In Which I Dare to Correct Felix Salmon

Felix Salmon is my favorite business blogger -- super smart, cosmopolitan and impressively unimpressed by the Masters of the Universe he spends his days observing. In general, I'd expect him to be much more on top of current financial data than I am. But in today's post on the commercial paper market, he makes an uncharacteristic mistake -- or rather, uncharacteristic for him but highly characteristic of the larger conversation around finance.

According to Felix:

The commercial paper market has to a first approximation become an entirely financial market, a place for banks and shadow banks to do their short-term borrowing while the interbank market remains closed.

According to David S. Scharfstein of Harvard Business School, who also testified last week, of the 50 largest issuers of debt to money market funds today, only two are nonfinancial firms; the rest are banks and other financial companies, many of them foreign.

Once upon a time, before the financial crisis, money-market funds were a mechanism whereby individual investors could make safe, short-term loans to big corporates, disintermediating the banks. But all that has changed now. For one thing, says Davidoff, “about two-thirds of money market users are sophisticated finance investors”. For another, the corporates have evaporated away, to be replaced by financials. In the corporate world, it seems, the price mechanism isn’t working any more: either you’re a big and safe corporate and don’t want to run the refinancing risk of money-market funds suddenly drying up, or else you’re small enough and risky enough that the money market funds don’t want to lend to you at any price.

I'm sorry, but I don't think that's right.

Reading Felix, you get the clear impression that before the crisis, or anyway not too long ago, most borrowers in the commercial paper market were nonfinancial corporations. It has only "become an entirely financial market" relatively recently, he suggests, as nonfinancial borrowers have dropped out. But, to me at least, the real picture looks rather different.

Source: Flow of Funds

The graph shows outstanding financial and nonfinancial commercial paper on the left scale, and the financial share of the total on the right scale. As you can see the story is almost the opposite of the one Felix tells. Financial borrowers have always dominated the commercial paper market, and their share has fallen, not risen, in the wake of the financial crisis and recession. Relative to the economy, nonfinancial commercial paper outstanding is close to where it was at the peak of the past cycle. But financial paper is down by almost two-thirds. As a result, the nonfinancial share of the commercial paper market has doubled, from 7 to 15 percent -- the highest it's been since the 1990s.

Why does this matter? Well, of course, it's important to get these things right. But I think Felix's mistake here is revealing of a larger problem.

One of the most dramatic features of the financial crisis of fall 2008, bringing the Fed as close as it got to socializing the means of intermediation, was the collapse of the commercial paper market. But as I've written here before, it was almost never acknowledged that the collapse was largely limited to financial commercial paper. Nonfinancial borrowers did not lose access to credit in the way that banks and shadow banks did. The gap between the financial and nonfinancial commercial paper markets wasn't discussed, I believe, because of the way the crisis was seen entirely through the eyes of finance.

I suspect the same thing is happening with the evolution of the commercial paper market in the past few years. The Flow of Funds shows clearly that commercial borrowing by nonfinancial borrowers has held up reasonably well; the fall in commercial paper lending is limited to financial borrowers. But that banks' problems are everyone's problems is taken for granted, or at most justified with a pious handwave about the importance of credit to the real economy.

And that's the second  assumption, again usually unstated, at issue here: that providing credit to households and businesses is normally the main activity of finance, with departures from that role an anomalous recent development. But what if the main action in the financial system has never been intermediating between ultimate lenders and borrowers? What if banks have always mostly been, not to put too fine a point on it, parasites?

During the crisis of 2008 one big question was if it was possible to let the big banks fail, or if the consequences for the real economy would be prohibitively awful. On the left, Dean Baker took the first position while Doug Henwood took the second, arguing that the alternative to bailouts could be a second Great Depression. I was ambivalent at the time, but I've been moving toward the let-them-fail view. (Especially if the counterfactual is that governments and central banks putting comparable resources into sheltering the real economy from collapsing banks, as they have into propping them up.) The evolution of the commercial paper market looks to me like one more datapoint supporting that view. The collapse of interbank lending doesn't seem to have affected nonbank borrowers much.

(Which brings us to a larger point, of whether the continued depressed state of the real economy is due to a lack of access to credit. Obviously I think not, but that's beyond the scope of this post.)

An insidious feature of the world we live in is an unconscious tendency to adopt finance's point of view. This is as true of intellectuals as of everyone else. An anthropologist of my acquaintance, for instance, did his fieldwork on the New York financial industry. Nothing wrong with that -- he's got some very smart things to say about it -- but you really can't imagine someone doing a similar project on any other industry, apart from high-tech internet stuff. In our culture, finance is just interesting in a way that other businesses are not. I'm not exempting myself from this, by the way. The financial crisis and its aftermath was the most exciting time in memory to be thinking about economics; I'm not going to deny it, it was fun. And there are plenty of people on the left who would say that a tendency, which I confess to, to let the conflict between Wall Street and the real economy displace the conflict between labor and capital in our political language, is a symptom -- a kind of reaction-formation -- of the same intellectual capture.

