internal/external adjustment and the EU

Yesterday I wrote about the tools a country has available if it faces a combination of sluggish GDP growth, excessive borrowing/weak banks and non-competitive industry (processes are outmoded and costs are too high).  Greece is the poster child among EU countries   …but Italy is the major EU economy that this description calls to mind.  France is riding a compartment or two away.

What can an EU country whose economy is structurally out of balance do?

Well, external adjustment–meaning currency depreciation–is out, since it’s part of the euro.

That leaves internal adjustment, which can take three forms:

–tariff or other regulatory barriers.  Yes, the EU can, and does, erect barriers to protect local industries against imports.  But most EU countries trade more with each other than the outside world.  So, say, Italy can’t bar imports from super-competitive Germany or lower-cost eastern Europe.

–slowing the borrowing, which is intended to maintain the current (unsustainable) lifestyle, by raising interest rates in a way that will cause a recession.  This is the German “austerity” solution, which few, if any, other countries (nor any politicians concerned about being reelected) will willingly adopt.  The EU experience after the 2008-09 recession shows austerity doesn’t work particularly well, either.

–that leaves structural reform.

This gets me to why I started writing about this.  Paul Krugman recently reviewed a book I haven’t read, The End of Alchemy, by  the former head of the Bank of England, Mervyn King. In the review, found in the New York Review of Books, Krugman says of King:

“He argues that Europe’s imbalances in production costs and hence in trade are too large to be resolved without either abandoning the euro or moving to full political union, and that given the lack of will for the latter, the former it must eventually be.”

What grabbed me is the “imbalances in production costs” part.   In other words, despite almost two decades of having the euro, plus all the time before its debut when companies knew it was coming, inefficient EU countries have done very little to bring their production costs down.  In addition, the reason Mr. King gives for this is “the lack of will.”  In other words, the forces of the status quo, aimed at preserving local fiefdoms (both political and industrial), are so strong that no progress can–or will–be made.

Sounds a lot like Japan, with a twenty-year lag.

Tomorrow:  investment consequences, if the King/Krugman analysis is correct.

 

 

internal and external economic adjustment

This is ultimately about the euro and the EU.  Today’s post is about creating a framework for thinking about this issue.

It’s a condensed version of a longer post I wrote six years ago on Balance of Payments (actually, a series, for anyone who’s interested).   Although a big simplification of what is actually going on in the world, it highlights what I believe is a central structural issue facing the EU and Japan today   …and potentially the US, at some point.

 

imports and exports

The residents of any given country typically don’t consume only items made in that country.  They buy imported goods as well.  In fact, the marginal propensity to consume imports is normally higher than the marginal propensity to consume, meaning that as spending increases imports rise at a faster rate.

paying for imports

The country as a whole gets the money to pay for imports in one of a number of ways:  it can make things to sell to foreigners, it can use accumulated savings, it can sell assets to foreigners or it can borrow.

imbalances

In an ideal world, every country would make and sell exactly enough goods and services through export to pay for the imports it purchases.  That’s seldom the case, however.

chronic deficit

Consider a country that, year after year, buys more from foreigners than it can pay for with the proceeds from what it sells.  To continue consuming foreign goods at the same rate, such a country has to either sell assets, like land or companies, or borrow from foreigners.  At some point, however, it will reach the limits either of what it has that others want to buy or the amount foreigners will lend.

This situation sets the stage for a potential foreign currency/trade/economic growth crisis.

internal/external adjustment

Here’s where we get to internal/external adjustment.

There are two ways of dealing with this issue:

internal

–the government can slow down overall consumption (essentially, create a recession) by raising interest rates/taxes by enough to decrease consumption of foreign goods and services

–domestic industries can voluntarily restructure themselves, with/without government help, to improve quality and lower prices so they make more things foreigners will want (unlikely to happen on a large scale)

–the government can erect tariff or regulatory barriers to imports, to try to redirect consumption to domestic goods (almost always a bad idea:  look at the US auto industry since the mid-Seventies)

None of these actions are likely to win unanimous applause from voters.  And if legislative action produces negative results, it will be completely clear who is to blame.  So politicians everywhere, and particularly in badly-run countries, tend to not to want to choose any one of them.  Instead, they most often opt for the external adjustment route.

external

–This means to encourage or embrace a decline in the local currency versus that of trading partners.  That simultaneously makes foreign goods more expensive for locals and local goods cheaper for foreigners.  Devaluation will encourage exports and inhibit imports, achieving the same end as rising interest rates, but without the sticky legislative fingerprints attached.  It’s those horrible foreign exchange markets instead.

 

More tomorrow.