Thursday, May 24, 2012

Prices and the European Crisis, Continued

In comments to yesterday's post on exchange rates and European trade imbalances, paine (the e. e. cummings of the econosphere) says,
pk prolly buys your conclusion. notice his post basically disparaging forex adjustment solutions on grounds of short run impact. but long run adjustment requires forex changes.
I don't know. I suppose we all agree that exchange rate changes won't help in the short run (in fact, I'm not sure Krugman does agree), but I'm not convinced exchange rate changes will make much of a difference even in the long run; and anyway, it matters how long the long run is. When the storm is long past the ocean is flat again, and all that.

Anyway, what Krugman actually wrote was
We know that huge current account imbalances opened up when capital rushed to the European periphery after the euro was created, and reversing those imbalances must involve a large real devaluation.
We "know," it "must": not much wiggle room there.

So this is the question, and I think it's an important one. Are trade imbalances in Europe the result of overvalued exchange rates in the periphery, and undervalued exchange rates in the core, which in turn result from the financial flows from north to south after 1999? And are devaluations in Greece and the other crisis countries a necessary and sufficient condition to restore a sustainable balance of trade?

It's worth remembering that Keynes thought the answer to these kinds of questions was, in general, No. As Skidelsky puts it in the (wonderful) third volume of his Keynes biography, Keynes rejected the idea of floating exchange rates because
he did not believe that the Marshall-Lerner condition would, in general, be satisfied. This states that, for a change in the value of a country's currency to restore equilibrium in its balance of payments, the sum of the price elasticities for its exports and imports must be more than one. [1] As Keynes explained to Henry Clay: "A small country in particular may have to accept substantially worse terms for its exports in terms of its imports if it tries to force the former by means of exchange depreciation. If, therefore, we take account of the terms of trade effect there is an optimum level of exchange such that any movement either way would cause a deterioration of the country's merchandise balance." Keynes was convinced that for Britain exchange depreciation would be disastrous...
Keynes' "elasticity pessimism" is distinctly unfashionable today. It's an article of faith in open-economy macroeconomics that depreciations improve the trade balance, despite rather weak evidence. A recent mainstream survey of the empirical literature on trade elasticities concludes,
A typical finding in the empirical literature is that import and export demand elasticities are rather low, and that the Marshall-Lerner (ML) condition does not hold. However, despite the evidence against the ML condition, the consensus is that real devaluations do improve the balance of trade
Theory ahead of measurement in international trade!

(Paul Davidson has a good discussion of this on pages 138-144 of his book on Keynes.)

The alternative view is that the main relationship is between trade flows and growth rates. In models of balance-of-payments-constrained growth, countries' long-term growth rates depend on the ratio of export income-elasticity of demand and import income-elasticity of demand. More generally, while a strong short-run relationship between exchange rates and trade flows is clearly absent, and a long-run relationship is mostly speculative, the relationship between faster growth and higher imports (and vice versa) is unambiguous and immediate. [2]

So let's look at some Greek data, keeping in mind that Greece is not necessarily representative of the rest of the European periphery. The picture below shows Greece's merchandise and overall trade balance as percent of GDP (from the WTO; data on service trade is only available from 1980), the real exchange rate (from the BIS) and real growth rate (from the OECD; three-year moving averages). Is this a story of prices, or income?

The first thing we can say is that it is not true that Greek deficits are a product of the single currency.  Greece has been running substantial trade deficits for as far back as the numbers go. Second, it's hard to see a relationship between the exchange rate and trade flows. It's especially striking that the 20 percent real depreciation of the drachma from the late 1960s to the early 1970s -- quite a large movement as these things go -- had no discernible effect on Greek trade flows at all. The fall in income since the crisis, on the other hand, has produced a very dramatic improvement in the Greek current account, despite the fact that the real exchange rate has appreciated slightly over the period. It's very hard to look at the right side of the figure and feel any doubt about what drives Greek trade flows, at least in the short run.

Now, it is true that, prior to the crisis, the Euro era was associated with somewhat larger Greek trade deficits than in earlier years. (As I mentioned yesterday, this is entirely due to increased imports from outside the EU.) But was this due to the real appreciation Greece experienced under the Euro, or to the faster growth? It's hard to judge this just by looking at a figure. (That's why God gave us econometrics -- though to be honest I'm a bit skeptical about the possibility of getting a definite answer here.) But here's a suggestive point. Greece's real exchange rate appreciated by 25 percent between 1986 and 1996. This is even more than the appreciation after the Euro. Yet that earlier decade saw no growth of the Greek trade deficit at all. It was only when Greek growth accelerated in the early 2000s that the trade deficit swelled.

I think Yanis Varoufakis is right: It's hard to see exit and devaluation as solutions for Greece, in either the short term or the long term. There are good reasons why, historically, European countries have almost never let their exchange rates float against each other. And it's hard to see fixed exchange rates, in themselves, as an important cause of the crisis.

