Buiter Vs. Krugman on European Rigidities

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.

26 replies on “Buiter Vs. Krugman on European Rigidities”

The discussion of real wage rigidity v nominal wage stickiness should surely distinguish between contexts of rising and falling prices. Ireland displayed fairly rigid real wages during periods of high inflation, which alerts us to the risk that a devaluation would not achieve a lasting real wage adjustment. But we really have no previous experience of how the economy adjusts in a context of falling prices, that is, how easy an ‘internal real devaluation’ will be, but the experience so far is not encouraging.

Brendan,

Paul Krugman points out that Ireland has managed a 5 percent reduction in average nominal wages over the last couple of years. At a time of rising international prices, this strikes me as a reasonably impressive decrease in real product wages for the internationally traded sector. It is no mean achievement to achieve a reduction in nominal wages at all, with a substantially larger increase coming in the public sector, where I would have expected the nominal rigidity to be most pronounced.

By Post Author

Krugman says:

“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.”

Buiter says:

“We are sceptical about the duration of the gain for countries like Greece, Spain, Portugal and Italy. 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.”

JTO says:

Krugman is wrong – Buiter is right (although he would have been more right if he had omitted the word ‘possible’ in relation to Ireland).

Krugman conveniently ignores the minor detail that the devaluation sets off an inflationary spiral. If all prices and wages remained the same after the devaluation, then, of course, it would be wonderfully effective. But, they don’t. A good illustration is the contrasting experiences of the UK and Ireland between December 2007 and December 2010.

In December 2007, the Euro was = 0.72064 £Sterling
In December 2010, the Euro was = 0.84813 £Sterling

That is, the £Sterling was devalued by 15.0% against the Euro between December 2007 and December 2010. If all prices had remained the same in local currency after the devaluation, then price levels in Ireland (and the rest of the Eurozone) would in December 2010 have increased by 17.2% over those in the UK relative to what they were in December 2007. Yet, figures out this week show:

(a) UK trade deficit hit record high in November 2010.

http://uk.finance.yahoo.com/news/UPDATE-1-UK-Nov-goods-trade-targetukfocus-152250541.html?x=0&.v=1

(b) UK manufacturing output lagging Eurozone in November 2010 – changes in manufacturing output between November 2009 and November 2010:

Ireland +14.2%
Eurozone +7.4%
UK +3.7%

Note: Before the usual suspects come on and say that Ireland’s figures are due to viagra, they aren’t – I checked.

(c) Cross-border shopping to Newry lowest since 2007.

So, if devaluation is so great, why aren’t UK exports and manufacturing doing better? Where is the UK exports and manufacturing boom that the devaluation was supposed to bring? The answer is that the UK devaluation has sent the UK into an inflationary spiral, in the process eroding most of the initial competitive advantage that resulted from the devaluation. These are the changes in the harmonised consumer price index between December 2007 and December 2010 in Ireland and the UK:

Ireland -1.0%
UK +9.5%

So, prices in the UK relative to those in Ireland rose by +10.6% between December 2007 and December 2010. This wiped out two-thirds of the competitive gain that the UK made against Ireland, as a result of the 15.0% devaluation of £Sterling v Euro between December 2007 and December 2010. One could argue that one-third of this competitive gain remains. But, that ignores the fact that the competitive gain is still being eroded by higher UK inflation and at an accelerating rate. UK annual inflation is predicted to hit 4.0% in the next couple of months, while in Ireland it is predicted to be around 0%. The competitive gain that the UK made against Ireland, as a result of the 15.0% devaluation of £Sterling v Euro between December 2007 and December 2010, will be completely eroded by next autumn. At that point, the UK will have to either (a) continue to devalue its currency to maintain competitiveness, in the process re-inforcing the inflationary spiral and, once investors realise how they have been conned, put up interest rates OR (b) act to bring its inflation rate down to that of the Eurozone.

If all this occurred in the UK, which is a relatively closed economy (exports/imports only around 25% of GDP), how much more true would it be of Ireland, which is one of the most open economies in the world (exports/imports 100% of GDP)?