But that is perhaps over-broadening the point, which is just this: That someone as smart as Felix Salmon could so badly misread the commercial paper market is a sign of how hard we have to work to distinguish the state of the banks, from the state of the economy.

The Story of Q

More posts on Greece, coming right up. But first I want to revisit the relationship between finance and nonfinancial business in the US.

Most readers of this blog are probably familiar with Tobin's q. The idea is that if investment decisions are being made to maximize the wealth of shareholders, as theory and, sometimes, the law say they should be, then there should be a relationship between the value of financial claims on the firm and the value of its assets. Specifically, the former should be at least as great as the latter, since if investing another dollar in the firm does not increase its value to shareholders by at least a dollar, then that money would better have been returned to them instead.

As usual with anything interesting in macroeconomics, the idea goes back to Keynes, specifically Chapter 12 of the General Theory:

the daily revaluations of the Stock Exchange, though they are primarily made to facilitate transfers of old investments between one individual and another, inevitably exert a decisive influence on the rate of current investment. For there is no sense in building up a new enterprise at a cost greater than that at which a similar existing enterprise can be purchased; whilst there is an inducement to spend on a new project what may seem an extravagant sum, if it can be floated off on the Stock Exchange at an immediate profit. Thus certain classes of investment are governed by the average expectation of those who deal on the Stock Exchange as revealed in the price of shares, rather than by the genuine expectations of the professional entrepreneur.

It was this kind of reasoning that led Hyman Minsky to describe Keynes as having "an investment theory of the business cycle, and a financial theory of investment." Axel Leijonhufvud, on the other hand, would warn us against taking the dramatis personae of this story too literally; the important point, he would argue, is the way in which investment responds to the shifts in the expected return on fixed investment versus the long-term interest rate. For better or worse, postwar Keynesians including the eponymous Tobin followed Keynes here in thinking of one group of decisionmakers whose expectations are embodied in share prices and another group setting investment within the firm. If shareholders are optimistic about the prospects for a business, or for business in general, the value of shares relative to the cost of capital goods will rise, a signal for firms to invest more; if they are pessimistic, share prices will fall relative to the cost of capital goods, a signal that further investment would be, from the point of view of shareholders, value-subtracting, and the cash should be disgorged instead.

There are various specifications of this relationship; for aggregate data, the usual one is the ratio of the value corporate equity to corporate net worth, that is, to total assets minus total liabilities. In any case, q fails rather miserably, both in the aggregate and the firm level, in its original purpose, predicting investment decisions. Here is q for nonfinancial corporations in the US over the past 60 years, along with corporate investment.

The orange line is the standard specification of q; the dotted line is equity over fixed assets, which behaves almost identically. The black line shows nonfinancial corporations' nonresidential fixed investment as a share of GDP. As you can see, apart from the late 90s tech boom, there's no sign that high q is associated with high investment, or low q with low investment. In fact, the biggest investment boom in postwar history, in the late 1970s, comes when q was at its low point. [*]

The obvious way of looking at this is that, contra Tobin and (at least some readings of) Keynes, stock prices don't seem to have much to do with fixed investment. Which is not so strange, when you think about it -- it's never been clear why managers and entrepreneurs should substitute the stock market's beliefs about the profitability of some new investment for their own, presumably better-informed, one. Just as well, given the unanchored gyrations of the stock market.

This is true as far as it goes, but there's another way of looking at it. Because, q isn't just uncorrelated with investment; for most of the period, at least until the 1990s, it's almost always well below 1. This is even more surprising when you consider that a well-run firm with an established market ought to have a q above one, since it will presumably have intangible assets -- corporate culture, loyal customers and so on -- that don't show up on the balance sheet. In other words, measured assets should seem to be "too low". But in fact, they're almost always too high. For most of the postwar period, it seems that corporations were systematically investing too much, at least from the point of view maximizing shareholder value.

I was talking with Suresh the other day about labor, and about the way labor organizing can be seen as a kind of assertion of a property right. Whether shareholders are "the" residual claimants of a firm's earnings is ultimately a political question, and in times and places where labor is strong, they are not. Same with tenant organizing -- you could see it as an assertion that long-time tenants have a property right in their homes, which I think fits most people's moral intuitions.

Seen from this angle, the fact that businesses were investing "too much" during much of the postwar decades no longer is a sign they were being irrational or made a mistake; it just suggests that they were considering the returns to claimants other than shareholders. Though one wouldn't what to read too much into it, it's interesting in this light that for the past dozen years aggregate q has been sitting at one, exactly where loyal agents for shareholders would try to keep it. In liberal circles, the relatively low business investment of the past decade is often considered a sign of something seriously wrong with the economy. But maybe it's just a sign that corporations have learned to obey their masters.