[1] Skidelsky gives the Marshall-Lerner condition in its standard form, but the reality is a bit more complicated. The simple condition applies only in cases where prices are set in the producing country and fully passed through to the destination country, and where trade is initially balanced. Also, it should really be the Marshall-Lerner-Robinson condition. Joan Robinson was robbed!

[2] Krugman wrote a very doctrinaire paper years ago rejecting the idea of balance of payments constraints on growth. I've quoted this here before, but it's worth repeating:
I am simply going to dismiss a priori the argument that income elasticities determine economic growth, rather than the other way around. It just seems fundamentally implausible that over stretches of decades balance of payments problems could be preventing long term growth... Furthermore, we all know that differences in growth rates among countries are primarily determined by differences in the rate of growth of total factor productivity, not by differences in the rate of growth of employment. ... Thus we are driven to supply-side explanations...
The Krugmans and DeLongs really have no one to blame but themselves for accepting that all the purest, most dogmatic orthodoxy was true in the long run, and then letting long-run growth take over the graduate macro curriculum.

UPDATE: I should add that as far as the trade balance is concerned, what matters is not just a country's growth, but its growth relative to its trade partners. This may be why rapid Greek growth in the 1970s was not associated with a worsening trade balance -- this was the trente glorieuse, when all the major European countries were experiencing similar income growth. Also, in comments, Random Lurker points to a paper suggesting that another factor in rising Greek imports was the removal of tariffs and other trade restrictions after accession to the EU. I haven't had time to read the paper properly yet, but I wouldn't be surprised if that is an important part of the story.

Also, I was discussing this at the bar the other night, and at the end of the conversation my very smart Brazilian friend said, "But devaluation has to work. It just has to." And she knows this stuff far better than I do, so, maybe.


  1. Googling around for info about Greek trade patterns I found this interesting paper from 2004:

    which mainly says that the admission in the EU caused an increase in the trade deficit because it caused an abolition of tariffs, quasi-tariffs and subsidies.
    There is also some discussion of what does Greece export, what does it import and how this influences trade routes.

    On the whole it seems to me that the problem for european periphery is that trade liberalization caused an accentration of high added value production in the core, while leaving to the periphery low added value fields.

    from the paper, p. 72 (the paper begins from p.61)

    On the other hand, Greek export demand is price elastic in the long run. As shown in equation (17), there is a large impact on export demand due to changes in relative prices, a result that is consistent with previous studies5. It is an expected result for Greece, since the country is a small open economy with no market power in world trade and its production remains concentrated in low technology and high competition sectors. Thus, it is inevitable that Greek export demand will be quite sensitive to relative price changes, since the emergence of lower cost close substitutes leads to substantial market share losses.
    The results for export demand also indicate a high income elasticity, which implies that Greek products abroad are treated as “luxury” goods. These results are
    consistent with those obtained by Arghyrou and Bazina (2003), which indicate that due to this high income elasticity Greek exports are vulnerable to downwards cycli-
    cal fluctuations abroad. Yet it is well known that Greek exports are mainly concentrated in agricultural and labor-intensive products, such as textiles, which cannot be considered as “luxury” items. The explanation is that Greek exports are treated as “luxury” goods only compared with similar exports (textile exports from south eastern Asia and the transition economies or agricultural exports from the Mediterranean countries) to the world markets.
    Greek import demand is price inelastic in the long run. The main reason for this result is that inputs not produced domestically constitute a large proportion of Greek imports. Imports of the public sector also contribute to the low sensitivity of import demand to relative price changes6 . Import demand is also affected in a positive way by domestic income and real international reserves stringency. There are also substantial effects on Greek imports due to changes in all trade barriers. As shown in equation (18), the gradual abolition of all trade barriers led to an increase in Greek imports, which of course replaced much domestic production. As Koukouritakis (2002) indicates, these imports came mainly from the EU, indicating trade creation.

  2. On a second tought, I think that the "devaluation" approach is flawed. take this formulation of Say's law by B. DeLong:

    "Nobody, Say argued, would ever produce anything beyond what they expected to use themselves unless they planned to sell it, and nobody would sell anything unless they expected to use the money they earned in order to buy something else."

    Notice that this law assumes that everybody who sells something, does so to buy something else (implicitly, consumption goods).
    However in the real world there are a lot of actors that sell whitout the desire to consume for strategical reasons (e.g. China or financial funds), thus Say's law breaks. In Europe this role has been played by Germany.

    Thus the real question is, why do the Germans programmatically consume less than they produce (in term of value)?
    I suppose that the reason is that Germany has apparently a very export-dependent economy (meaning that the kind of products that are Germany's strength need a broader market than Germany itself), and as a consequence "mercantilist" policies may seem the most prudent choice for them.

