Thursday, July 5, 2012

The Devaluation Chorus Sings again

The chorus to devalue (and then inflate) the euro as the key to solving Europe's ills is singing again.

Ken Griffin and my colleague Anil Kashyap have a big OpEd on the Euro in the New York Times. They want Germany to leave the Euro, followed by quick euro depreciation relative to the Mark and Dollar.

Martin Feldstein, writing in the Wall Street Journal, echoes this faith in devaluation
The only way to prevent the dissolution of the euro zone might be a sharp decline in the value of the euro relative to the dollar and to other currencies
As you might have guessed, I think it's a terrible idea.

The biggest reason is the vanity that you can do it just once. "Devalue and inflate the currency" is hardly a new idea. Portugal, Italy, Spain, and Greece lived on a cycle of continual devaluation and inflation until they joined the Euro.  Going on the Euro was a hard won transformation to precommit to get off this cycle.

Imagine that  your brother in law had been drinking too much for 40 years, perpetually on and off the sauce, never really able to give it up. He went  through a painful 12 step program and rehab, and finally quits the sauce for 10 years. He threw away all the liquor in the house. Then he loses his job. Is "one more big night out to soothe the pain, and then I'll really really never do it again"  at all a credible plan?  That's exactly what my normally sensible colleagues are advocating.

Kashyap and Griffin make some sharp predictions.
Reintroducing the mark [and devaluing the Euro] would not solve the debt burdens of southern European countries, but it would give them needed breathing room to restructure their economies, reform labor markets, collect more taxes and reassure investors
When in human affairs has "breathing room" ever led to expeditious "reform," especially when such reform meant stepping on the toes of very powerful interests?

Witness: The Germans gave Greece three years of "breathing room" already, repeatedly bailing out and rolling over its debts. And look at the great progress Greece has made on "structural reform." Not. Italy just backed off its effort to repeal its stultifying labor law. Heck, look at the "breathing room" of the forty previous years of perpetual devaluation when all the "structural rigidities" were enacted.

With the "breathing room" of currency depreciation and inflation, won't the unions and other powers arrayed against reform just reassert themselves?

A crisis is indeed a terrible thing to waste. Nobody ever reforms in good times. Heck, look at how well the US is doing -- we have the same entitlement disaster heading our way, we just have a few more years of "breathing room." And we're  really putting the pedal to the metal on tax and entitlement reform, aren't we?  We advocate "structural reform" in Greece, yet where is the deregulation effort here?

Kashyap and Griffin make some more interesting cause-and-effect predictions
 a weaker euro would give a boost in competitiveness to all members of the monetary union, including France and the Netherlands,
A weaker euro would also encourage greater foreign investment. For example, Spain’s distressed real estate market would become far more attractive.
Let's see if they come true. The first: Is there any exchange rate at which France ships Citroens to Stuttgart? Are Europe's "compeititiveness" problems really all about some mysterious exchange rate misalignment and not pervasive sand in the gears? Would Detroit roar back if it could only introduce a Detroit dollar and finagle its monetary policy?

The second: When Germany goes its own way, and Spain has embarked on a let's-all-inflate-our-way-out-of-this-mess along with its neighbors, will this really be the signal of great times to invest?

My prediction -- investment runs to Germany anyway. Even faster, Why? Ken and Anil recognize
Although repeated currency devaluations are not the path to prosperity,
Right. Just this once. But how do you sin just once? How do you devalue once, then convince the rest of the world that the rump euro is now a hard-money area, determined for structural reform, and not back to its  pre-euro history of  repeated and continual devaluations?

Investmet and growth are about expectations, institutions, rules, commitments, not one-time devaluations with empty promises not to do it again. That's what the euro was about. You can't throw out the euro and have anyone believe a devaluation is just this once, and not back to the perpetual stagnation of the 70s and 80s.

Kashyap and Griffin go on twice to argue that devaluation will lead to greater "dignity" for Southern workers. We know a little about how printing money devaules a currency and inflates. We know a tiny bit about whether that effort can give a one time boost to exports, and sets up poor expectations about another bender. This is the first time I've heard serious economists adduce that we know a cause and effect relationship from monetary policy to "dignity," and that depreciating the currency promotes more of the latter.

Doesn't devaluation automatically mean inflation, at least eventually? Kashyap and Griffin are silent. Feldstein goes on to 
Although a decline of the euro would mean higher import prices in euro-zone countries, it need not mean higher inflation or even a higher overall price level. The ECB could in principle continue to aim at a 2% inflation rate with lower prices of domestic goods and services offsetting the higher prices of imports from outside the euro zone. At worst, the ECB could allow a one-time pass-through of the higher import costs but prevent any further increases in inflation rates.
I thought the one thing we all agreed on is that money is neutral in the long run.  Certainly the repeated devaluations of the 70s and 80s were almost perfectly matched with extra inflation. Why would this time be different? We might as well hope that the Physicists at CERN will repeal conservation of energy with the new Higgs Boson.

OK, one point of agreement: 
What is essential is the preservation of the European Union’s greatest accomplishment: the free movement of labor, goods and services.
Yes. Keep the euro, and all its comitments against devaluation and inflation. [Update to clarify in response to comments: the most important commitments are that the South, as part of the euro, does not resort once again to devaluation and then inflation relative to the North. The second most important commitement is that the ECB was once set up as a central bank with a pure inflation target. This is a precommitment against deliberate devaluation and inflation relative to the rest of the world.]   Recognize that a currency union, without fiscal union, works only if you countenance sovereign default and default of banks who invest in sovereign debt.

In the end, the devaulation idea is this: In the warmth of summer, the crickets of Europe voted in laws that you can't fire people, can't lower wages, and they will only work 35 hours, with long paid vacations. Now those structures are no longer tenable. In winter, der ants don't want to buy stuff that crickets are producing with those huge labor costs. What to do? Let's devalue the hour! Pass a law that the hour is 75 minutes.

Really. The euro is the unit of value, as the hour is the unit of time and the meter is the unit of value. You could engineer a one-time boost by fiddling with the hour, the meter, the kilo and the euro. Until people catch on and rewrite contracts. And then they are aware you will do it again, since you throw out all the precommitments not to devaule built in to the current system of units.

Anyone for a drink?