EDIT: In retrospect, the idea of labor as residual claimant does not really belong in this argument, it just confuses things. I am not suggesting that labor was ever able to compel capitalist firms to invest more than they wanted, but rather that "capitalists" were more divided sociologically before the shareholder revolution and that mangers of firms chose a higher level of investment than was optimal from the point of view of owners of financial assets. Another, maybe more straightforward way of looking at this is that q is higher -- financial claims on a firm are more valuable relative to the cost of its assets -- because it really is better to own financial claims on a productive enterprise today than in the pr-1980 period. You can reliably expect to receive a greater share of its surplus now than you could then.



[*] One of these days I really want to write something abut the investment boom of the 1970s. Nobody seems to realize that the highest levels of business investment in modern US history came in 1978-1981, supposedly the last terrible days of stagflation. Given the general consensus that fixed capital formation is at the heart of economic growth, why don't people ask what was going right then?

Part of it, presumably, must have been the kind of sociological factors pointed to here -- this was just before the Revolt of the Rentiers got going, when businesses could still pursue growth, market share and innovation for their own sakes, without worrying much about what shareholders thought. Part must have been that the US was still able to successfully export in a range of industries that would become uncompetitive when the dollar appreciated in the 1980s. But I suspect the biggest factor may have been inflation. We always talk about investment being encouraged by stuff that makes it more profitable for capitalists to hold their wealth in the form of capital goods. But logically it should be just as effective to reduce the returns and/or safety of financial assets. Since neither nominal interest rates nor stock prices tracked inflation in the 1970s, wealthholders had no choice but to accept holding a greater part of their wealth in the form of productive business assets. The distributional case for tolerating inflation is a bit less off-limits in polite conversation than it was a few years ago, but the taboo on discussing its macroeconomic benefits is still strong. Would be nice to try violating that.

A Greek Myth

Most days, I'm a big fan of Paul Krugman's columns.

Unlike his economics, which makes a few too many curtsies to orthodoxy, his political interventions are righteous in tone, right-on in content, and what's more, strategic -- unlike many leftish intellectuals, he clearly cares about being useful -- about saying things that are not only true, but that contribute to the concrete political struggle of the moment. He's so much better than almost of his peers it's not even funny.

But -- well, you knew there had to be a but.

But this time, he's gotten his economics in his politics. And the results are not pretty.

In today's column, he rightly dismisses arguments that the root of the Euro crisis is that workers in Greece and the other peripheral countries are lazy, or unproductive, or that those countries have excessive regulation and bloated welfare states. "So how did Greece get into so much trouble?" he asks. His answer:

Blame the euro. Fifteen years ago Greece was no paradise, but it wasn’t in crisis either. Unemployment was high but not catastrophic, and the nation more or less paid its way on world markets, earning enough from exports, tourism, shipping and other sources to more or less pay for its imports. Then Greece joined the euro, and a terrible thing happened: people started believing that it was a safe place to invest. Foreign money poured into Greece, some but not all of it financing government deficits; the economy boomed; inflation rose; and Greece became increasingly uncompetitive.

I'm sorry, but the bolded sentence just is not true. The rest of it is debatable, but that sentence is flat-out false. And it matters.

The analysis behind the "earning enough" claim is found on Krugman's blog. He writes,

One of the things you keep hearing about Greece is that if it exits the euro one way or another there will be no gains, because Greece basically can’t export — so structural reform is the only way forward. But here’s the thing: if that were true, how did Greece pay its way before the big capital flows starting coming? The truth is that before the euro and the capital flow bubble it created, Greece ran only small current account deficits (the broad definition of the trade balance, including services and factor income)...

And he offers this graph from Eurostat:

The numbers in the graph are fine, as far as they go. And there is the first problem: how far they go. Here's the same graph, but going back to 1980.

Starting the graph ten years earlier gives a different picture -- now it seems that the near-balance on current account in 1993 and 1994 wasn't the normal state before the euro, but an exceptional occurrence in just those two years. And note that that while Greek deficits in the 1980s are small relative to those of the mid-2000s, they are still very far from anything you could reasonably describe as "the country more or less paid its way." They are, for instance, significantly larger than the contemporaneous US current account deficits that were a central political concern in the 1980s here.

That's the small problem; there's a bigger one. Because, what are we looking at? The current account balance. Krugman glosses this as "the broadest measure of the trade balance," but that's not correct. (If he taught undergraduate macro, I'm sure he'd mark someone writing that wrong.) It's broad, yes, but it's a different concept, covering all international payments other than asset purchases, including some (transfers and income flows) that are not trade by any possible definition. The current account includes, for example, remittances by foreign workers to their home countries. So by Krugman's logic here, the fact that there are lots of Mexican migrant workers in the US sending money home is a sign that Mexico is able to export successfully to the US, when in the real world it's precisely a sign that it isn't.

Most seriously, the current account includes transfer between governments. In the European context these are quite large. To call the subsidies that Greece received under the European Common Agricultural Policy export earnings is obviously absurd. Yet that's what Krugman is doing.

The following graph shows how big a difference it makes when you call development assistance exports.

