Thursday, December 29, 2011

Currency and Productivity ... A Look at Europe's Problems and Solutions

Recently the economic news has been pretty much all Europe all the time. And it's been mostly bad news at that.

As a huge part of the global economy, the U.S. will be impacted by what happens in the Euro zone, good or bad. The only question is by how much and for how long.

Let's look briefly at the available lessons for us to learn. The Euro Zone's German Crisis is an editorial by Alan Blinder, former vice chairman of the Federal Reseve. In the article he discusses the Euro currency's problems:

"All financial eyes are fixed on the euro. Europe's common currency actually has two gigantic problems. The debt and banking crisis hogs all the attention because of its immediacy, plus the high drama of all those summit meetings. But the other, slower-acting problem—lopsided competitiveness within the euro zone—is far more intractable.

First, the immediate problem. The euro was an audacious venture that put the cart before many horses. The fundamental problem is that the euro zone is not a country. Initially 11, and now 17, sovereign nations signed up for a currency union without first homogenizing their budget policies, their tax systems, their bank regulations or much else. And they did so without creating a central government strong enough to, for example, impose cross-border discipline or finance large cross-country transfers. To use an American analogy recently promoted by Nobel laureate and New York University economist Thomas Sargent, the 17 have been trying to fix their debt and banking problems under the equivalent of the Articles of Confederation, not the Constitution."

Notably, the Euro currency and the individual European countries have different governing bodies. Unlike the jointly managed Euro currency, when it comes to fiscal policy each sovereign country is on its own.

If the U.S. had that approach, each separate state would go its own fiscal way as well. Its spending, debt and competitiveness issues would be its very own.

Accordingly, entitlement programs such as social security, medicare, medicaid and even public school funding would all be left to the discretion, funding and management of each individual state or sovereign. Texas would handle Texas, Illinois would look out solely for Illinois, California for California and so on. There would be no IRS either.

But let's move back to the problems of Europe. To wit, why is the commonly shared Euro currency such an enormous and seemingly insoluble problem for Greece? Well, here's Blinder's explanation:

"Normally, a weak economy has three ways to fight back. It can loosen monetary policy, it can loosen fiscal policy, or it can let its currency depreciate. (If the currency is floating, the market will do this automatically.) But membership in the euro zone forecloses two of these escape hatches, leaving only fiscal policy. And once a member country stretches its borrowing capacity to the limit—as Greece did—that route is closed, too. Then what happens?

One answer is playing out now as a Greek tragedy: You have a depression. And if neither monetary stimulus, fiscal stimulus, nor currency depreciation is possible, when does this depression end? It may take quite a while. Real GDP in Greece is already down about 12% and still falling—which is why you've heard so much talk about Greece leaving the euro. Of course, what happened in Greece didn't stay in Greece. Markets started turning on the other wounded antelopes in the European herd: Portugal, Ireland, Spain, Italy and so on."

The lesson for the U.S. is straightforward. Heavily indebted, uncompetitive and financially weak countries invariably end up with one or more, perhaps even all, of the following dilemmas to solve; depression, deflation, stagflation or inflation, any and/or all of which lead to even weaker economies.

And it doesn't help an individual sovereign much, if at all, to be a member of a common monetary union or perhaps even a fiscal union if the country can't compete globally.

In other words, a country which attempts to address its problems by printing more money brings on inflation. Debasing or weakening its currency creates inflation as well. That leaves fiscal policy, and spending money that a country doesn't have by borrowing from other countries causes inflation, too. At least until the lenders refuse to loan the big spending and borrowing country any more money.

At that point it's game over. That's essentially where Greece finds itself today.

So today Greece is where Greece is because of its lack of global competitiveness and because lenders aren't willing to throw more good money after bad. At least not based on Greece's individual credit standing. Since the Germans aren't inclined to throw more good money after bad to rescue Greece, the good citizens of Greece now find themselves between the proverbial rock and a hard place.