    If this is true, then other european nations had three choices: Go in deep debt (either private or public), or have a permanent recession, or enter a trade war vs. Germany. Devaluation simply means that other nations choose 3 instead than 1, while austerity represents choice 2.

  3. The rapid increase in merchandise imports and the increased growth are probably most closely tied to surging private debt/gdp in the 2000s :

    It's the U.S. story , basically.

    "the relationship between faster growth and higher imports (and vice versa) is unambiguous and immediate"

    I wonder if this would hold as tightly if you could disentangle debt boom growth cycles from those not associated with rising debt/gdp.

    Anon Y. Mous

  4. "The Krugmans and DeLongs really have no one to blame but themselves for accepting that all the purest, most dogmatic orthodoxy was true in the long run, and then letting long-run growth take over the graduate macro curriculum."


    The deadliest phrase in economics may be [Krugman's] "we all know that . . ."

    It is hard to suppress the hypothesis of a strong desire to hide the importance of economic rents and bargaining over the terms of trade. Do you suppose only banksters know that prices are the shell of a shell game?

    1. Yes, the idea of bargaining -- and more generally, the possibility of conflicting interests -- must be ruthlessly suppressed. one of these days I'm going to write a long piece on "the anatomy of DeLongism" and that is going to be one of its central points.

  5. trying to make two points at once is dangerous


    1) the relative national growth rate method of trade balance control is prefered by corporations
    2 ) its prefered by corporations
    because it preserves arbitrage gains


    that in no way counters facts
    indeed the hegemony of this strategy produces these numbers

    if forex has a role its secondary its targeted and its most often about pumping and dumping selected emerging national currency zones

    ie enhancing dynamic corporate arbitrage games

    conttradictions among the corporations here ?


    consequences over the time horizon:

    balancing trade
    without the use of forex policy
    can over a few cycles fantasically undermine
    a nation's industrial wage class
    (see rust bowl)

    in particular like a silent heart attack
    this undermining can proceed
    even with little or no trade deficits
    at least for a certain period

    the present btwo track global speedway
    with a yellow flag north and green flag south

    is a perfect example of corporate prefered rebalancing of trade
    without attacking the fundemental forex tilts
    there you have it
    everything explained
    and no one acting irrationally ..once you know who calls the shots


    the pk smoking gun

    its buried in sarcasm but
    here is pk saying

    well short term forex deval
    isn't able to push a fast recovery

    "...the answer is devaluation of the euro as a whole.
    Um, against whom?"

    " while I and others have been pushing for years for an end to Chinese currency manipulation, China is at this point (a) not looking very strong itself (b) just not that big in the world economy — not yet."

    major walk back that

    and his straw man argument
    is the euro against NA dollars and japan's yen
    misses the rest of the EU ie britain sweden poland hungary etc
    and the oil states and the slavic belt and ....

    "More generally, Europe as a whole, like America, remains a relatively closed economy. Its salvation must be mainly internal."

    an amazing statement really

    as if america as he calls it isn't open enough to be effected by imperial dollar policy

    "Now, if devaluation is a code word to mean raising the inflation target, fine."

    no devaluation is a code word for crush cross currency trade arbitrage profiteering


  7. Wow, a lot to respond to here. And I'll confess straight up, I don't follow all of it. But I will have some proper replies up shortly.

  8. This comment has been removed by the author.

  9. "Joan Robinson was robbed!"

    Much as she was robbed of the pseudo-Nobel that many thought she deserved. I think I see a pattern.

  10. I think the last bit about Krugman is completely unfair. He has been publicly calling freshwater macro stupid for 20 years now.

    In general, left economics blogs have an unhealthy obsession with Krugman. He's the left edge of acceptable opinion in mainstream economics, which means that by definition he's the least wrong mainstream economist. If you're going to attack a mainstream economist, he's the least deserving target.

    The people ultimately to blame for wacko orthodoxy are the wacko orthodox.

  11. Walt
    I see your argument
    And it touches the old lefty "main enemy" debate right on it's nose

    I for one find pk the best of all targets much as I do Joe stiglitz and dani rodik and good hearted Bobby Reich even

    These are popular front allies in my jargon
    But at the level of a blogcast versus a broadcast
    We can fence among ourselves
    Contradictions among the people and all that

    Yes pk is not the main enemy nor are the austrians

    The main enemy in my estimation exists within the Rubin Rogoff Summers types
    The core of new Keynesian savants with a clear wall street twist

  12. A little point: the German current account moved back into surplus in 1992, before the famous Harz reforms of 1993. Restraining domestic demand in Germany in a situation where surrounding economies were growing did the trick, instead of structural reforms. Which of course seems to be consistent with the blogpost.

    Merijn Knibbe

    1. Oops, 1992 should read '2002' and 1993 should read '2003'.

      Merijn Knibbe

  13. Thanks for this very interesting and insightful article! It is my honest opinion however that if Greece exports more procust and especially Ouzo things would be much better!!