The blue line is the current account balance, same as in Krugman's graph, again extended back to 1980. The red line is the current account balance not counting intergovernmental transfers. And the green line is the current account not counting any transfers. [*] It's clear from this picture that, contra Krugman, Greece was not earning enough money to pay for its imports before the creation of the euro, or at any time in the past 30 years. If the problem Greece has to solve is getting its foreign exchange payments in line with with its foreign exchange earnings, then the bulk of the problem existed long before Greece joined the euro. The central claim of the column is simply false.

Again, it is true that Greece's deficits got much bigger in the mid-2000s. I agree with Krugman that this must have ben connected with the large capital flows from northern to peripheral Europe that followed the creation of the euro. It remains an open question, though, how much this was due to an increase in relative costs, and how much due to more rapid income growth. By assuming it was entirely the former, Krugman is implicitly, but characteristically, assuming that except in special circumstances economies can be assumed to be operating at full capacity.

But the key point is that the historical evidence does not support the view that current account imbalances only arise when governments interfere in the natural adjustment of foreign exchange markets. Fixed rates or floating, in the absence of very large flows of intergovernmental aid Greece has never come close to current account balance. According to Krugman, Greece's

famous lack of competitiveness is a recent development, caused by massive post-euro inflows of capital that raised costs and prices. And that’s the kind of thing that currency devaluations can cure.

The historical evidence is not consistent with this claim. Or if it is, it's only after you go well beyond normal massaging of the data, to something you'd see on The Client List.

* * *

So why does it matter? What's at stake? I can't very well go praising Krugman for writing not only what's true but what is useful, and then justify a post criticizing him on the grounds of Someone Is Wrong On the Internet. No; but there's something real at stake here.

The basic issue is, does price adjustment solve everything? Krugman won't quite come out and say Yes, but clearly it's what he believes. Is he being deliberately dishonest? No, I'm sure he's not. But this is how ideology works. He's committed to the idea that relative costs are the fundamental story when it comes to trade, so when he finds a bit of data that seems to conform to that, he repeats it, without giving five minutes of critical reflection to what it actually means.

The basic issue, again, is the need for structural as opposed to price adjustment. Now if "structural adjustment" means lower wages, then of course Godspeed to Krugman here. I'm against structural whatever in that sense too. But I can't help feeling that he's pulling in the wrong direction. Because if external devaluation cures the problem then internal devaluation does too, at least in principle.

The fundamental question remains how important are relative costs. The way I see it, look at what Greece imports, most of it Greece doesn't produce at all. The textbook expenditure-switching vision implicitly endorsed by Krugman ignores that there are different kinds of goods, or accepts what Paul Davidson calls the axiom of gross substitution, that every good is basically (convexly) interchangeable with every other. Hey Greeks will have fewer computers and no oil, but they'll spend more time at the beach, and in terms of utility it's all the same. Except, you know, it's not.

From where I'm sitting, the only way for Greece to achieve current account balance with income growth comparable to Germany is for Greece to develop new industries. This, not low wages,  is the structural problem. This is the same problem faced by any developing country. And it raises the same problem that Krugman, I'm afraid, has never dealt with: how to you convince or compel the stratum that controls the social surplus to commit to the development of new industries? In the textbook world -- which Krugman I'm afraid still occupies -- a generic financial system channels savings to the highest-return available investment projects. In the real world, not so much. Figuring out how to get savings to investment is, on the contrary, an immensely challenging institutional problem.

So, first step dealing with it, you should read Gerschenkron. We know, anyway that probably the rich prefer to hold their wealth in liquid form, or overseas, or both. And we know that even if -- unlikely -- they want to invest in domestic industries, they'll choose those that are already cost-competitive, when, we know, the whole point of development is to do stuff where you don't, right now, have comparative advantage. So, again, it's a problem.

There are solutions to this problem. Banks, the developmental state, even industrial dynasties. But it is a problem, and it needs to be solved. Relative prices are second order. Or so it seems to me.

[*] Unfortunately Eurostat doesn't seem to have data breaking down nongovernmental transfer payments to Greece. I suspect that the main form of private transfers is remittances from Greek workers elsewhere in Europe, but perhaps not.

ΣΥ.ΡΙΖ.Α.

So the ECB's agenda is pain. What about our agenda?

One positive thing about the crisis in Europe is that, unlike many earlier occasions on which neoliberalism has been imposed by financial coercion, this one is calling forth a serious response from the left. Hopefully, we'll see a victory for Syriza in tomorrow's elections in Greece. In the meantime, check out their economic program. Good stuff.

THE ECONOMIC PROGRAMΜΕ OF SYRIZA-EKM


UPDATE: Well, that was disappointing. The Guardian says it was moral victory; perhaps we'll get a Greek perspective here in the next week.

