Friday, May 18, 2012

A Greecy Mess

I think it's time for a few words about Greece---and Spain (we could include Italy and Ireland, but let's stick with the Greece/Spain question).

Over the next few months Greece and the European Union will do their best to find a way out of the damnable mess they are in, and to hold Europe and the Euro together.  The austerian intransigence of Germany and the European Central Bank makes success much less likely, but they will try, very hard, because there is already a historical sense of union there, and a sense of pride in belonging to a larger vision.  They will try, and I hope they succeed.   No, not hope---hope is becoming difficult.  But I want them to succeed. 

But I have to admit that I want them to succeed for historic reasons, and for political reasons, not for economic reasons.  If they fail there will be, at least briefly, an opening for some political extremes and for some nationalist extremes that we never want to see again.  But in terms of economics---well, I find that I need a disclaimer before I go on, and it's this: I will defer to Krugman on the facts and deeper theory of international economic issues; he follows them closely, and I don't, really.  I have to work every day on very different things, which means that I don't have time to pursue the details.

So I admit that my view of the events in Europe is a little fuzzy.  But from here it looks like this: because Europe has unified under a common currency, but has not unified in a common economy in any other real sense---no common fiscal union, no common language that would make economic migration of workers easy, and so on---there is no easy mechanism to transmit Germany's relative prosperity to Greece, or to Spain, both of which are now in full depressions.  Here is what should be happening: prices in Germany and France should rise relative to those in Greece and Spain.  That would enable the latter countries to increase their exports to the former; it would tempt German companies to invest in Spain or Greece to take advantage of relatively cheap labor and materials and land.  But Germany will not permit price inflation, which means that the only way to change relative prices is for prices to actively decline in Spain and Greece.  And deflation, particularly wage deflation, is a long, hard, painful process.

Why is it hard?  Why are wages sticky downward?   Peter Kennedy in his book  "Macroeconomic Essentials" lists four reasons for sticky downward wages:

1. Contracts, explicit or implicit;
2. Relative wages (workers are reluctant to lose status relative to others)
3. Temporary recession (both workers and employers may believe the recession is temporary, so it's not worth the internal cost of adjusting salary rates)
4. Efficiency wages: it may be efficient to retain the best workers at higher than market-clearing rates while the recession continues, to reduce the need to train new labor when the recession is over.

When he talks about contracts, I think he is talking only about wage contracts between workers and employers.  But I'll add another reason: the households to which those workers belong also have contracts they have agreed to, and those household contracts constrain them financially.  Households have mortgages to pay, or leases they have signed, or credit card bills or student loan bills or car payments, all at fixed monthly amounts, and unfortunately the average worker's household doesn't have a lot of spare income at the end of the month.  If the worker accepts a cut in pay that means his or her household is at risk of defaulting on one or more of its contracts or possibly all of them.  And it's not just the worker's own pleasure, or own consumption, that is at stake: it's the entire structure of their life and the lives of others around them.  For households it may be much more than an inconvenience, it may be a full-on calamity

There are large costs outside the households in reducing unemployment by decreasing wages: workers will have to renegotiate their mortgages or leases, or they will have to move, and either of these options is costly---costly not only for the worker and his household,  but for the banks that hold the mortgages or the landlords who hold the leases, who may end with a foreclosed house or an empty apartment that, because of social turbulence, collapsing wages and mass unemployment, they can't sell or rent.  

In other words, if wages decline by very much, a huge part of the web of contracts---household contracts, wage contracts, banking contracts, credit contracts----may become fractured.

Now, in the end, it will all resolve itself: bankruptcies will reduce debt, empty houses and apartments will force housing prices down, farmers will accept lower prices for food and will demand lower prices for their inputs, used cars will be plentiful on the market and will command small fractions of their original prices, and so on and so forth.  Banks will fail and others will take their place.  In the long run, when the storm has passed, the ocean is flat again.  But that long process takes time, time, time, and will create decades of pain, lost production, lost opportunities, and lost or blighted lives as the whole population of people, businesses, banks, governments, and other economic creatures, adjusts to a new price structure, and as the price structure adjusts to the new wage levels.  

For independent countries with their own currencies, the solution is much simpler: keep local wages and prices intact, but reduce the exchange value of their currencies.    Internal prices are maintained for a time, and internal contracted payments are maintained, but the wages in that country have been reduced when paid in other countries' currencies.  Of course, this means that over time prices will need to change, because imports are now more costly, but the nation can adjust to that more gradually and with much less trauma.

For example, if a new Drachma were created, initially convertible one-to-one with Euros, and all internal contracts, including both employment contracts, debts, leases, everything, were simply redrawn in Drachmas, initially nothing would have changed.  But if that new Drachma were allowed to float, and it declined against the Euro so that in the end a Euro could buy two Drachmas, then the wage of Greek workers which has not changed in Drachmas, and has not changed relative to his or her contractual obligations, is now half of its former price in Euros.  And not only wages, but everything in Greece would now look cheaper in Euros.  Vacations in Greece would be a bargain.  Local products would be a bargain, and exports would rise.  There would be a period of real discomfort in Greece as they adjusted to the new costs of imports.  Loans and other financial arrangements would be difficult while the Drachma found its level.  But I doubt that would last more than a year.  And after that, Greece would be much, much better off than it is now.

I know that everyone is afraid of breaking up the Euro, and I am not advising it.  As I said at the start of this post, I hope Europe can find a way to stay unified, and to maintain the Euro.  But if I were advising Greece or Spain on what they could do to help themselves, leaving the Euro and establishing their own currency would be near the top of the list of possible actions.  The fact that they have not done it yet is a sign of their dedication to the vision of a unified Europe---or a sign of economic delusion.

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