A guest commentary by Henry Kaspar
Kantoos‘ and my articles on whether insolvency or illiquidity concerns are driving the euro crisis have provoked a number of reactions, both here and in other blogs. This is an attempt to reply to the main criticisms and counter-claims.
1. „As long as there is liquidity, solvency does not really matter“
This is Ryan Avent’s position, and it is remarkable indeed. Note that the view is not „the Italys and Spains are fundamentally solvent and this is just a market panic“ – it is „sufficient liquidity makes solvency irrelevant“. Not only do I find it impossible to agree, the view seems so absurd that I wonder whether I misunderstand Avent. After all he continues:
Convince markets that solvency is irrelevant and you allow the damaged institutions time to muddle their way back to health.
The sentence contains a contradiction in terms: institutions that can be nurtured back to health are not insolvent (=incapable of generating the revenue to repay their debts). But this apart, I agree with Avent that the peripheral euro area sovereigns should be kept afloat as long as they are muddling their way back to health (within a reasonable time frame). The point is that outside Ireland and maybe Spain, this is not what we observe. And this is a problem: in a currency union, uncompetitive economies that fail to engineer sufficiently large internal devaluations – or indeed an internal devaluation at all – cannot return to health, no matter how much time and liquidity they are being granted.
2. „If everybody devalues nobody wins“, „it’s a matter of the math“
Another point made by Avent, but also by many others, for example Matthew Yglesias. The answer is: not everybody should devalue – and not everybody does.
Matt_US kindly pointed to the ECB Statistical Yearbook that contains unit labor cost data through Q2 2011 (p. 41). They show that with the remarkable exception of Italy, all crisis countries are now devaluing. Against who? Economies like Finland or Germany (yes, Germany) that are close to full employment and are beginning to feel wage pressures (in fact this is not entirely new – we observed this already in 2009).
This is how adjustment in a currency union should – and can only – work. Overvalued economies devalue through cuts in labor cost to restore competitiveness and growth prospects; undervalued economies attract capital inflows that stimulate domestic demand and put upward pressure on wages and prices, thus reducing their competitive edge. As Kantoos and myself have pointed out repeatedly, Germany found itself in a poor competitive position in the early 2000s, forcing it through years of painful wage cuts and capital outflows, while Europe’s banking system channeled German savings to the euro area periphery. This process is now turning around.
[P.S.: the European tragedy is that capital flows funded unproductive booms in real estate (Spain) or government spending (Greece) rather than investments in the tradable sector - this is where the process went wrong. The countries that revalue now should work hard to avoid repeating this mistake].
Unfortunately, internal devaluation is tough. Assume Portugal is overvalued by 20 percent, and suppose it maintains its current speed of adjustment, i.e. -0.9 percent per year. If unit labor costs for the average of the euro area continue to grow by just 0.8 percent annually, it will take 14 years until Portugal has restored a competitive position. Neither investors nor the Portuguese and wider European public will grant the process that much time.
But suppose Portugal doubles its efforts, while unit labor costs in the euro area grow by 2 percent (instead of 0.8 percent) per year. This cuts the necessary period of adjustment to less than 7 years – still stiff, but at least imaginable. Here is where the ECB comes into play: by allowing somewhat more inflation it could facilitate adjustment, and thereby improve the prospects of the euro area to function. But the ECB can only facilitate adjustment, it cannot replace it. As long as labor costs in Italy grow faster than for the average of the euro area, Italy will be unable to safeguard competitiveness and, therefore, solvency.
3. „Ireland is different from Portugal et al.“
Without question. Ireland’s labor market is more flexible than those of the southern European PIIGS (=it is easier to reduce unit labor costs), it is a more open economy (=a given cut in unit labor costs triggers a larger adjustment in the external balance), and it has a more diversified export base, with important trading partners outside the euro area (=it is less exposed to euro area specific shocks). So overall Ireland is in a better position to adjust.
Unfortunately, all this means is that Ireland is better suited for membership in a currency union than others. It does not invalidate that capacity to adjust is a pre-requisite for being part of the euro area.
[P.S. Paul Krugman is right that Ireland's CDS spread went back up some 50 bps in the days before the Brussels summit. This does not undo the different trend from Portugal since mid-year, however].
4. „All this is inhumane“
This is a common, anti-intellectual claim against any economic reasoning (here made eloquently by the poster Marbleone). But in this specific context there is a wider truth to it: the economics of currency unions are brutal and rigid. With multiple currencies, competitiveness can be regained through exchange rate adjustment, and excess debt can, at least in part, be inflated away. With a single currency, wage adjustment takes the place of exchange rate adjustment, and fiscal austerity replaces inflation (a tax on money holdings).
As a result, there are few (if any) examples in history of heterogeneous countries that were able to tie their currencies together for long periods. During the classical 19th century gold standard – often hailed as prime example of a functioning currency union – countries outside the gold core (U.K., U.S., Germany, France) were repeatedly forced off gold and into default, especially during the deflationary 1880s and early 1890s. And also in the core countries there was strong popular opposition against the rigid constraints of a fixed currency, U.S. presidential candiate William Jennings Bryan famously demanded in 1896 „not to crucify mankind on a cross of gold“. In the 1920s, the attempt to restore gold parity ended in an economic, financial and political implosion without parallel. Since World War II, emerging economies have suffered primarily the pitfalls of fixed and quasi-fixed exchange rate regimes. Argentina’s traumatic abolition of its currency board with the U.S. dollar in 2002 is a recent example, when an appreciating U.S. dollar rendered the Argentine economy uncompetitive and undermined all attempts to control the situation with austerity.
From a historical perspective, it would be an exceptional feat if the Europeans could maintain their currency union for an extended period – at least with its current, heterogeneous membership. To stand a chance, the capacity of the euro area economies to adjust is indispensable.