In the meantime, the question has been raised, what do I specifically like about this program? Well, let's be honest, beside the tone of it -- which is wonderful -- it's not everything one might hope for. But it's a small party in a small country, putting together its program in a short time under extreme conditions. That said, I think the focus on tax reform, and on taxing the rich -- including the Church -- is important. Unlike Spain or Italy or Ireland, Greece does have a genuine fiscal problem. Resolving that in a progressive way is important. And if it does turn out that GReece leaves the Euro -- I won't guess how likely that is -- capital flight is going to be a huge problem. Putting in place the institutions now to capture the wealth of that fraction of the Greek elite that abandons ship strikes me as very worthwhile.

Pain Is the Agenda: The Method in the ECB's Madness

Krugman is puzzled by the European Central Bank:

I’ve been hearing various attempts to explain the ECB’s utterly bizarre refusal to cut interest rates... The most popular story seems to be that the ECB wants to “hold politicians’ feet to the fire”, letting them know that they won’t get relief unless they do what’s necessary (whatever that is). This really doesn’t make any sense. If we’re talking about enforcing austerity and wage cuts in the periphery, how much more incentive do these economies need?

He is certainly right that if the goal is resolving the crisis, or even price stability, then refusing further rate cuts is mighty strange. But who says those are the goals? His final question is meant to be rhetorical, but it really isn't. Because the more austerity you want, the more enforcement you need.

I met someone the other day with a fairly senior position at the Greek tax authority; her salary had just been cut by 40 percent. When, outside of an apocalyptic crisis, do you see pay cuts like that? Which, for you or me or Paul Krugman, is an argument to End This Depression Now. But if you are someone who sees pay cuts as the goal, then it could be an argument for not quite yet.

It's a tenet of liberalism -- and a premise of the conversation Krugman is part of -- that there are conflicting opinions, but not conflicting interests. But sometimes, when people seem to keep doing things with the wrong outcome, it's because that's the outcome they actually want. Paranoid? Conspiracy theory? Maybe. On the other hand, here's Deutsches Bundsbank president Jens Weidmann:

Relieving stress in the sovereign bond markets eases imminent funding pain but blurs the signal to sovereigns about the precarious state of public finances and the urgent need to act. Macroeconomic imbalances and unsustainable public and private debt in some member states lie at the heart of the sovereign debt crisis. It may appeal to politicians to abstain from unpopular decisions and try to solve problems through monetary accommodation. However, it is up to monetary policymakers to fend off these pressures.

That seems pretty clear. From the perspective of the central banker, resolving the crisis too painlessly would be bad, because that would allow governments to "avoid unpopular decisions." And it's true: If there's something you really want governments to do, but you don't think they will make the necessary decisions except in a crisis, then it is perfectly rational to prolong the crisis until you see the right decisions being made.

So, what kind of decision are we talking about, exactly? Krugman professes bafflement -- "whatever that is" -- but it's not really such a mystery. Here's an editorial in the FT on the occasion of last summer's ECB intervention to support the market for Italy's public debt:

Structural reform is the quid pro quo for the European Central Bank’s purchases last week of Italian government bonds, an action that bought Italy breathing space by driving down yields. ... As the government belatedly recognises, boosting Italy’s growth prospects requires a liberalisation of rigid labour markets and a bracing dose of competition in the economy’s sheltered service sectors. This is where the unions and professional bodies must play their part. Susanna Camusso, leader of the CGIL, Italy’s biggest trade union, is threatening to call a general strike to block the proposed labour law reforms. She would be better advised to co-operate with the government and employers... The government’s austerity measures are sure to curtail economic growth in the short run. Only if long overdue structural reforms take root will the pain be worthwhile.

A couple of things worth noting here. First the explicit language of the quid pro quo -- the ECB was not just doing what was needed to stabilize the Italian bond market, but offering stabilization as a bargaining chip in order to achieve its other goals. If ECB was selling expansionary policy last year, why be surprised they're not giving it away for free today? Note also the suggestion that a sacrifice of short-term output is potentially worthwhile -- this isn't some flimflam about expansionary austerity, but an acknowledgement that expansion is being give up to achieve some other goal. And third, that other goal: Everything mentioned is labor market reform, it's all about concessions by labor (including professionals). No mention of more efficient public services, better regulation of the financial system, or anything like that.

The FT editorialist is accurately presenting the ECB's view. My old teacher Jerry Epstein has a good summary at TripleCrisis of the conditions for intervention; among other things, the ECB demanded "full liberalisation of local public services…. particularly… the provision of local services through large scale privatizations”; "reform [of] the collective wage bargaining system ... to tailor wages and working conditions to firms’ specific needs...”;  "thorough review of the rules regulating the hiring and dismissal of employees”; and cuts to private as well as public pensions, "making more stringent the eligibility criteria for seniority pensions" and raising the retirement age of women in the private sector. Privatization, weaker unions, more employer control over hiring and firing, skimpier pensions. This is well beyond what we normally think of as the remit of a central bank.

So what Krugman presents as a vague, speculative story about the ECB's motives -- that they want to hold politicians' feet to the fire -- is, on the contrary, exactly what they say they are doing.

