Making things worse to make them better?

Ok, so Germany agreed to the EFSF, a new round of credits worth some 400 billion Euro to “stabilize” the states of the European Union. Of course, that is not exactly what is going on – the credits merely serve as an increased buffer.

What it takes to stabilize a system is simple: negative feedback.

That’s the property of a system to respond to a situation in which it is out of equilibrium with some kind of dynamic that will gradually push it back towards the equilibrium – no matter what side of the equilibrium you are on. Positive feedback merely pushes it even further away from that point. The buffer is telling you, just how far away from equilibrium you can go, before bad things happen(TM).

Unfortunately, there is no sign that sufficient negative feedback is in place to turn things around before the new round of credits is running out. Especially since more and more positive feedback is kicking in, making things worse. Interest payments are mainly a concern for countries already in trouble. Austerity measures lead to decreasing economic activity and decreasing income for governments, “requiring” even more austerity measures.

The problem is the massive economic imbalance that has been allowed to build up in the European Union after the Euro has been introduced. Now, to be sure, the Euro has had a massive benefit for the European Union since its inception in 1999 – but the downside was, that it took out a powerful negative-feedback mechanism – exchange rates.

A country that is exporting a lot of goods necessarily gets a lot of money and its currency will gain in value. At the same time, the currency of the importing country will lose some of its value compared to the exporting country. This is very much how it ought to be. A country importing goods will gradually lose its ability to pay for more goods to be imported – it will have to export goods in order to import more.

On the other hand, the exporting country will gradually lose the ability to profit from exports, as the money it is offered in return for those exports is losing more and more of its value – and ever fewer people in the importing countries will be able to afford them. The export business will lose its attractiveness as the country is piling up money and indeed more and more obligations from other countries that have yet to be redeemed.

It is, in other words, a mechanism that enforces fair exchange – countries will roughly give as much as they get from others and they will have to redeem obligations before incurring more. The Euro took this mechanism, that had both been a nuisance and an impediment to the European economy, away without replacing it.

Suddenly, the value of the currency of an exporting country would not rise and that of an importing country not fall – allowing two countries to develop a much greater imbalance before other negative feedback mechanisms started to kick in – ones that are much less desirable than unfavorable exchange rates. Namely: people running out of money, corporations and governments defaulting on credits, exporting companies losing customers and reducing payrolls. It’s pretty much a race to the bottom that the (formerly) importing countries will have to win by somehow ending up with wages or general productivity being ‘more competitive” (as people like to call it) than that of the formerly exporting countries.

Both countries, you should think, have an incentive to take action. The exporting country because a part of its industry is sitting idle for lack of customers, the importing country because it can’t import goods vital to running its economy. Of course, the actions to be taken are also opposite. The exporting country should start to create domestic business opportunities by increasing wage levels (allowing its own population to take up the slack from the exporting industries) and importing more goods. The importing country should find ways to cut its wage levels and increase productivity to export more goods.

What is going on today, however, is that the exporting countries want to keep their advantage in exports. Which is understandable in a way, since specialized export industries usually don’t produce products that can be sold on domestic markets in appropriate quantities. This is alleviated somewhat by the fact that they typically lack competition in the countries they are exporting to (as there was no need to produce those things there), but aggravated by the fact that such companies usually also have large political clout.

The result is that, currently, the exporting countries in the European Union tend to hold their wage levels constant, expecting importing countries to cut theirs. But there are a number of factors, that make this an extremely damaging proposition for the importing countries in the short run (and thus a problem for the exporting countries in the longer run). At least in an environment of very low inflation, which the EU has imposed on itself (and especially Germany is committed to).

One of the greatest problems is that people are psychologically much more reluctant to reduce prices than they are to increase them. Which means that in an environment of reduced wages, prices will remain above market equilibrium for a longer time than should be expected. The more elegant and time-tested solution is to have moderate inflation on the order of 5%. Prices increase at a moderate pace while wages stay the same. This may seem like no different than the former case, but prices will typically reach equilibrium faster – because prices only have to rise to the equilibrium and don’t need to fall.

Unfortunately, German politicians have no such concept as moderate inflation. The general perception of inflation is that it is a disastrous slippery slope that will automatically lead to the kind of hyperinflation Germany saw in the early 1920ies (or Zimbabwe much more recently). You can find the minutia of the contentious issue how the hyperinflation came about accurately described and its dire consequences predicted in Keynes book “The Economic Consequences of the Peace” written 1919. (All the way to a quote of a French General describing the unfair conditions of the peace treaty imposed on Germany after WWI in 1919 as not being a peace treaty, but “a cease fire for 20 years” – you may remember that WWII started in 1939.)

The question is, whether the Germans will come to their senses and allow some inflation in the European Union to occur and real wages to rise (which, they fear, can only lead to increased unemployment) in order to speed up the process of allowing countries with trade balance deficits to balance those.

This latter part requires, for the time being, that they be allowed to export into the current exporting countries – because everything outside of the OECD countries (which are currently in an economic crisis) can be quite accurately described as an economic wasteland. And even though this is going to change in a matter of a few decades – the EU doesn’t have decades, but years at most. So its member countries are stuck with helping each other getting out of the mess.

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3 thoughts on “Making things worse to make them better?

  1. tp1024
    Great Post! What I understand is that your view is the ECB should not be only worried about and target inflation, but also do something about the current unemployment within the Euro zone. Am I correct?
    However, I am not sure I agree that the negative feedback mechanism that the Euro fixed exchange rate system members have given up are the exchange rates themselves. The idea of the “impossible trinity” (Mudell-Flemming model) states that once you have fixed exchange rates, you give up independent monetary policy. There is centralized monetary policy (the ECB), which however would not be able satisfy both the needs of the booming export-based economies (like Germany) and the high-unemployment deficit-running countries (PIGS) in the same time, while its main and only concern is inflation.
    I am not trying to undermine your opinion, but I read your posts quite often and felt necessary to bring this clarification to your attention.

    It is another question whether the increased buffer of credits to the stability fund would calm the investors and speculators in the current chaos. I feel that at least some subtle move towards fiscal union is necessary here to shape expectations in the long run.

    Thanks for the nice blog, enjoy your day!

    yanchev

    • All constructive criticism is greatly appreciated, even if it undermines my opinion – I’m far from infallible after all. And yes, I agree with your point.

      As to the buffer, I have the feeling that it is not enough. The dynamics have to be changed and there is, perhaps, a that subtle move on the way in the European stability pact, towards enforcing the balance of payments in both ways – ordering countries to prevent excessive deficits as well as surpluses. It’s anybodies guess whether this will work or governments will comply.

      In the medium run (starting in perhaps 10-20 years), this problem will probably be mitigated by the growth of the developing world. In the long run however (during the late second half of the 21st century) we’ll probably face the exact same problem all over again – but this time on a truly global scale.

  2. Nice post. Keep up with good work.

    Actually there is an economically possible but politically impossible solution: Endless transfer of money from surplus countries to deficit countries. The US did similar thing in the federal level. As long as Greece chooses to stay inside Euro area, Germany must hand out cash, or Greece can leave the Euro. It is the point raised by Martin Wolf in FT.

    Even Greece is 100% default, I still do not see any hope of winning against deflation in a decade as long as it stays inside without continuous supply of cash from the EU of IMF to run a deficit budget. It took Hong Kong, which has a currency peg with the US dollars, nearly 7 years to go back from deflation to inflation, even the internal price adjustment system in Hong Kong was much more flexible than the one in Greece today.

    Do you think eventually there will be an agreement in the EU to let Greece go? Or will EU simply sacrifice Greece (no cash supply) to protect the Euro?

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