Sunday, June 24, 2012

A Currency Union by any Other Name

...still suffers from the same adjustment problems

Recently there's been a spurt of discussion on the part of Simon Johnson and Paul Krugman on Optimum Currency Areas and productivity growth, and Nick Rowe is still a bit confused. Why should productivity growth differentials matter? Nick lists out a variety of thought experiments and finds no satisfactory answer. As he says, "There must be something else. Some other hidden (to me) assumption they are making. What is it?" With some thought, I believe the "something hidden" is something that market monetarists (including Nick Rowe) have written extensively about: nominal GDP.

Why nominal GDP? Because it's the "something" that can link "productivity differentials, current account deficits, and exchange rate regimes".

First, let's talk about the relationship between higher productivity growth and higher nominal GDP. At least within the United States, productivity growth has a strong correlation with nominal GDP growth. A 1 percentage point in YoY multifactor productivity predicts about a 0.66 percentage point increase in nominal GDP growth. This observation is likely compounded by the Balassa-Samuelson effect, which would imply higher inflation in the regions with higher productivity growth. In terms of the AS/AD model, if the AD curve has a price elasticity of greater than 1, positive AS shocks boost nominal GDP. Fiscal policy is not an answer, as politicians are rarely going to pull back during a boom. And if monetary policy intervenes to cool down the growth, this puts the brakes on nominal GDP growth for the rest of Europe, thus compounding the asymmetric shock problem. Either way, a permanent productivity differential can lead to permanent nominal GDP growth differentials, even if the central bank targets mean nominal GDP growth.

Nominal GDP also can help explain exchange rate regimes and current account deficits. As Scott often reminds us, "You decide whether a currency is under or overvalued by looking at whether aggregate demand is at an appropriate level." And what measures aggregate demand? Nominal GDP. Consequently, if we shift discussion to nominal GDP growth rate differentials, we can talk more intelligently about exchange rate issues. The rate of nominal depreciation of one country's currency vis-a-vis another should equal the difference between the first country's NGDP growth rate and the second country's NGDP growth rate. Thus, if one country has lower NGDP growth than the second, the currency of the first should also depreciate. However, this cannot be the case in the present environment. As Evan Soltas has noted, the Euro has recreated the world of the gold standard. The Euro prevents currency depreciation. Instead of depreciating currencies, we have falling nominal GDP. Countries like Spain and Greece are forced to grind through internal devaluations, imposing massive costs on their citizens.

By refocusing on nominal GDP, a lot of the questions Nick and others are asking become much clearer. Why does a permanent differential in productivity growth matter? Because it implies a permanent differential in NGDP growth, which causes pressures for an exchange rate to change. But because the euro pegs the exchange rates all together, the pressure manifests itself as internal devaluation, which carries very severe negative consequences on count of sticky wages/prices and safe asset shortages. Why does a permanent differential in productivity levels not matter as much? Because if productivity growth rates are the same, there is no differential in nominal GDP. Therefore there's no pressure for currency adjustment. Productivity growth may not force trade deficits, but it can still cause nominal GDP differentials.

Why do fiscal transfers matter? Because in a gold standard world, fiscal transfers between regions (countries) can affect regional NGDP growth. Fiscal transfers are a crude way of "taking" aggregate demand in one region and putting it in another. Fiscal transfers do what domestic central banks can not; stabilize country level NGDP growth. This is politically justifiable if shocks are temporary and distributed among the countries. But when one country has permanently higher real growth and nominal GDP growth, that country will be permanently paying transfers to the others. This is the political problem to which Krugman and Johnosn refer. These permanent NGDP differentials necessitate a one-sided transfer union, which we do not have. As a result, we see the painful process of internal devaluation in periphery countries.

A narrative in terms of nominal GDP also subsumes discussions about unit labor costs. By the New Keynesian business cycle model, lower nominal GDP growth rates arise because of higher real wages or labor costs. So the lower nominal GDP growth in the periphery raises the real wage, rendering the periphery uncompetitive. This is then a more concrete reason why internal devaluation is the only option in a world without transfers or national currencies. Unit labor (and capital) costs need to adjust.

We can now try to answer Nick's thought experiment on a country filled with both low-productivity "Greeks" and high-productivity "Germans", If you separated them, you would observe that the Greeks would have lower growth in nominal production relative to the Germans. This would manifest itself in a growing income gap over time. But what keeps countries together? First, there's "labor mobility". There's no reason  why the Greeks have to stay Greek; maybe they can intermarry and become high-productivity Germans. Second, there's "transfer payments", along the lines of social welfare. High productivity Germans are taxed to pay transfers to the low productivity Greeks. And as in the currency union, the Germans will likely complain about having to subsidize the laziness of the Greeks. If the Greeks can't fight for these policies in the sober halls of Parliament, they can threaten an "exit".This is the basic story behind nationalist secession.


  1. Just wanted to note that I thought this was an excellent post and pulls the whole narrative together with impressive lucidity.

  2. This is an interesting article, however I think that you mistake two concepts: capital flows and fiscal policy. So obviously differences in productivity growth are the reason fir differences in rates of NGDP growth that needs to be balanced through transfers. This is the reason why European Union was founded - to integrate Euro Area economies via the process of convergences. So capital should flow into countries with high productivity growth until they are saturated and they can no longer grow.

    And until recently this is what happened - capital went from low growing Germany to faster growing Greece:

    So in short - to repeate Nick's argument, fiscal transfers have nothing to do with permanent differences in productivity growth. They have something to do with reaction to asymetric shocks. It is all there is and productivity growth or level has nothing to do with this.

    1. I think we're actually talking about very similar things here. In the model I had in my mind, I imagined two regions at a steady state, with two given levels of productivity growth and given NGDP paths that are stable. Then, one region has a boost to productivity (the asymmetric shock). My argument was that monetary policy would be fundamentally be unable to cope with this new productivity differential. As you wisely pointed out, Greece actually had rather fast growth as a result of convergence, which makes me question how much my model actually applies to the Eurozone. But I do think that, in a currency union, changes in relative NGDP growth rates, whether by asymmetric productivity or demand shocks, can have a destabilizing effect that even optimal NGDP targeting can't solve. Only transfer payments represent a reasonable solution.