It's true that the conditions imposed by the ECB on Italy and Greece were in the context of programs relating specifically to those countries' public debt, while here we are talking about a rate cut. But there's no fundamental difference -- cutting rates and buying bonds are two ways of describing the same basic policy. If there's conditions for one, we should expect conditions for the other, and in fact we find the same "quid pro quo" language is being used now as then.

Here's a banker in the FT:

The future of Europe will therefore be determined by the interests of the ECB. Self-preservation suggests that it will prevent complete collapse. If necessary, it will overrule Germany to do this, as the longer-term refinancing operations and government bond purchase programme suggest. But self-preservation and preventing collapse do not amount to genuine cyclical relief and policy stimulus. Indeed, the ECB appears to believe that in addition to price stability it has a mandate to impose structural reform. To this extent, cyclical pain is part of its agenda.

Again, there's nothing irrational about this. If you really believe that structural reform is vital, and that democratic governments won't carry it out except under the pressure of a crisis, then what would be irrational would be to relieve the crisis before the reforms are carried out. In this context, an "irrational" moralism can be an advantage. While one can take a hard line in negotiations and still be ready to blink if the costs of non-agreement get too high, it's best if the other side believes that you'll blow it all up if you don't get what you want.  Fiat justitia et pereat mundus, says Martin Wolf, is a dangerous motto. Yes; but it's a strong negotiating position.

But this invites a question: Why does the ECB regard labor market liberalization (aka structural reform) as part of its mandate? Or perhaps more precisely, when the ECB negotiates with national governments, on whose behalf is it negotiating?

The answer the ECB itself might give is, society as a whole. After all, this is the consensus view of central banks' role. Elected governments are subject to time inconsistency, or are captured by rent seekers, or just don't work, so an "independent" body is needed to take the long view. It's never been clear why this should apply only to monetary policy, and in fact there's a well-established liberal view that the independent central bank model should be extended to other areas of policy. Alan Blinder:

We have drawn the line in the wrong place, leaving too many policy decisions in the realm of politics and too few in the realm of technocracy. ... the argument for the Fed's independence applies just as forcefully to many other areas of government policy. Many policy decisions require complex technical judgments and have consequences that stretch into the distant future. Think of decisions on health policy (should we spend more on cancer or aids research?), tax policy (should we reduce taxes on capital gains?), or environmental policy (how should we cope with damage to the ozone layer?). Yet in such cases, elected politicians make the key decisions. Why should monetary policy be different? ... The justification for central bank independence is valid. Perhaps the model should be extended to other arenas. ... The tax system would surely be simpler, fairer, and more efficient if ... left to an independent technical body like the Federal Reserve rather than to congressional committees.

I'm sure there are plenty of people at the ECB who think along the same lines as the former Fed Vice-Chair. Indeed, that central banks want what's best for everyone is practically an axiom of modern economics. Still, it's funny, isn't it, that "structural reform" so consistently turns out to mean lower wages?

Martin Wolf's stuff on the European crisis has been essential. But it has one blind spot: The only conflicts he sees are between nations. What perplexes him is "the riddle of German self-interest." But maybe the answer to the riddle is that national interests are not the only ones in play.

It's hard not to think here of Perry Anderson's thesis, developed (alongside other themes) in The New Old World, that the EU project is fundamentally a response by European elites to their inability to roll back social democracy at the national level. The new supra-national institutions of the EU have allowed them to bypass political cultures that remain stubbornly (if incompletely) egalitarian and solidaristic. In Alain Supiot's summary:

In Anderson’s view, the European project has engendered neither a federation nor an intergovernmental organization; rather it is the most fully realized form of Hayek’s ultraliberal ‘catallaxy’. ... Like a secular version of faith in divine providence, belief in the spontaneous order of the markets entails a desire to protect it from the untimely interventions of people seeking ‘a just distribution’ which, according to Hayek, is nothing more than ‘an atavism, based on primordial emotions’. Hence the need to ‘dethrone the political’ by means of constitutional steps which create ‘a functioning market in which nobody can conclusively determine how well-off particular groups or individuals will be’. In other words, it is necessary to put the division of labour and the distribution of its fruits beyond the reach of the electorate. This is the dream that the European institutions have turned into a reality. Beneath the chaste veil of what is conventionally known as the EU’s ‘democratic deficit’ lies a denial of democracy.

Jerry Epstein puts it more bluntly. The ECB's insistence on structural reform "represents a cynical raw power calculus to destroy worker and citizen protections  without any real belief in the underlying neo-liberal economics they use to justify it." (If you prefer your political economy in audiovisual form, he has a video talking about this stuff.)

This kind of language makes people uncomfortable. Rather than acknowledge that the behavior of people in power could represent a particular interest -- let alone that of the top against the bottom, or capital against labor -- much better to throw your hands up and profess bafflement: their choices are "bizarre," a "riddle." This isn't, let's be clear, a personal failing. If you or I occupied the same kind of positions as Krugman or Wolf, we'd be subject to the same constraints. And I anyway don't want to find myself talking to no one but a handful of grumpy old Marxists.

