Spain, Greece and the Euro

Paul Krugman has a number of posts on Spain, Greece, et al, and specifically how being part of EMU means they won't be able to depreciate to avoid crushing recessions. The point he is making is of course perfectly valid, and he is - as usual - ahead of the pack in correctly perceiving the real problem as being loss of competitiveness in the PIIGS and the need for substantial deflation, potentially crippling growth for years.

His conclusion is also the correct one:

Am I calling, then, for breakup of the euro. No: the costs of undoing the thing would be immense and hugely disruptive. I think Europe is now stuck with this creation, and needs to move as quickly as possible toward the kind of fiscal and labor market integration that would make it more workable.

First of all, I was, and still am, a strong supporter of the Euro. The common currency is more than anything else a step towards the dream of political integration, a sceptical Europe of nation states moving towards a post-nationalistic era of many cultures but common political goals and aspirations, based on respect for human rights and the rule of law, a belief in the power of free trade and the absurdity of borders, and a desire to for ever leave behind the madness of the past and other petty differences. No-one in their right mind can possibly argue that the demons haunting Spain and Greece today are scarier than the demons that political union can forever banish.

A common currency brings with it not only disadvantages but also advantages, but whichever way you cut it it was never meant to be a brilliant economic idea, even if reasonable people can claim it is a good one. It was meant to be a trojan horse leading us to closer and closer union: not a superstate, but an unbreakable union of culturally diverse nations living together in peace - and if this political experiment is to succeed in Europe, why not the world?

This crisis may yet bring people to their senses - what was everyone thinking when they picked Van Rompuy? - and remind them what the Euroland is all about; if this happens, the current mess may well lead to a better Europe and a better world.

So, the first thing bothering me about Krugman's analysis (and the debate more generally) is a lack of perspective. It is the same thing I talked about when I posted on the misguided economics of Scottish independence.

The second thing that bothers me is Krugman's style. Krugman is always right; and I really mean that. On top of that, he is incredibly good at homing in the most important aspects of every issue, as he did in this case by focusing on the prospect of deflation in the PIGGS rather than the state of public finances. But not being wrong is a good thing, right? It would be if he then didn't push his case to the extent that he paints a misleading picture. In the words of Vladimir Nabokov, Krugman deals in doughnut truths: only the truth, and the whole truth, with a hole in the truth.

First of all, he posts this graph to support his thesis:

What is the problem with this? Well, by picking Germany, he makes the degree of appreciation look much more extreme than is actually the case - here is what a more representative graph would look like:

The divergence in price appreciation between Greece and the EMU average is about 10%, which could go away with only moderately lower inflation in Greece compared to the rest of the Euroland over the next, say, 10 years. [Addendum: to his credit, Krugman also posted this after I'd written this post, which paints a more balanced picture, if only by including France. And yes, he is absolutely right again in calling for higher inflation for EMU as a whole.]

Even more importantly, by posting this graph he is strongly implying (although not quite saying- that same irritating 'he's never actually wrong' thing again) that these discrepancies need to go away. But it is not so: between 2000 and 2008 Germany's real GDP grew by about 13%, Spain's by 33% and Greece's by a whopping 40%. Yes, some of this is illusory, 'debt-driven bubble growth'; but the biggest part is probably pure Solow coupled with a speedier institutional reform in the poorer, more backward PIIGS compared to Germany. And guess what: even after this decade of strong gains, employment as a percentage of the working age population is 70% in Germany (from 65% in 1998), in Spain it is 65% (from 52%), and in Greece 62% (from 56%). Hourly wages in the latter two countries remain a fraction of German levels, and I'm sure there is a similar picture when it comes to unit labour costs (sorry, can't find the relevant data).

A large part of this capital inflow and price appreciation is here to stay: As Spain and Greece have become richer, with the potential to grow even more in the future, you would also expect the price level to go up. If country A has half the nominal GDP of country B, you would expect the price level in country A to also be lower; if country A grows to have the same level of GDP as country B, you would expect price levels to be the same. Things are expensive in France and cheap in Algeria.

So, would Spain and Greece benefit from being able to depreciate? Yes. Should EMU move towards more fiscal integration? Hell yes. Would EMU benefit from more inflation? Yes indeed.