Turning now to comparison between Ireland and Spain and Greece. Buiter is right in highlighting the differences between Ireland and the others. The reality is that Ireland has significantly improved its competitiveness, while the others haven’t. These are again the changes in the harmonised consumer price index between December 2007 and December 2010:

Ireland -1.0%
Eurozone +5.1%
Spain +5.3%
Greece +10.7%

So, Ireland’s competitiveness v the Eurozone improved by 6.1% between December 2007 and December 2010, while Spain achieved no improvement at all, and Greece’s competitiveness actually worsened by over 5% between December 2007 and December 2010. As Ireland’s current annual inflation rate (December 2010) is about 3% below that of the Eurozone, while Spain’s is about the same as the Eurozone, and Greece’s is about 3% above that of the Eurozone, there is every likelihood that this trend will continue.

These gains and losses in competitiveness are again borne out by the manufacturing output figures for November – changes in manufacturing output between November 2009 and November 2010:

Ireland +14.2%
Eurozone +7.4%
Spain +2.3%
Greece -8.0%

BOTTOM LINE:

Ireland has successfully achieved an internal devaluation, sufficient to make its export and manufacturing sectors highly competitive, as evidenced by its skyrocketing export and manufacturing output figures – the others haven’t.

“K”-man wins this one.

Now I know that the UK in 1992 could not be said to have quite the rigidities of the typical periphery but back then the City’s “top” economics team at James Capel were arguing along the lines of:

“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”

to back up their forecast that ERM exit would result in inflation moving to and sticking at about 8.5%. It was the consensus view among economists that any gains would just go to inflation with Capel the most hawkish. Some of us looked at the recession, the knackered housing market, high unemployment and globalisation – and thought that was total bollox.

The mistake the consensus guys made was to underestimate the common sense effects of the economic realities on the behaviour of actual people.

I would argue that the influence of the structural problems in the periphery would be quite ineffective at pushing up nominal wages and costs in the post bubble, deleveraging environment.

They will however, be very, very effective at resisting a ratcheting down in nominal terms of those costs. Surely nobody in Ireland could argue with that given the fact that the country (the most flexible of the PIIGS) cannot go any further on public sector pay than the once-off Croke Park deal of ages ago – even though it contained a clause that made it void should the economic situation worsen.The IMF have arrived but everyone that counts is pretending that doesn’t matter.

Krugman says: “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.”

How obvious does something have to be before it is possible to get economists to agree that it is correct?

It is actually a worse problem if anything, than Freidman described. It isn’t just an unwillingness to be the first to take pay cuts, it’s a dogged determination to be the last – and to take the least pay cut.

This is because what is on the table is a redistribution of comparative earnings power within the country. It isn’t that once the pay cuts start there is an avalanche and everyone goes along with it. If you can be the group with the stickiest wages to adjust downwards then your position in society improves at the end of the national adjustment.

What happens is social polarisation with the most economically vulnerable, least powerful, least well connected being pushed by the others to the front of the que – welfare recipients, carers, self-employed etc. Meanwhile the professions that regulation require are used hold out, the powerfully unionised hold out etc.

What I find quite ironic is that some of the most determined hold-outs use a version of Paul Krugman’s arguments that deficit spending is useful when there is a demand shortage to make out it is their duty to refuse to participate.

Americans do not have a good handle on the political, business and economic machinations of the EU. Politically the Germans and the French have to keep the Euro weak in order to export their way out of stagnation. This policy helps all of Europe including Ireland. The Chinese and Japanese step up to the table with substantial offers of help. This action stops the erosion of confidence in Portugals bond auctions and strengthens the Euro. Immediately Merkel and Sarkozy make statements that undermine the Euro. Sit down put your feet up and watch fate unfold as the Franco-German alliance wishes.

This is a link to the most disturbing article I have ever read concerning Eugene Fama of the Booth School of Business.

http://www.newyorker.com/online/blogs/johncassidy/2010/01/interview-with-eugene-fama.html

Krugman seems more focused on Europe’s capacity to deal with shocks to minimise adverse short term impacts (which may also have longer term consequences), while Buiter is more focused on Europe’s competitiveness over the long-term. So their respective views are not necessarily inconsistent.

@ Mickey Hickey

interesting article, he seems to have a lot of opinions but not too many answers, totally shyed away when he was asked what he would do…..clearly he would have let anglo collapse, and he talks about work when playing golf…like all of us, bar those hardy few who live purely for the game and cannot be distracted by any outside noises..