But on the other hand, as Doug Henwood likes to quote our late friend Bob Fitch, "vulgar Marxism explains 90 percent of what happens in the world." And then, I keep looking back through FT articles on the crisis, and finding stuff like this:

The central bank has long called for eurozone economies to press ahead with structural reforms. That the ‘E’ in EMU, or Economic and Monetary Union, has not occurred is a complaint often voiced by ECB officials. On this score, the central bank has managed to win an important concession in forcing Italy to sign up to liberalising its economy. Some may see this as a pyrrhic victory for the damage that the bond purchases have done to the central bank’s independence. But there was a significant threat to stability if the central bank did not act. ...That Mr Trichet, always among the more politically savvy of central bankers, managed to get some concessions on structural reform was all that could be hoped for.

One has to wonder: What does it mean for the ECB to "win an important concession" from an elected government? Who is it winning the concession for? And if the problem with the ECB is just an ideological fixation on its inflation-fighting credibility, why would it be willing to sacrifice some of that credibility to advance this other goal?

It's hard to suppress a lingering suppression that central bankers are, after all, bankers. And then you think, isn't there an important sense in which finance embodies the interests of the capitalist class as a whole? (In an anodyne way, this is even sort of what its conventional capital-allocation function means) You wonder if the only reason Karl Marx called "the modern executive is a committee for managing the common affairs of the whole bourgeoisie," is that central banks didn't yet exist.

Imagine you're a European capitalist, or business owner if you prefer the sound of that. You look at the United States and see the promised land. Employment at will -- imagine, no laws limiting your ability to fire whoever you want. Private pensions, gone. Unions almost gone, strikes a thing of the past. Meanwhile, in 2002, 95 out of every 1,000 workers in the Euro area -- nearly ten percent -- was on strike at some point during the year. (In Spain, it was 270 out of every 1,000. In Italy, over 300.) And of course there's the vastly greater share of income going to your American peers. Look at it from their point of view: Why wouldn't they want what their American cousins have?

It seems to me that what would really be bizarre, would be if European capitalists did not see the crisis as a once-in-a-lifetime opportunity. They'd be crazy -- they'd be betraying their own interests -- if, given the ECB's suddenly increased power vis-a-vis national governments, they didn't insist that it extract all the concessions it can.

Isn't that what they're doing? Moreover, isn't it what they say they're doing? When the "Global Head of Market Economics" at the world's biggest bank says that the ECB should only cut rates "as part of a quid pro quo with governments agreeing to more far-reaching structural reform," what do you think he means?

Posts in Three Lines

I don't know what other peoples' experience is, blogging, but me, I find myself thinking about far more posts than I ever manage to put on electronic paper. Seems like if one can't write them, at least one should write down the idea of them. So here is some of what I wish I'd wrote.

The paranoid hypothesis on European austerity. Maybe the ruling class in Europe isn't so confused, maybe the crisis, like the Euro project in general, is an effort to do an end run around European national-democratic institutions, where social democracy is still stubbornly implanted. This is the thesis, mostly implicit, of Perry Anderson's The New Old World, and more explicitly of the NLR discussion of the same. Jerry Epstein offers some supporting evidence at Triple Crisis.

What's So Effective About Effective Demand? There's a conventional understanding that "effective demand" means demand backed by money; no, that's just demand. Keynes introduced the term specifically to call attention to the way actual expenditure depends on expected income, and the possibility of multiple self-consistent expectation equilibria. Think effect as in "in effect," not "having effect."

Margaret. It's a good movie, you should see it. It's dialectical. Best thing I've been to in a while.

Honest Signals: Thoughts Around Mary Gaitskill. Her stories are the best fiction I've read in the past couple years; she's attuned, like almost no one else, to the way we are both free reasoning selves and embodied social animals. Her collection Don't Cry is particularly attuned to the "honest signals" we use to communicate unconsciously, a kind of natural telepathy, and ways in which our moral and physical selves don't quite coincide. I've been writing this post in my head for the past year and change.

Larry Summers and the Anti-QE. He wants the government to take advantage of transitory low rates to adopt a more favorable financing position. Fine, except this is precisely the opposite of what quantitative easing is supposed to be doing. In general, sound finance for government is the opposite of Keynesianism; the Keynesian view is that government financing decisions should be taken with an eye to their effect on private, not public, balance sheets.

The Future Is Stasis. Everyone knows the Fermi paradox, almost everyone knows its updated version as the Great Filter. My opinion, this is almost certain proof that the future is socialism, or rather socialism or extinction. Humans will never live anywhere but Earth.

Low interest rates, really? My next project with Arjun Jayadev is a short paper arguing that, contrary to conventional wisdom, interest rates in the past decade were not historically low. The central bank does not set "the" interest rate. For business borrowers, in particular, changes in the Fed Funds rate have very little effect on credit conditions. 

