemarks and have just euros. Now that automatic signal that kept consumption and production close together no longer exists. Inevitably, Greek consumption outpaced production. It all went on the credit card. In Greece, it was the government's credit card; in Spain, it was private sector credit cards.

Except, of course, the credit card bill eventually got so large, lenders clued into the fact that Greece's tax revenues would never be enough to pay it, and stopped lending. Of course, since Greece was continually issuing new debt to pay off old, this meant that Greece could no longer pay its existing debt. Nor could it provide services to Greeks without borrowing money.

The solution (so far) has been for Germany and other northerners to keep lending money to Greece in place of the private sector. (It's important to note that the oft-abused word 'bailout' actually means loans, not grants.) As a condition of getting these loans, Greece then ordered to bring consumption in line with production by brute force - lay off workers, cut pensions, cut wages, cut government services etc. Unfortunately doing this just cuts production as well as consumption, so Greece is not actually better able to pay its debts.

The only two solutions are for either Greece to exit the euro, or for the eurozone to become a single country, not just a single currency. Multiple countries sharing a currency doesn't work.

tyronen: OK, but your story is a story about budget deficits and current account deficits, but has got nothing to do with productivity differentials as far as I can see.

Obviously I didn't write this post clearly enough. Perhaps I wasn't thinking clearly enough (what would Deirdre McClosky say?)

Yes, a "country" is many things. But, and this depends on the question we are asking, some of those things will be relevant for a particular question and others of those things will not be relevant for that particular question.

And the question here isn't productivity shocks. It's about permanent productivity differentials.

And it's not about why those productivity differentials exist. I'm just assuming they do exist. And you can assume that permanent productivity differential is somehow just inherent in the country, due to geography, politics, culture, or whatever, if you like.

(Simon: "But let me see whether I understand your wage/productivity/region correlation puzzle. Am I right in thinking that you're puzzled about what might cause one region to lose/gain competitiveness relative to another? Seriously?"

No, I can think of all sorts of reasons why that might happen. But that's not the question. I'm not talking about a competitiveness shock, and I'm not talking about the reasons for competitiveness differentials. I'm just assuming they exist, and they might easily be regional.)

Maybe I should re-think/re-write. When lots of good commenters are not getting my point (I think), it must be me. Sorry guys.

I actually had the feeling I might not be getting you either as I was writing. Because, of course, Nick Rowe knows about asymmetric shocks and OCA theory, but that seemed at least to be the question.

So, overall I think Simon Johnson is wrong (or being sloppy) in claiming permanent productivity differentials doom the Euro, with the following caveats; it may be possible that the business cycles of countries with differing productivity levels have business cycles that are less in sink, and in the case of the Euro, I do think there was a false expectation among policy makers and finance markets that there would be a rapid convergence in productivity levels (which drove interest convergence and 'hot' money flows).

OGT: thanks, yes. If Simon Johnson had said that permanent productivity differentials are what cause asynchronised productivity/competitiveness shocks (because low productivity means you are stuck producing olives rather than BMWs, and shocks to the olive harvest are not well correlated with shocks to BMW production??), then his story would at least be complete.

While waiting for Nick's reformulation of the issue, in defense of Simon Johnson, let it be noted that Johnson's views concerning productivity differentials at the root, is widely shared in IMF publications including Blanchard,the OECD, central banking - see Gov Carney's speech of yesterday in Halifax and the think tanks e.g. VoxEU.

For example, see "The Eurozone’s May 2010 strategy is a disaster: Time to pay up and end this crisis", Charles Wyplosz, 20 June 2012 - http://www.voxeu.org/index.php?q=node/8117

Or see any of Ambrose Evans-Pritchard's columns

Or Munchau at EuroIntelligence

Or, gasp, Martin Wolf's latest columns.

Nick: I do remember that old post, since it was really interesting. I got some other things and since comments are closed, I would add just last comment to that post. We already know that all money in the world would end up in the country with higher interest rate and that in the other country people would expect permanent deflation.

In the discussion I already mentioned wealth effect as possible reason that could interrupt the whole bond purchase process, that was not formulated well enough. So lets do it again - we know that if the first country expects deflationary spiral, sooner or later prices would be so low that any individual could use proceeds from bonds to buy the whole real product monopolizing it and dictating whatever price he wants. So if people expect that this will happen in the future, they would not start buying those bonds in the first place. Now this strongly reminds me of backward induction proof of why fiat money should be worthless by Earl Thompson. Except that your model does not recognize any authority that would ensure redeemability of these essentially worthless bonds into someting (like CPI basket of good etc.).


So my take is, that if there are permanent productivity (and real interest rate) differentials between "countries", they cannot remain in a tradable sector forever. They may exist in nontradable sector, but since I think that I proved that your model with common curency for countries that cannot trade are not affected by purely financial transactions, any such transactions should reflect just that part of the economies that are tradeable.

But all this really means is that differences in productivity are not the reason for crisis (financial or otherwise). This is why I would define "country" as the largest entity that is potentially able to manage nominal shocks (by monetary policy, by fiscal policy, by factor mobility etc.). So you are right, it is strange that people so loudly speak about difference in productivity between Germany and Greece, while even bigger difference in productivity like that between Germany and Slovakia is overlooked. And by the way, Slovakia is supposed to have highest GDP growth in the whole Eurozone.


Ian: You are definitely right that Simon Johnson is very much not alone in stating that view. It's very widely held. But I pick on Simon because he's...whatever is the opposite of a strawman. And someone I usually agree with.