I agree with Kien. I don’t think there is a fundamental inconsistency between Krugman and Buiter. And I think any perception of one disappears if we focus on structural rigidities in Ireland relative to the other peripherals. For me the key is the last sentence in John McHale’s extract from Buiter:
“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.”

For want of a better word, Ireland’s tradable sectors have become ‘internationalised’; they are flexible, resilient and dynamic – as JtO persistently points out – in stark contrast to these sectors in the other peripherals. This reflects the change in the balance of economic and political power that Buiter highlights. (I am, however, unpersuaded about the direct causation between relative declines in Irish prices and the sterling manufacturing output performance. Yes, it demonstrates flexibility, but it also reflects the extent to which the level of prices in Ireland had gotten out of line with our EU peers – and needed to be brought back.)

But this necessary flexibility and lack of rigidity is not evident in the non-tradable sectors. I think grumpy puts his finger on it – and this is where Krugman’s observations are relevant:

“What happens is social polarisation with the most economically vulnerable, least powerful, least well connected being pushed by the others to the front of the queue – welfare recipients, carers, self-employed etc. Meanwhile the professions that require regulation … hold out, the powerfully unionised hold out etc.

What I find quite ironic is that some of the most determined hold-outs use a version of Paul Krugman’s arguments that deficit spending is useful when there is a demand shortage to make out it is their duty to refuse to participate.”

So I’m back beating the my worn drum and emphasising that the deadweight costs that these sectors impose must be weeded out as they are imposing unnecessary burdens on the tradable sectors – which are the sectors that will generate the badly needed growth in employment. A further point is that the German economic strategy is generating and will generate a lot of economic activity, but Germany is short of the bodies to perform this activity. Some re-orientation of Ireland’s industrial strategy is required to take advantage of this. It doesn’t matter whether the activity is performed there or here – once Irish firms and workers are capturing a fair share of the added value.

The 1986 devaluation, unlike most others, seems to have conformed more to the Krugman rather than the Buiter, pattern as Brendan Walsh and Patrick Honohan pointed out in their Celtic Hare paper:-

“The devaluation of 1986, initiated as a defensive measure in light of the loss of competitiveness associated with a rapid depreciation of sterling, was especially timely in that sterling suddenly recovered, leaving Ireland well-placed in terms of wage competitiveness to benefit from the accelerating economic boom in the UK and other trading partners countries after 1987. As it happened, this was the first step in a sustained improvement in wage competitiveness … “

It is interesting how both authors (and many other commentators) treat the nominal price and wage rigidity of the Euro regime as an unalloyed drawback to the Euro regime that was “traded off” for political reasons in the push for European political integration. In fact, nominal price and wage rigidity was one of the main perceived benefits of the Euro regime for many countries. The Euro regime would allow the “softer” political-economic systems (Italy, Greece, Ireland, Spain) to lock in German-style near-zero inflation. It is only with hindsight that this rigidity is perceived as a drawback. At the time of the Euro regime inception this was perceived as one of the major advantages.

Nominal “rigidity” and German-style hard money are intimately connected. In the pre-Euro post-war regime in (W) Germany the Central Bank maintained hard money, and businesses and labour accepted low annual rates of nominal price and wage increase. In “softer” polities (Italy is a classic example) businesses and labour demanded high annual rates of nominal price and wage increases, and the Central Bank maintained softer money policies. International equilibrium was maintained via depreciation of the soft-market currencies. The “softer” polities saw its advantages and wanted to move to the nominally rigid, hard-money German-type regime.

Which is the causal factor and which is the cause? Neither — it is an equilibrium relationship between the two.

A perceived key benefit of the Euro was that it would force the Italian (and Irish and Greek etc) economies to move to the German system of hard money and wage and price discipline, by eliminating the Italian (etc.) monetary authority and effectively replacing it with a single effectively-German Central Bank. This, more than the desire for political integration, was the swing factor in many countries in adopting the Euro.

Obviously now that the Euro regime requires downward wage and price movements, rather than just the absence of upward movements, this price discipline seems less desirable as a feature of the regime. But at the time it was a major selling point.

WHAT ABOUT ASSET PRICES?
There is a critically important aspect to this debate that doesn’t appear to be covered at all: asset prices.