The logic of business cycles. I'm still struggling with the monetarist/New Keynesian thesis that a less than full employment state of aggregate demand is just equivalent to an excess demand for money, or for some set of financial assets. Leijonhufvud argues that this is the case in the downturn, but that there is then an unemployment quasi-equilibrium in which all markets clear except for a notional excess supply of labor. Seems right.

Tobin's article, "Commercial Banks as Creators of Money." 1963. An old one, but a bad one. Sometimes it's worth reviving old arguments.

Crotty on Keynes on politics. One of the best things about studying economics at the University of Massachusetts was learning Keynes from Jim Crotty. What's tragic is that his book on Keynes' political vision has never been published, so no one who hasn't sat in his classroom knows Crotty's Keynes. I should disseminate some of it here.

Relitigating the ACA. Well, we are. Which means we need to revisit the individual mandate, a right-wing approach to health care that inexplicably migrated almost overnight to the liberal side. The economic arguments for it, IMO, remain bullshit; the ethical and political arguments are worse.

Adventures in Central Bank Independence. It's increasingly at least somewhat recognized that Bernanke's policies as a central banker in the face of an incipient depression fall more than a bit short of what he advocated as an academic. Best piece on this evolution I've seen is by Laurence Ball. Krugman's cited it, but he left out some sordid details.

Graeber's Debt. Don't care what anyone says, it's the best book I read last year. The final section -- on the last half century -- is weaker than the rest of it, but it's still got a higher rate of brilliancies per page than any other piece of social science I've read since I don't know when. Plus, the dude practically started OWS.

"Mortal Beings Cannot Hold Land to Maturity." The special place of very long-lived assets in our economy doesn't get the attention it deserves. (Hello Henry George!) It's arguable that most investment is technologically longer-lived than it optimally should be, and the rents from the "excess" assets (and of course land) constitute some of the most politically important classes under modern capitalism.

Classics: A Pattern Language. I'd like to write a bunch of posts on books you ought to read. This would be the first one. Utopian architecture theory from the 1970s: how the world should be, from the scale of cities down to the chairs in your kitchen.


One could write lots more hypothetical posts, I certainly won't write all of them. Maybe, with some luck, two or three. So I admit this exercise is a little pointless: Map is not territory. But if you're short on territory, it can be fun to draw maps.


UPDATE: It looks like this is now a thing.

Welcome Wonkupy

When I first started reading blogs a decade ago (I'm pretty sure the first blogpost I ever read was one of these Eschaton posts on Trent Lott) there was a distinctly truncated Left in the blog world, especially on economics. Just mainstream liberals, conservatives, and libertarians as far as the eye could see. Which, what else is new, right? Except that it really wasn't true of mailing lists, the predecessor medium, where you had super active lists like PEN-L and LBO Talk. I used to wonder if there was something specific about the formats that made mailing lists more hospitable to radical politics. Like, flatteringly, maybe we prefer collective discussions rather than one-man shows? Anyway, the question is moot now, because there's certainly no shortage of left/radical blogs now, economics-oriented and otherwise.

All of which is a long-winded introduction to introducing a new progressive economics blog, Wonkupy. It's by "Rotwang," a very sharp comrade who needs to remain pseudonymous for professional reasons. It bills itself as "Occupy for wonks," but my sense is it's going to be more the other way round; well worth reading either way.

Adventures in Cognitive Dissonance

Brad DeLong, May 25:

WHAT ARE THE CORE COMPETENCES OF HIGH FINANCE? 

The core competences of high finance are supposed to be (a) assessing risk, and (b) matching people with risks to be carried with people with the risk-bearing capacity to carry them. Robert Waldmann has a different view:

I think their core competencies are (a) finding fools for counterparties and (b) evading regulations/disguising gambling as hedging.

Regulatory arbitrage, and persuading those who do not understand risks that they should bear them--those are not socially-valuable activities.

Brad DeLong, yesterday:

NEXT YEAR'S EXPECTED EQUITY RETURN PREMIUM IS 9% 

If you have any risk-bearing capacity at all, now is the time to use it.

So I guess last week's doubts have been assuaged. Or did he really mean to write "If you have any capacity for being fooled into being a swindler's counterparty, now is the time to use it"?


EDIT: Oh and then, the post just after that one argued -- well, really, assumed -- that the current value of Facebook shares gives an unbiased estimate of future Facebook earnings, and therefore of the net wealth that Facebook has created. (I guess not a single dollar of FB revenue comes at the expense of other firms, which must be a first in the history of capitalism.) Is there some way of consistently believing both that current stock values give an unbiased estimate of the present value of future earnings, and that stock values a year from now will be much higher than they are today? I can't see one. But then I've never had the brain for theodicy.

UPDATE: Anyone reading this should immediately go and read rsj's much better take on the same DeLong post over at Windyanabasis. He explains exactly why DeLong is confused here.

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.

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.