Do Prices Matter? EU Edition

The Euro crisis. One thing sensible people agree on is that the crisis has little or nothing to do with fiscal deficits  (government borrowing), and everything to do with current account deficits (international borrowing, whether public or private.) And one thing sensible people do not agree on, is how much those current account deficits are due to relative costs, or competitiveness.

A thorough dissection of competitiveness in the European context is here; Merijn Knibbe has some good posts critiquing it at the Real World Economics Review. Krugman, on the other hand, defends the competitiveness story, suggesting that the alternative to believing that relative prices drive trade flows, is believing in the "doctrine of immaculate transfer." What he means is, the accounting identity that net capital flows equal net trade flows doesn't in itself provide the mechanism by which trade adjusts to financial flows. A country with an increasing net financial inflow must, in an accounting sense, experience an increasing current account deficit; but you still need a story about why people choose to buy more from, or are able to sell less to, abroad.

So far, one can't disagree; but the problem is, Krugman assumes the story has to be about relative prices. It's not the case, though, that relative prices are the only thing that drive trade flows. At the least, incomes do too. If German wages fall, German goods may become more cost-competitive; but in any case, German workers will buy less of everything, including vacations in Greece. Similarly, if Greek wages rise, Greek goods may be priced out of international markets; but in any case Greek workers will buy more of everything, including manufactured goods from Germany. Estimating the respective impacts of relative prices and incomes on trade flows, or the elasticities approach, is one of the lost treasures of the economics of 1978. Both income and price elasticities solve the immaculate transfer problem, since capital flows from northern to southern Europe were associated with faster growth of both income and prices in the south. But their implications for policy going forward are quite different. If the problem is relative prices, a devaluation will fix it; this is what Krugman believes. If the problem is income elasticities, on the other hand, then balanced trade within Europe will require some mix of structural reforms (easier said than done), permanently faster growth in the north than the south, or -- blasphemy! -- restrictions on trade.

Let's pose two alternatives, understanding that the truth, presumably, is somewhere in between. In the one case, EU current account imbalances are due entirely to countries' over- or undervalued currencies. In the other case, current account imbalances are due entirely to differences in growth rates. One thing we do know: In the short run -- a year or two -- the latter is approximately true. In the short run, the Marshall-Lerner-Robinson condition is almost certainly not satisfied, so a change in prices will have the "wrong" effect on foreign exchange earnings, or at best -- if the country's imports and exports are both priced in foreign currency -- have no effect. In the long run, it's less clear. Do prices or incomes matter more? Hard to say.

So what is the evidence one way or the other? One simple suggestive strand of evidence is the intra- and extra-European trade balances of various countries in the EU. To the extent that trade flows have been driven by price, the deficit countries should have seen larger deficits with other EU countries than with other countries, and the surplus countries similarly should have seen larger surpluses within the union than outside it. Those countries whose currencies would otherwise, presumably, have appreciated relative to other EU members should have shifted their net exports towards Europe; those countries whose currencies would otherwise have depreciated should have shifted their net exports away. Is that what we see?

As is often the case with empirical work, the answer is: Yes and no. From Eurostat, here are trade balances as percent of GDP, within and outside the currency union, for selected countries and selected years.

Intra-EU Trade Balance
	1999	2007-2008	2011
Germany	2.0%	4.8%	2.1%
Ireland	19.0%	7.4%	12.6%
Greece	-10.0%	-9.6%	-5.3%
Spain	-2.9%	-4.0%	-0.6%
France	-0.3%	-3.1%	-4.3%
Italy	0.5%	0.5%	-0.2%
Netherlands	14.8%	24.5%	27.9%
Austria	-3.9%	-3.0%	-5.0%
Extra-EU Trade Balance
	1999	2007-2008	2011
Germany	1.2%	2.8%	4.0%
Ireland	6.1%	7.8%	15.1%
Greece	-3.9%	-9.1%	-4.4%
Spain	-2.1%	-5.1%	-3.8%
France	1.0%	-0.1%	0.0%
Italy	0.8%	-1.2%	-1.4%
Netherlands	-11.8%	-17.5%	-20.5%
Austria	1.4%	2.7%	1.9%

What we see here is sort of consistent with the competitiveness story, and sort of not. Germany did increase its intra-EU net exports about twice as much as its extra-EU net exports over the pre-crisis decade, just as a story centered on relative prices would predict. And on the flipside, the fall in Irish net exports over the pre-crisis decade was entirely with other EU countries, again consistent with the Krugman story. 

But for the other countries, it's not so simple. The increase of the Euro-era Greek deficit, for instance, was entirely the result of increased imports from non-Euro countries. Euro-area trade, and non-Euro exports, were approximately constant in the ten years from 1999. This is more consistent with a story of rapid Greek income growth, than uncompetitively high Greek prices. Similarly, the movement toward current account deficit of Spain was mostly, and of Italy entirely, a matter of trade with non-EU countries. This is not consistent with the relative-price story, which predicts that intra-EU trade imbalances should have grown relative to extra-EU imbalances. Note also that today, Germany's net exports to the rest of the EU area are no higher than when the Euro was created, while Greece and Spain have substantially improved their intra-EU balances; but all three countries have moved further toward imbalance with extra-EU countries. This, again, is not consistent with a story in which trade imbalances are driven primarily by the relative price distortions created by the single currency.

Conclusion: Krugman is right that how much relative prices have contributed to intra-European current account imbalances, is a question on which reasonable people can disagree. But as a doctrinaire Keynesian, I remain an elasticity pessimist. It seems to me that we should at least seriously consider a story in which European current account imbalances are due to relatively rapid income growth in the periphery, and slow income growth in Germany, as opposed to changes in competitiveness. A story, in other words, in which a Greek exit from the Euro and devaluation will not do much good.

UPDATE: While I was writing this, Merijn Knibbe had more or less the same thought.