The Economic Consequences of Mr. Hugh

Edward Hugh and Paul Krugman and even Dani Rodrik are in agreement, as Ed meets the elite; although we don’t know how much Spain’s external account needs to swing towards surplus in order to get the economy growing, we know it needs to be going that way, and therefore it’s a choice between “internal devaluation” – i.e. wage cuts for everybody – of the order of 20% or else, departure from the eurozone.

I cannot support this contention.

Let’s have some axioms – things that have to be true, and which are generally accounting identities.

Number one: Exports to Mars remain a losing business. Therefore, the world economy cannot but have a balanced trade account. One man’s current account deficit is another’s surplus. This is true by definition. It is also true, but less so, of the eurozone – of course, the eurozone has a net imbalance with the world, but it is true that if a eurozone country has a current account surplus with the rest of the eurozone, a sufficient current account deficit must exist elsewhere in the eurozone to match it.

Number two: The money has to go somewhere. One man’s trade deficit is also his capital account surplus. If Spaniards want to buy more German goods than they sell Spanish goods to Germany, absent a massive extra-eurozone trade surplus, somebody must lend them the money. Similarly, if Germans want to sell more goods to the eurozone than they buy, they must do something with the surplus of euros that results.

Number three: The money still has to go somewhere. Stashing your export sector earnings in ultra-safe eurozone government bonds, like a stereotype German, is an economically identical activity to borrowing German money to spend on stereotypical Mediterranean corruption – for example having real-estate banks managed by the Church, although how DEPFA or IKB Deutsche Industriebank were any better is not obvious. Every Sparbuch is the flipside of a tax break for a mobbed-up developer setting fire to a Greek hillside. Obviously, it would be silly to hold individual German savers responsible – but the Great Banks of Frankfurt, the institutions through which the German trade surplus is recycled?

And it is no sillier than holding individual Greeks or Spaniards responsible, which is what Ed Hugh, Paul Krugman, the European Commission, the International Monetary Fund, the CEO of Banc Sabadell, etc, etc, actually propose to do.

As Ed rightly says, the real issue is “where will the growth come from?” With recovery, everything else will be surprisingly easy; his example of Finland is a case in point. Another would be the UK budget consolidation of the mid-90s, or for that matter, of the post-war era. Without it, there is arguably no point in worrying – in that case, in the fairly short term we are all dead, and default, euro failure, and an unquantifiable degree of misery are inevitable.

Unfortunately, although his analysis is correct, Ed’s prescription is very unlikely to lead to growth. What export market for Spanish goods is there that will outweigh a 20% hit to aggregate demand? Who will buy? What will they buy, that is currently overpriced by 20% divided by the percentage of marginal cost accounted for by labour? Labour is asked to fork out, but where are the guarantees that this patriotic sacrifice will achieve anything? One might well conclude that the actual content of this proposal is in the bit that is clear and well specified – the 20%.

To be more rigorous about this intellectually, think of it as follows; Spaniards suffer the 20% wage cut, and all else remains equal. We have no reason to think all else does not remain equal. No doubt this reduces the Spanish trade deficit by some number. This implies that the eurozone exporters – Exportland – see their trade diminish by the same value. The Spanish trade account is balanced, but we are all, on balance, poorer. And it is possible that the eurozone exporters will redouble their efforts to cut prices and hold onto market share – they have no reason not to, and in fact it is their core national economic strategy to export at all costs.

The only way this approach might not actually be deflationary at the eurozone level would be if it caused prices to fall sufficiently that they undercut Chinese prices; this is unlikely, and anyway would represent the export of European deflation to the poor.

So, to sum up so far, it’s just as possible to have a beggar-your-neighbour “internal devaluation” as it is to have a beggar-your-neighbour devaluation. The difference is that the “internal devaluation” option is also a beggar-yourself-and-indeed-everyone-else policy, and one that will create more actual beggars. And, in fact, beggar-your-neighbour internal devaluation accurately characterises the policy of Exportland’s economic leaders.

There is, of course, an alternative – it is the sunshine policy. Pay Germans more money – perhaps 20% more – and they can spend it, among other things, on one of Spain or Greece’s biggest exports, which happens to be sunshine. The dangerous imbalances would be reduced; demand would be created for the products of whatever new industries Ed’s new circle can think of. After all:

Put another way, thanks to the foreign funds which flowed in to finance the housing boom Spain became a major imports powerhouse, with the consequence that both the trade and the current account deficits deteriorated sharply, while a significant part of Spanish industry simply died. One of the major tasks of any recovery programme is to bring this industry back to life. In this sense what Spain’s economy needs is not rejuvenation but resurrection.

Better yet, there is a simple policy lever available to make this happen. German wages are essentially set by the annual bargaining round between IG-Metall and the Industriellenvereinigung, which acts as a price leader for the rest of the economy.

Surely, though, we need to cut, cut, and cut again to stay competitive with China? Well, this statement would be interesting if it wasn’t wildly counterfactual. At the current relative wage rates, it’s blindingly obvious that eurozone exporters are not succeeding in beating Chinese producers on price. They are doing so on their products. And, soon enough, the question will be absurd because the Chinese will themselves be looking over their shoulders – apparently, GDP per capita in Shanghai is comparable to that in Lisbon. The only future strategy is to have good products; after the bubble world of the 90s and 2000s, we’re back to the late 80s view that the future belonged to whoever had the best products and supply chains.

Some other ideas: perhaps the ECB should make it a policy objective to run over the shorts? There are surely some hints here.

Fitch, meanwhile, thinks that Spain’s creditworthiness is adversely affected by its plans for internal devaluation, but I am on record as saying that anyone whose investment decisions were guided by credit rating agencies would have lost their shirts three times over in the 2000s – once with Enron, once with the alt-telco bonds, and again with mortgage-backed securities. (I’m also the proud owner of the domain name standardispoor.com, if anyone has ideas about what to do with it.) However, our hypothetical investor would have avoided these catastrophes, because they would have had no money to lose in them, having already lost it all in Russian GKOs in 1998, Thai or South Korean corporates the year before, or Mexican government bonds in 1994.

I commend the proposal of just sitting back and being rich, as Harold MacMillan once said, to my readers, and indeed to the CEO of Banc Sabadell, who no doubt has greater expertise in this matter than myself.

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