FIXED CURRENCY REGIME & DEBT DEFLATION
Irish property prices were driven skywards by the credit bubble. With us locked into the Euro, price deflation must take place in nominal terms. That has unleashed debt-deflation as nominal property prices fall while nominal debt levels remain largely unchanged. The effect of this debt-deflation dwarfs any other effect currently at play in the Irish economy.

DEBT DEFLATION & WEALTH LOSS DOMINATE DOMESTIC ECONOMY
Back in 2007, Bank of Ireland Private Banking published a study analysing Ireland’s wealth. It was estimated that gross wealth was €945 billion with net wealth (ex borrowings) €784 billion. Over 70% of gross wealth was represented by residential property. That has halved in value and I reckon, when one applies rough haircuts to the other asset categories, that total wealth destruction exceeds €400 billion.

That’s more than three times our national income (GNP). It would be good if the economy grew at 3% this year. But even that would pale beside the more than 300% wealth destruction we have suffered. And it is wealth destruction rather than economic uncertainty which has sent our savings rate sky-high. In the face of a pauperised old age, citizens are responding appropriately by reducing current consumption and by jacking up savings for the future.

HAD WE RETAINED PUNT, WE COULD HAVE REDUCED DEBT DEFLATION EFFECTS
Had we “enjoyed” credit and property bubbles with our own currency, then a large devaluation would have not just helped correct property prices. It would also have led to a devaluation of the real debts owing. Foreign creditors would have had to bear a significant proportion of the economic adjustment. The debt-deflation impulse imparted to the Irish economy would have been significantly reduced.

@Greg

Interesting historical perspective. Even so, I am still struggling with the link from an essentially monetarist macroeconomic policy stance to a Keynesian-type economy (distinguished by nominal rigidities). Miltion Friedman would not be pleased.

@Brendan

I agree. Even though real wages have come down (and so we don’t have full real wage rigidity), the increase in unemployment needed to bring about the limited adjustment we have seen has been very high, indicating substantial “real wage resistance”.

It is fair to say that we now know that extreme nominal rigidity does not apply in the Irish case. This does weaken the case for using the nominal excahnge rate as a relatively low cost means of bringing about necessary changes in the real exchange rate for Ireland. I don’t see it as conclusive, however: there are likely to be pockets of nominal rigidity (or ranges of nominal rigidity after nominal wages have dropped a certain level as in the public sector), and nominal depreciation could still have a degree of effectiveness.

@Cormac

Indeed, this thread has neglected the other element of the alternative “international devaluation strategy”: the impact on the real value of debt and thus on aggregate wealth and demand.

I think you exaggerate the case, however.

FIXED CURRENCY REGIME & DEBT DEFLATION: You focus on the rising real value of nominal liabilities under deflation. But there is also the rising real value of nominal assets (say deposits). The famous Pigou effect is all about the effect on demand from the change in net real wealth that results from a change in the price level. Even if net real wealth is falling overall — which is the case wiith a large stock of nominal mortgage debt outstanding — surely the nominal asset side must be considered.

DEBT DEFLATION & WEALTH LOSS DOMINATE DOMESTIC ECONOMY: Here I think you neglect the positive impact of the lower cost of housing on lifetime wealth. A young couole planning to live out their days in their current house don’t feel hugely poorer even if their house has halfed in value. They intuititively sense that it won’t affect their lifetime consumption. Essentially, the fall in the nominal value of the asset is being offset by the fall in the implicit (opportunity) cost of that housing. An older person planning to downsize in retirment and live off proceeds would experience a real wealth loss. However, a young person yet to buy will have a real gain given that they will benefit from the lower cost of housing. Again, ithe wealth effects are much more complicated than the dramatic picture you paint.

HAD WE RETAINED PUNT, WE COULD HAVE REDUCED DEBT DEFLATION EFFECTS: You appear to assume that outside the euro our foreign borrowing would have been in punts! Thus devaluation would have led to devaluation of real debts owing, putting the burden on foreign creditors. Do you really believe that foreigners would have lent to us in punts? If a foregin borrowing binge happened, as in Iceland, the most likey course is that the banks would have raised funds in euros, dollars, sterling, etc, and would have lent the money on in punts to Irish residents. But from a national perspective, the devaulation would leave the foreign debts unaffected. And the banks would be banjaxed by a different route (assuming that the foreign borrowing binge would have occurred outside the euro, which is debatable).

