This is really just a sub-thread on Greg’s Krugman post and Kevin’s earlier Buiter post.
A significant part of Paul Krugman’s case against the Euro relates to the resulting loss of macro flexibility. As he explains, nominal exchange rate devaluations/depreciations are effective in lowering the real exchange in an economy with substantial nominal rigidities. However, Willem Buiter and co-authors argue that European countries tend to display real rigidity rather than nominal rigidity, making changes in the nominal exchange less effective in producing improvements in cost competitiveness. Interestingly, however, Buiter holds out Ireland as a possible exception to the European pattern.
Ireland appears to display a reasonable degree of both nominal and real flexibility, although it has taken a large increase in unemployment and a severe fiscal crisis to bring about downward adjustments in the private and public sectors respectively. I would be interested in views on about the nature of wage and price flexibility in the Irish economy.
Krugman on the costs of a currency union where there are nominal rigidities
The case for a transnational currency is, as we’ve already seen, obvious: it makes doing business easier. Before the euro was introduced, it was really anybody’s guess how much this ultimately mattered: there were relatively few examples of countries using other nations’ currencies. For what it was worth, statistical analysis suggested that adopting a common currency had big effects on trade, which suggested in turn large economic gains. Unfortunately, this optimistic assessment hasn’t held up very well since the euro was created: the best estimates now indicate that trade among euro nations is only 10 or 15 percent larger than it would have been otherwise. That’s not a trivial number, but neither is it transformative.
Still, there are obviously benefits from a currency union. It’s just that there’s a downside, too: by giving up its own currency, a country also gives up economic flexibility.
Imagine that you’re a country that, like Spain today, recently saw wages and prices driven up by a housing boom, which then went bust. Now you need to get those costs back down. But getting wages and prices to fall is tough: nobody wants to be the first to take a pay cut, especially without some assurance that prices will come down, too. Two years of intense suffering have brought Irish wages down to some extent, although Spain and Greece have barely begun the process. It’s a nasty affair, and as we’ll see later, cutting wages when you’re awash in debt creates new problems.
If you still have your own currency, however, you wouldn’t have to go through the protracted pain of cutting wages: you could just devalue your currency — reduce its value in terms of other currencies — and you would effect a de facto wage cut.
Won’t workers reject de facto wage cuts via devaluation just as much as explicit cuts in their paychecks? Historical experience says no. In the current crisis, it took Ireland two years of severe unemployment to achieve about a 5 percent reduction in average wages. But in 1993 a devaluation of the Irish punt brought an instant 10 percent reduction in Irish wages measured in German currency.
Why the difference? Back in 1953, Milton Friedman offered an analogy: daylight saving time. It makes a lot of sense for businesses to open later during the winter months, yet it’s hard for any individual business to change its hours: if you operate from 10 to 6 when everyone else is operating 9 to 5, you’ll be out of sync. By requiring that everyone shift clocks back in the fall and forward in the spring, daylight saving time obviates this coordination problem. Similarly, Friedman argued, adjusting your currency’s value solves the coordination problem when wages and prices are out of line, sidestepping the unwillingness of workers to be the first to take pay cuts.
So while there are benefits of a common currency, there are also important potential advantages to keeping your own currency. And the terms of this trade-off depend on underlying conditions.
Buiter on real rigidities in the Euro Area (p. 43)
The main alleged benefit from leaving the EA [Euro Area] or a highly-indebted, low growth, internationally uncompetitive economy is often argued to be that the introduction of a new national currency (New Drachma, say) would permit (and indeed would be immediately followed by) a sharp depreciation of the effective nominal exchange rate of the new currency. If this nominal depreciation were to result in a long-lasting real depreciation, the country’s international competitive position would be improved and net external demand for its output would be boosted, which would be welcome.
However, the question is how long such a gain in competitiveness would last. We are sceptical about the duration of the gain for countries like Greece, Spain, Portugal and Italy. If these were Keynesian economies, with enduring rigidity of nominal wages and flexible real wages, nominal exchange rate depreciation or devaluation will produce a lasting real depreciation and improvement of competitiveness. But unlike the USA, where this may be a reasonable characterisation, the EA periphery countries, with the possible exception of Ireland, are in our view distorted classical economies with rigid real wages and flexible nominal wages. If the key wage and cost rigidities in the EA periphery member states are real rigidities, not persistent Keynesian nominal rigidities, then even a sharp depreciation of the currency will go through the real wage, cost and competitiveness configuration of the economy like a dose of salts, with the old uncompetitive real exchange rate restored in short order through a sharp increase in nominal wages, other costs and domestic currency prices. Unless the balance of economic and political power is changed fundamentally in the key factor and product markets, the use of national monetary autonomy to pursue a more competitive real exchange rate will be dissipated in higher inflation, with no lasting improvement in the international competitive position.