In addition to Greece, here's what the article says about the problem of many other European nations' lack of competitiveness:

"The euro-zone's other, barely mentioned but huge problem is competitiveness. It's far more basic and looks less solvable than the sovereign debt problem.

To see why, remember the two fundamental determinants of exchange rates: (1) productivity in different countries—so, other things equal, faster productivity growth should lead to a rising exchange rate; and (2) prices and wages in different countries—so lower inflation should lead to a rising exchange rate. Thus, for a currency union to succeed, its member nations need to register approximately equal productivity growth and approximately equal wage and price inflation.

How has the euro zone fared on this score? In principle, the ECB's common monetary policy should (approximately) equalize inflation rates across all the member countries. In practice, it hasn't. You won't be surprised to learn that, since the start of the euro, Germany has had the lowest rate of inflation among the major countries, followed closely by France. The highest inflation rates have been in Greece and Spain. While these inflation differentials are not gigantic, they are large enough to strain a system of fixed exchange rates.

The other part of the equation is worse. When it comes to productivity, Germany has simply pulled away from the pack. Partly because of thorough-going labor-market reforms in the last decade, and partly because it's, well, Germany, Europe's powerhouse economy has achieved vastly higher productivity growth than its euro partners. Since 2000, German unit labor costs have risen about 20%-30% less than unit labor costs in the other euro countries. That gap has left Germany with a large intra-Europe trade surplus while most other countries run deficits.

If we were talking about China, at this point we would accuse the Chinese of manipulating their currency to gain an "unfair" trade advantage. But, of course, Germany has not manipulated anything. It has acquired a seriously undervalued currency by locking into fixed exchange rates with Greece, Spain, Italy and the others."

Summing up, a country's productivity over time determines its global competitiveness. In turn, that competitiveness determines its citizens' prosperity and standard of living.

As a consequence, lenders and equity investors will choose to invest in those companies and countries that have productive and competitive work forces.

Currency unions among countries are well and good, all other things being equal. But, of course, all other things never are equal.

If countries aren't competitive with other countries, currency adjustments must take place. That serves to restore the balance of trade between countries and also acts to direct investment funds into those competitive countries and companies.

It's really that simple.

Martin Feldstein, former Chairman of President Reagan's Council of Economic Advisors, says this about Europe's optimal solution to its countries' debt crises in The Euro Zone's Double Failure:

"The Merkel-Sarkozy team should recognize that they have been on the wrong track. Europe needs country-by-country fiscal reforms and not a renewed push for a fiscal union and political integration."

He further argues convincingly that Italy and even Spain are not facing similar fiscal or competitiveness problems compared to Greece:

"It's wrong to speak about Greece and Italy in the same breath, as the euro-zone politicians did when they insisted that Greece had to be rescued to prevent a default in Italy. That undermines confidence in Italy. Greece has a budget deficit of 9% of GDP, a current account deficit of 8%, and a GDP that is collapsing at an annual rate of more than 5%. Greece cannot hope to get its deficit under control fast enough to stabilize its debt and attract private lenders. Instead of remaining a permanent ward of Germany and the IMF, Greece should default on its debt, leave the euro zone, and return to a more competitive drachma.

Mario Draghi, the new head of the European Central Bank, has clearly and correctly rejected the French suggestion that the ECB should announce that it will buy whatever quantities of Italian and Spanish bonds would be required to keep their interest rates at low levels. Doing so would violate the ECB rules established in the Maastricht Treaty that prohibit ECB bailouts of insolvent member governments. It would also destroy the incentive for politicians in Italy and Spain to make the politically difficult changes that will lead to lower future deficits. And it would weaken international confidence in the ECB and therefore in the euro."

My take is that Germany and the ECB are properly practicing a painful form of financial 'tough love' with respect to dealing with the various European countries' financial and competitiveness issues.

It's a shame we don't have the same approach for states like California, Illinois, New York, Michigan and other big spending states in our own country. Oh well, maybe someday we will when the ability to borrow as much as want at the federal level runs out.

Thanks. Bob.

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