JV: I think we are on the same page.

Hmmm. Paul Krugman says that productivity differentials are about the same in the US as in the Eurozone.

But in his last 3 paragraphs he says that it's fiscal transfers in the US that make the difference. Why? If we are talking about productivity differential shocks I get the point. But if we are talking about long run non-convergence, I just don't see it.

There are macro arguments for automatic fiscal stabilisers to handle shocks. And there are micro arguments for transfers to the permanently poor. But I don't see him making a macro argument for transfers to the permanently low productivity regions.

Nick - I am looking to you for the answer to this macro question - which I have puzzled over.

My question is not rhetorical.

Did Canada establish fiscal equalization to the poorer provinces - because they had lower productivity and thus generated less economic activity including jobs (that pay taxes) and thus could not provide the same level of social services as those provinces had lower budgetary income w- used to finance social goodies?

Updated to southern Europe: Do the permanently lower levels of productivity - acceptable with e.g. the drachma (as the drachma depreciated to compensate for lower productivity) - now produce increasing unemployment as the Greek firms could no longer compete via a depreciated currency – within a common Euro currency, as their goods were now more expensive than Dutch or German or Austrian goods and the cost of visiting Greece as a tourist became more expensive than Turkey?

In turn, was it this factor that caused sovereign borrowings to increase to compensate for declining govt income from higher unemployment?

I recently read an interesting paper (Harvard economics?) trying to explain why current account deficits often occurred in tandem with government budgetary deficits.

I think - but not sure - if I am puzzling over the same question you are asking.

What is the relationship between permanently lower productivity levels in a country (in a common currency) and the deficit and sovereign total indebtedness?

Not looking for concrete steppes. Just trying to understand the relationship – if any - between permanently lower productivity and sovereign deficits, between micro and macro.

Ianlee mentioned the productivity differences over centuries re the north and south. I'll ask again why EU can't just force Germany to take in more labouring immigrants the way the north forced USA students to learn at parity in the South. It creates a demand for language instructors and such. I wanted Canada to build wind turbines instead of the holosands; the company I googled for California was a German tool-and-die maker. It has been hypothesized Greece has bad transportation compared to german intra-city trading.

This suggests some inequality is not fixable and there should be city planning. ie) Grecians forming a new "Canberra" between German cities insteas of prolonging the bleeding. Is like the manufacturing vs resources thread a few weeks ago. Either build cities in the tarocaust where I presume Mulcair died of terminal cancer, or be prepared to invest in manufacturing (including hightech "services") where cities are now (assuming past efficiencies of locations still stand). But it seems like everytime I rationally criticize AB/petro/CPC the room goes silent. CPC can't be efficient and greedy at the same time. When you give money to parasitic petro or neutral banks, you take away from researchers, from $5/day geniuses, from pretty much most future humans who will be hunting and gathering their way out of AGW...

Ian: if the A's have permanently lower productivity than the B's, then we would expect the A's to have permanently lower real wages than the B's. If, for some reason, the A's insist on having the same real wages as the B's, then the A's will have a higher unemployment rate than the B's.

Permanent fiscal transfers from the B's to the A's could offset the lower incomes of the A's. Permanent fiscal subsidies to A's employment, paid for by taxes on B's employment, could also help offset lower real wages and/or higher unemployment for the A's.

If there is a temporary shock to productivity, so that A's productivity falls quickly relative to B's, then maybe A's wages can't or won't fall quickly enough to compensate and keep them competitive. In this case, giving A's and B's different monies, and devaluing the $A against the $B, could help. Devaluation can happen more quickly than nominal wage changes. But if there is a permanent difference in productivity, a permanent devaluation of the $A against the $B could only help if there is some sort of permanent money illusion, or permanent nominal wage stickiness. It's like saying: "The Japanese need to have a Yen worth only one hundredth of a dollar, because Japanese productivity is only 1% of US productivity."


Along the lines of several comments above, a "country" is a set of arrangements for, inter alia, generating and distributing the joint output of a group of people. This obviously requires a whole complex set of institutions, commitments, allegiances, accommodations etc. Taking these for granted, what might "shock" such a set of arrangements? Well, one things might be changes in access to external resources by one group; another might be a growing connection with other groups whose arrangements are very different. Easy to find examples of the first include, say, when landlords find it easier to get state military or political support (the tenants find their share diminishing. See also recent Western experience as state pressure has been brought to bear against unions). The second will pose choices about how far and how fast arrangements can be renegotiated. It will also be vulnerable to perceptions about the degree and permanence of the external support. So the shock might come when people see some change in the creditworthiness of the lenders or borrowers. The Greek (and Irish, Italian, Spanish) experiences have both flavours. It wasn't Germany lending to Greece, it was some Germans (confident in the support of German arrangements) lending to Greeks (confident that German patrons would behave as Greek patrons) finding out that German arrangements are not Greek arrangements, and then trying to reach some new deal where other Germans, or other Greeks, or someone else entirely, paid for the damage.

Nick, those productive people and less productive people are all mixed up in your example. They don't have balance of payments problem. If anything, the less productive people will earn less, but I don't think that is the story. Productivity has everything to do with the society. Let's take 1000 American laborers to some poor African country and let them work there. And let's take 1000 of that country's workers and let them work in America. You know what is going to happen to their productivity right? Sorry if this has been talked about in the comments already.
And you know you can't have that kind of 'equilibrium' in EZ ever, or in any monetary zone.

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