A Keynesian Wolf misleads about the Euro

I thought I had finally settled the debate about the euro crisis with my last post (ha ha) and then along comes this piece by Martin Wolf in the Financial Times (December 1, 2010). http://www.ft.com/cms/s/0/259c645e-fcbb-11df-bfdd-00144feab49a.html#axzz16y45YdFO

My previous post argued that the euro might depreciate more but it would surely not implode. Wolf is a great writer and I usually like to disagree with him because he is a not-so-closeted Keynesian and I am neither closeted nor Keynesian. This article irks me more than his usual writing because it epitomizes really good analysis based on a really wrong premise. His article illustrates what is wrong with much of what is written these days and helps me try to live up to my goal for this blog – to spout off.

The title of Wolf’s article is “Why the Irish crisis is a huge test for the eurozone” and he concludes that by joining the eurozone, a country consigns itself to credit crises. His words of advice to countries that give up their own currencies to be part of something like a eurozone, “… be careful what you wish for: credit crises would replace currency crises – and these are likely to be even worse.” 

He has an elegant explanation for all that. He begins with the premise that it is inevitable that countries with “divergencies in relative costs” would have international trade imbalances. That is, without flexible exchange rates a country with a bump in relative costs would soon find itself less competitive and would soon have a structural trade deficit. A depreciated currency could have come to the rescue and offset the cost change and restore its competitiveness. Sans an exchange rate depreciation in countries like Greece and Ireland, each would be stuck with a trade deficit implying a need to borrow from abroad to finance their trade deficits. This means a larger foreign debt and should a country have trouble meeting the debt at some point – wham bam thank-you mam – a credit crisis would occur. Then –oh my goodness – national prices would fall worsening the credit crisis – and that makes it much worse than a currency crisis might have been (if the country had its own exchange rate).

Since you know I love to use analogies – Wolf’s point is like saying that you can solve the morning after problem for the drunk by taking aspirin instead of Ibuprofen. We can spend until hell freezes over debating which drug is more effective for a hangover (I prefer a nice strong Bloody Mary myself). We might even find that one of them is better for hangovers. But the only real solution for a hangover is to not drink so much and to not dance to 1970s disco music like John Travolta wrapped in colorful beads with a lampshade on your head. My point is that Wolf is writing about “effect and effect” rather than “cause and effect”. His defect is in his focus on effects without causes. He shifts our attention away from the real problems to a choice of medications.

When this very intelligent man analyzes the issue of the euro, why does he not once – not one single time – does he not go back to the idea he starts with – the cause of it all – the change in relative prices? Why – because he is a closet Keynesian. They usually ignore the original problem. They see any problem as an excuse or some clever ploy to get the government involved by spending more. After all – there are so many things the government could be doing if they just spent more!

If a rise in relative costs and prices causes a country to lose competitiveness – I ask – then why cannot this country work directly on reducing its relative costs and prices? Would it be impolite to even ask this question?  If a country is made more vulnerable because its households go on a spending spree and forget to save; if a country’s government goes on an economic development spending binge that reduces national saving available to corporations; if a country’s companies get lazy and don’t invest in the right technologies or products – in all these cases its competitiveness will be reduced. But notice that in all these examples of cost disadvantage there is a direct cause that could be directly addressed if politicians had the cough-cough sincere interest or kahunas to investigate. But that is too hard for them to do. All that discussion of details might not fit on the teleprompter. Rather than take a real educational and leadership role about a complicated problem – it is much easier to advocate a policy to increase government or household spending.

In this particular case Wolf is blaming the problem on a single currency. If the poor babies only had their currencies back then the boo boo would go away. NO IT WOULDN’T AND READING ANOTHER CHAPTER OF DR. SUESS WON’T HELP IT GO AWAY. If those weakened countries had their currencies back their exchange values would plummet towards zero and contribute to a generally hysterical situation. The rapidly declining currencies would lead to large and rapid outflows of portfolio and real capital. Declining currency values would make it more impossible to pay off their debts.  Maybe you have read about past currencies crises? They do happen – and it seems to me they happen a lot more often than credit crises.

But I don’t want to get sucked into Wolf’s trap. It isn’t about the currencies. It is all about the CAUSES of competitiveness changes. If countries lose competitiveness for fundamental reasons then their leaders ought to decide what those reasons are and address them. Debating whether European nations would be better off with or without the euro misses the target, misleads, and misdirects our energy. Policymakers should not be discussing a euro break-up. They should be discussing the regulatory, housing, financial, spending, and saving practices that led to their current predicaments. If leaders don’t get this right then they ought to be replaced. I hope our own policymakers in the USA get this message too or 2012 could be really interesting.