@JMcHale
“(assuming that the foreign borrowing binge would have occurred outside the euro, which is debatable).”
I agree with the rest of your critique of Cormac’s points, but I don’t think that it is debatabe that the foreign borrowing binge would have happened. Can anyone really see Mr. Hurley upsetting the Bertie Property Show with interest rate rises post 2001?

@Cormac Lucey
It sounds as though you view debt deflation as a bad thing? I view it as inevitable, but not in and of itself bad. Some of the effects are bad, but that is where policy should be directed. Accept that the inevitable will happen and work to diminish the bad outcomes. Accentuate the positive. If property prices keep falling, housing workers in Ireland will be the cheapest per employee of anywhere in Europe…

@JohnMcHale

You wrote “You focus on the rising real value of nominal liabilities under deflation. But there is also the rising real value of nominal assets (say deposits).”

That is true but as our loan liabilites significantly exceed our deposit assets, the net effect is as originally described.

You wrote “surely the nominal asset side must be considered”.

I did consider that in applying haircuts to the BoI wealth estimates they published in 2007. So I applied a zero haircut to bank deposits. It doesn’t alter the fact that there has been a calamitous destruction of wealth (as that was mostly concentrated in residential property). This destruction of wealth has, in my opinion, received very little public or professional attention.

You wrote “I think you neglect the positive impact of the lower cost of housing on lifetime wealth.”

That is true. But the short term impact of wealth destruction (and related income drops) may drive tens of thousands into personal bankruptcy. Such people (e.g. Ivan Yates) may find it hard to see much of a silver lining in reduced future housing costs. I also find it hard even though I have never bought a house (renting since my marriage in 2001) and thus should qualify as a clear “winner” from this development.

You wrote “You appear to assume that outside the euro our foreign borrowing would have been in punts!”

I take your point here and in your subsequent argumentation. The im0pact of this factor really depends on the jurisdiction under which public and private debts have been issued (and whether they are therefore subject to subsequent legislative change).

I would therefore take some comfort from Page 73 of the current edition of “The Economist” (January 15th, 2011) where the following quote can be found: “the bulk of peripheral Europe’s debts are issued under local law”.

@hoganmahew

You wrote “It sounds as though you view debt deflation as a bad thing? I view it as inevitable, but not in and of itself bad.”

I do regard debt deflation as a bad thing.

IMO it was the key driver of the depth and length of the Great Depression in the 1930s. People forget that its wasn’t Roosevelt who ended the Great Depression. It was Hitler and his unleashing of world war (a global demand stimulus of the sort that no sensible person wants) which finally led to US unemployment rates dropping permanently.

I fear that we are suffering something similar (as the Great Dperession) at present but our society lacks the tools to see this or to combat it. Instead we opt for a range of peicemeal responses condemned to be inadequate. My posts on this website have attempted to warn of the dangers of debt deflation and to explore possible paths away from it.

BOTTOM LINE
Wealth destruction of the order of €400b is the single biggest factor now affecting Irish economic behaviour. I believe that the extent of that wealth destruction (and the associated debt deflation effects) would have been mitigated had we remained outside the Euro.

Not sure how I managed to answer Cormac’s points before he made them… perhaps some trans-temporal feedback loop? (The clock on the server is broken…).

Bother, the comment I was referring to didn’t make it…

@Cormac
“My posts on this website have attempted to warn of the dangers of debt deflation and to explore possible paths away from it. ”
Whereas I see it as inevitable and my posts have been a request to address the effects of it rather than make it worse by trying to prevent it (for example by artificially supporting asset prices and so destroying the market for them).

The piecemeal responses need to be coherent and need to make sure that they don’t exacerbate the problem. Shifting huge private debt to public debt being one of those piecemeal exacerbations.

@Cormac Lucey, John McHale

Since you bring it up – from an earlier discussion:

………may be missing out the asset management side that doesn’t talk much, but focuses on the implications for economies and assets. Here the basic “trap” that awaited consumers in the UK and Ireland was understood to be the trap that would open up after membership as inflation remained low over the medium to long term thanks to the German influence.

It was thought by many that the trick of gearing-up to buy real estate and have the debt inflated away over time, would be assumed to be still a runner – because it was so firmly ingrained in the cultural experience. It would, however, prove different as the money borrowed would retain its value and eventually people would appreciate that it had to be paid back at full value. It took a decade for this penny to actually drop with Joe Soap.

