The pre-2007 Irishman abroad in Europe had a little swagger to him. He thought his economy was a Tiger. When abroad in Europe, he spent like crazy, and generally annoyed his European counterparts with his brash ways. (Of course I’m not thinking of anyone in particular). The reverse is happening at the moment. We’re humble little chappies. My French and German friends are sending me emails with pictures of the Book of Kells saying ‘please take care of our investment’ and ‘are you enjoying your bailout?’ and ‘we’re still waiting for the thank you card’.
They’ll be waiting a while longer. When I say our European friends should be thanking us, they assume it’s a throwback to the hubris of pre-2007 Ireland or something to do with keeping eyes off the balance sheets of German and French banks. It’s not, and here’s just one reason why.
Imagine there are two countries trading with one another, with different cost structures and different currencies. Exchange rates then become important because they affect the relative price of domestic and foreign goods. So for example the dollar price of German goods to an American is determined by the interaction of two factors: the price of German goods in euros and the euro/dollar exchange rate.
When a country’s currency appreciates (meaning it rises in value relative to other currencies), then the country’s goods abroad become more expensive and foreign goods in that country become cheaper (if we are holding domestic prices constant in the two countries). By the same token, when a country’s currency depreciates, its goods abroad become cheaper and foreign goods in that country become more expensive.
So far, so boring. Simple economics would hold that in the more expensive country, a rise in a country’s price level (relative to the foreign price level) will just cause its currency to depreciate, thus hammering demand for its exports, until competition brings the price level down, and off we go again. The exchange rate is allowing price levels to equilibrate without deflating the domestic economy too much, and things are put back on an even keel.
What’s not normally acknowledged in this story is that, while the expensive country is returning to equilibrium, exporting firms in the less expensive country are making out like bandits because they are so much more competitive than firms in the more expensive country.
Now let’s put our two countries into a monetary union, but leave the cost imbalances. Let’s consider just Germany and Ireland, trading between one another with two currencies, Irish Euros and German Euros, that just happen to trade at 1:1, independent of the supply and demand forces acting on the currency. Relative to their cost structures, the currency of one nation–Germany–is relatively undervalued, generating increases in exports for the Germany and resultant GDP growth, while the Irish-Euro is overvalued, leaving that Ireland with only one option: a hard internal devaluation through the wage channel. This leaves aside all discussion of competitiveness, it’s just looking at the currencies in a different way.
We can see this reflected in changes in the real effective exchange rates for Ireland and Germany over the past decade. The effective exchange rate is a trade share weighted average of a basket of foreign currencies. The real effective exchange rate adjusts for difference in price levels in those different countries. It can be viewed as a rough measure of the country’s external competitiveness.
Plot the data for Ireland, Germany and the European Union of 27 countries over a 15-year period from 1994 to 2009 (all data from Eurostat, axis starts at 80, and this is the latest data available). What do you see? You see the deterioration of Ireland’s competitiveness relative to the Eurozone average, but importantly, to Germany.
What does this all mean? Say in 2009 I bought a Mercedes from Germany. I bought it using my overvalued Irish Euros. My German friend accepted these overvalued euros and proceeded to use the funds from the sale of the car to buy another Mercedes in Germany in Germany. When he bought that second Mercedes, he was hoovering up the 30% price difference in 2009 euros between Ireland and Germany. There’s an implicit wealth transfer going on.
Now think about the competitiveness challenge Ireland has. Ireland must (and will) return to the Eurozone average at least, by accepting lower wages and deflating the economy. But will it ever really get close to Germany’s level of competitiveness? Probably not, because a lot of that is being driven (and hidden) by the relative valuations of the currency on their domestic and international assets, and while Ireland continues its internal devaluation, German firms will soak up the transfer.
So: the next time you hear a core country complaining about a peripheral nation, remember the favour you’re doing them by buying their goods and services. (German exports, by the way, registered a 10.9 billion Euros trade surplus this month). Of course lots of sensible Germans (and other Europeans) recognize the great deal they are getting from Eurozone membership, but this doesn’t get reflected in most of the commentary we see today.