Saturday, December 31, 2011

Don’t reason from a trade balance

This is based on a comment I made here.

The idea of the Euro was simple—a Deutschmark for everyone who signed up. With Deutschmark interest rates for everyone. And it worked, for a while.

But it married together different political economies. The PIGS countries relied on competitive devaluations to compensate for their institutional failings. Germany had long accepted the institutional demands of a "hard" currency (think Ludwig Erhard's "bonfire of the regulations").

Germany and co are net exporters because they have the institutional back-up to be competitive given the value of the Euro (especially within the Eurozone): the PIGS countries are net importers because they do not. Which is fine if you have the future productive capacity (and current debt-servicing income) to back up the required importing of capital. But they don't because of the ECB's tight money/low income growth policy's effect on their current income and their institutional failings on their future productive capacity. It comes back to institutional differences (common currency bad) and current income (ECB monetary policy bad). The sovereign debt/financial crisis (lender of last resort needed) is a product of the interaction of ECB policy with institutional differences and failings. With different countries suffering different levels of intersection of these problems.

Scott Sumner warns to not reason from a price change: perhaps people should not reason from a trade balance either.

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