There was a second thing that made the trap more dangerous. For Ireland, there was actually a boom in house prices at the end of the nineties. I remember being told by tuned-in Dublin types that they were very nervous and should get out because real estate had to be unsustainable and would crash just like a decade earlier in London. They couldn’t see that the mechanism that had caused the UK property price decline was ruled out for the foreseeable, by EMU.

At the time Ireland required interest rates to go up. There would have been an accompanying punt appreciation. What it got was a nice, low exchange rate fix, a series of ludicrous interest rate reductions to pretend that there was some economic convergence and an asset price boom that became turbo-charged with all downside risks of interest rate rises (aka the brakes) switched off.

This effectively baited the trap.

I’ve written this before but I think it bears repeating. I remember advising people in rhetorical fashion along the lines of “what do you think is going to happen to house prices as interest rates are forced down?” for those that didn’t get it the follow-up was “things will go totally mad”. What I found most disturbing was that most said nothing but acquired a stupid grin and a few muttered something like “oh, as bad as that” and then acquired the stupid grin. For those that were warned it was short termist gombeenism that motivated joining and for a lot of the rest it was about giving the finger to the Brits.

The argument against was always about how volatile the cycles for each country were, where they were in that cycle vs Germany and France, and how the longer run impact of joining on their cycle would be managed within the EMU structure. For Ireland it was just the wrong move at the wrong time and nobody was in the mood to listen.

Without joining the Euro the little island’s quite mediocre bankers wouldn’t have been given the keys to Europe’s booze cupboard. Ireland would have continued with a modest boom and its population’s wealth would have increased partly via an appreciating currency rather than crazy asset price inflation.

At some point there would have been a downward move in the punt when competitiveness started to be a problem and the drawn-out pantomime of everyone – academic economists included – keeping their heads down waiting for everyone except them to chip-in to an internal depreciation, would have been avoided.

@hoganmahew
I agree with you that substantial debt-deflation is inevitable, whatever policy options we now choose.

Irving Fisher, the man who coined the phrase debt-deflation, believed that reflationary policies could be used to stem its worst effects: “it is always economically possible to stop or prevent such a depression simply by reflating the price level up to the average level at which outstanding debts were contracted by existing debtors and assumed by existing creditors, and then maintaining that level unchanged.”

Hyman Minsky might disagree.

@ Grumpy

“Without joining the Euro the little island’s quite mediocre bankers wouldn’t have been given the keys to Europe’s booze cupboard. Ireland would have continued with a modest boom and its population’s wealth would have increased partly via an appreciating currency rather than crazy asset price inflation.”

Could not agree more.

By joining the Euro we deactivated the currency circuit-breaker which forced the UK to realise (in 1992) the folly of its attempt at monetary union with Germany. But, even though it involved “enjoying” only 5 years of too-low German interest rates, the “Lawson boom” caused considerable economic and political dislocation in the UK. We’ve had 10+ years of that stimulus here. The resulting financial imbalances are grotesquely large. And we will shortly see the consequent political dislocation.

@Cormac Lucey
Yeah, one of the problems is that debt deflation as a concept has been largely dismissed out of hand. People like Steve Keen are still fighting for acceptance that there is a tipping poing to debt. As such, there has been very little academic examination of how to get out of debt deflation. It is not, I believe, just a matter of spending, nor is it just a matter of cutting taxes. So far, all I’ve come up with is “I wouldn’t start from here”.

@Kevin
😳 I forgot about Barry; a beacon of light on the bits of the euro story that are not under the streetlamps. Sorry Baz…

Not sure whether this belong here or in the History of Economic thought thread, but the Irish situation is somewhat reminiscent of the silver discussions in the late 19th century in the USA. See http://en.wikipedia.org/wiki/Cross_of_Gold_speech and the whole history of the Coinage Act, farmer indebtedness, etc.

Now, the particularly nasty trick that the Irish govt and the ECB/EU have managed in today’s situation is to transfer a large chunk of the debts onto people who had nothing to do with incurring the debts in the first place.

Not only are the bubble warriors to pay, but the prudent, the young and even potentially the unborn.

While I’m a fan of hard currencies, the phrase “A Cross of Gold” seems appropriate to the Irish situation.

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