Category: EMU

Deflationary spirals

It appears that the fear of a deflationary spiral is being used as a major argument against wage cuts. My impression is that the idea is gaining traction out there in the real world, and so it seems worthwhile restating the reasons why it is wrong.

‘The’ price level in the Irish context is the European price level, which is determined by policy in Frankfurt. Nothing that happens in Irish labour markets will move this price level by one iota in either direction, and so nothing that we do here will set off a deflationary spiral. What we can influence is a relative price, namely the relative cost of living and doing business here. This relative cost exploded during the bubble, and it will eventually come down. The only issue is whether this happens quickly, or whether relative Irish costs will be ground down by unemployment and stagnation over the course of many years.

David Begg is right to fear a deflationary spiral, but what will determine whether we get one or not is the relative supply of ideologues and pragmatists in the ECB, not anything that happens here. And the sort of intertemporal logic which explains why deflation is so damaging can be turned on its head in the Irish context: as Philip points out, it implies that wage cuts need to happen all at once, now.

The Government should announce that all public sector wages, which it controls, be cut by x%, where x is determined by real exchange rate considerations. It should strongly suggest that all private sector wages be cut by the same amount. Ideally we would all jump together, and so the wage cuts would come into effect simultaneously on a given date. St Brigid’s Day would seem appropriate.

Did the Euro contribute to the Irish bubble?

Jim O’Leary discusses Ireland’s EMU membership in his Irish Times column today.  An interesting question is whether Ireland would have avoided a bubble had it opted not to join EMU.  The issue here is the relevant counterfactual.  Since quite a number of non-member European peripheral countries that were growing quickly for convergence reasons also enjoyed credit booms due to the global decline in risk aversion and compression of spreads, it is not so obvious that staying outside EMU would have delivered stability (think of Iceland and various CEE countries).

If expectations of price appreciation grip the housing market, small differences in the level of interest rates do not make too much difference.  To the extent that high levels of immigration helped to fuel perceptions of strong fundamentals in the housing market, that dimension is orthogonal to EMU:  the two other countries that were early liberalisers were also not members of EMU (Sweden and the UK).

Accordingly, if the relevant comparison set is composed of other non-advanced European countries (in terms of income levels relative to potential in the late 1990s), then it is not clear that EMU was a fundamental factor.   Rather, key differentiating factors may include the quality of banking regulation and the probity of fiscal policy.

Clearly, this is a very open debate that calls for more research!

Eichengreen on EMU

Barry has a nice piece on Vox today. He is clearly right: we need the ECB to move to zero interest rates now, and match London and DC when it comes to quantitative easing. On the latter point: is this easy to do in the Eurozone context, or does it require institutional reform? Can a banking expert set me straight here?

Krugman: Nominal Wage Cuts Necessary but Difficult

Paul Krugman discusses the problem facing those EMU member countries that are currently suffering from a lack of competitiveness (note, by the way, his use of the word competitive!) and accepts that nominal wage reductions are a necessary part of the adjustment: you can read his discussion here.

He also links to a posting by Edward Hugh that probes the difficulties involved in engineering nominal wage reductions: you can read it here.

Ireland and EMU

The Daily Telegraph gives prominence today to the recommendation by David McWilliams (made on RTE radio over the weekend) that Ireland should consider leaving the euro area: you can read the article here. The notion that Ireland or some other member country might leave the euro area is now a factor in the government bond market.

However, the adverse economic consequences of leaving the euro area are so large that this option should not be taken seriously. Barry Eichengreen has written a comprehensive paper on this topic, which you can download here.

The benign scenario described in the comments attributed to McWilliams in the Telegraph article envisages Ireland being able to use monetary independence to achieve real exchange rate depreciation in a stabilising fashion. However, a new Irish currency would be emphatically not trusted by the markets (a government that is willing to take the steps to exit the euro area is not a government that can be counted upon to keep its promises), such that either the new central bank would have to offer high interest rates or the government would have to impose capital controls. Neither is a recipe for a growth recovery.