Does the price level in Greece need to fall by 30% so that Greece can be competitive and grow again? Most definitely no. The imbalances are simply not as great as Krugman presents them to be, and he is being disingenuous, if not outright mistaken, by presenting growth in GDP deflators since the formation of EMU to support his (basically valid) main points. Growth in GDP deflators in itself is irrelevant to the point he is making.

Addendum: Why are poor countries cheaper than richer countries? The answer lies in the existence of non-tradable goods: things like haircuts and doctor visits. The price of tradeables (grain, plasma TVs, cars, etc) is common across the EU since there are no barriers to trade, but it costs much more to get a haircut in Germany than in does in Portugal. If Portugal becomes richer and Germany stays where it was, the price of TVs will still be the same in both countries, but the price of haircuts in Portugal will no longer be as low relative to Germany as it used to be. With Germany and Portugal sharing a common currency, higher real GDP growth in Portugal means the price level in Portugal will increase relatively to Germany - and there's nothing weird about that. Simply pointing to divergence in GDP deflators between countries with no reference to real GDP growth (or growth prospects for that matter, as this is also about current account deficits) is silly.

by datacharmer | Sunday, February 14, 2010
  , | | Spain, Greece and the Euro @bluematterblogtwitter


  1. Anonymous Says:

    Choosing Germany as your base is always misleading in this context (yet everyone does it). There is a strong argument that Germany entered the euro overvalued and had to regain competitiveness by way of very low wage and price inflation for a number of years.

    That said, a degree of price convergence to regain competitiveness is needed (this is already happening in Ireland and to a certain extent Portugal). But fiscal consolidation is doubly difficult in these circumstances. Greece has outlined plans to reach a government deficit of 3% of GDP by 2013. Achieving this will be much more difficult if nominal GDP (which is what matters) is shrinking due to deflation.

  2. Leigh Caldwell Says:

    Very nice post. I have one ( on the same topic but you have made the point more clearly.

    I also had a paragraph about the political as opposed to economic motivations for the euro, but deleted it before posting as I was already going off on enough tangents. But you're quite right that it's a really important factor. The desire of several countries outside the eurozone to join it, just as the clamour to join the EU itself, strongly support this case.

  3. stef Says:

    On recessions:
    I do not agree with the common notion that recessions are bad and should be "crushed" by governments. Recessions are a natural process that can be found in all areas in life and throughout history, the earliest reference to a recession on record can be found in the old testament: "There would be seven years of plenty with abundant crops, followed by seven years of drought".

    Democratic capitalism is not free of flaws, but it is the best model we've got. History has proven that, or you wait until the guy from Pyongyang has learnt English to prove you wrong!

    If governments would keep their hands off intervention and let the free markets operate by themselves, a recession would clean out the bad parts of the economy and help good business emerge stronger and with a solid base to foster new businesses. Bailouts and stimulous are just bandaids rather than the cure to the problem, the merely postpone a recession by propping up business with unprofitable business practices and putting the burden of this artificial support onto the entire economy.


    On the Euro:
    I am also pro Euro, but not at all cost: Whether the Euro, AIG, the Champions league or your kids Ivy league kindergarden, if you aim at retaining a degree of competitiveness, your members gotta adhere to standards and deliver the required performance, or else you're out. Rules can be bent to a small degree, but if Greece (or any other country) continues to fail by a large margin over an extended period of time to deliver the required results it should leave the Euro. It is unfair that the other member States who deliver the performance should bare the burden.

    In any case, a lot of the other countries do not deliver either, that is why I am pessimistic about the long term future of the Euro. In general most major currencies are currently flawed, the USD has to tackle inflation and huge US debt, the Renminbi is a closed currency, the JPY has socioeconomic issues with an aging society, the BRL, NOK, CAD, AUD, NOK, are somewhat stronger but too small to act as a major global currency.


    On depreciation in Greece:

    Germany is a high-income country and a world-class exporter. So is South Korea. You don't need to depreciate to retain competitiveness, but there is no place for protectionist measures. There never was anywhere in the world at any point in time! It is clear that Greece cannot compete with China in manufacturing. Greece should focus on what it can do best: Shipping and tourism. Beyond that it is governments role to provide a modern infrastructure and expand education in order to nurture the next generation of entrepreneurs who will be able to generate the next big industry in which Greece can prove it's world class status.

    PS: Germany wants Greece out: