Winner of the New Statesman SPERI Prize in Political Economy 2016

Thursday 10 December 2015

Competitiveness: some basic macroeconomics of monetary unions

From comments on an earlier post, it is clear how many people do not understand how a monetary union works. Thinking about it, I also realise that while the macroeconomics involved is entirely straightforward and uncontentious, it may only be obvious to someone who is used to working with models. As I do not want to restrict my readership to those with such knowledge, I thought a brief primer might be useful.

We need to start with the idea that for a country with a flexible exchange rate, you will not increase your international competitiveness by cutting domestic wages and prices. The reason is that the exchange rate moves in a way that offsets this change. This is what economists might call a basic neutrality proposition, and there is plenty of evidence to support it. The Eurozone as a whole is like a flexible exchange rate economy. So if wages and prices fall by, say, 3%, then the Euro will appreciate by 3%.

So what happens if just one country within the Eurozone, like Germany, cuts wages and prices by 3%. If Germany makes up a third of the monetary union, then overall EZ prices and wages will fall by 1%. Given the logic in the previous paragraph, the Euro will appreciate by 1%. That means that Germany gains a competitive advantage with respect to all its union neighbours of 3%, plus an advantage of 2% against the rest of the world. Its neighbours will lose competitiveness both within the union and to a lesser extent against the rest of the world.

That may seem complicated, but to a first approximation it is in fact very simple. The Eurozone as a whole gains nothing: the gains to Germany are offset by the losses of its union neighbours. For the union as a whole, it is what economists call a zero sum game. Germany gains, but its EZ neighbours lose.

One of the comments on this earlier post said that there was nothing in the ‘rules’ to prevent this, the implication being that therefore it was somehow OK. But it must be obvious to anyone that this kind of behaviour is very disruptive, and hardly compatible with Eurozone solidarity. An idea sometimes expressed that it represents healthy competition is wide of the mark. The only incentive it provides is for other countries to try and emulate this behaviour. If they all achieved that, nothing would be gained. The Eurozone inflation rate would, other things being equal, be lower, but other things would not be equal: the ECB would cut rates to try and get inflation back to its target.

The reason there are no formal rules about all this is straightforward: you cannot legislate about national inflation rates. What you could do, to incentive governments, is establish fiscal rules based on inflation differentials of the kind described here. That would have meant that as relative German inflation rates fell, the government would have been obliged to take fiscal (and perhaps other) measures to counteract it. Once again, this is a symmetrical case to what should have happened in the periphery countries. But if rules of this kind had been on the table when the Euro was formed, I’ll give you one guess about which country would have objected the most.


  1. But wages and prices will vary across Germany as they will across the Eurozone, and across the UK, and across the world.
    By this measure, Liverpool has a competitive advantage against London (and Munich, and Barcelona).
    Are you saying that it should not?

    1. Within any country there will be differentials in the speed of wage growth. This is an effect of a functioning market and it is desirable because it encourages people to move to where the attractive (and higher productivity) jobs are. The problem comes when an economic area forcibly tries to keep its wages down since it causes macroeconomic troubles for others who share the currency. Germany did this but Liverpool never has AFAIK.

      Honestly I think you've hit upon the strongest objection to Simon's proposed rule: some wage and price adjustments are desirable in a currency union.
      @Simon Wren-Lewis
      What if the a country has the wrong price level relative to others when it enters a currency union? With your proposal it would be penalised if it tries to correct this error through inflation/disinflation and/or wage adjustments. What if some countries have higher productivity growth than others? In the longer term some wage and price adjustments are needed.

      Apologies for any spelling or grammar errors but I'm writing this on an iphone.

    2. Think of "dumping" and the downward wage-price spiral in the 1930s. E.g. four Liverpool-musicians have this competitive advantage and they abuse it against London: they claim Wembley, so 2x11+3 artists cannot perform there.
      This post tells you should be aware it has that effect.
      Liverpool-musicians and London-soccer players should show community-sense in their trade-offs.

      PM Liverpool and London share a currency, not with Munich and Barcelona.
      PM The fab four came from Hamburg, not Bremen.

    3. This is exactly what it means.

      I don't understand why Simon has taken this line of argument over these two blogs.

      Competition is the nature of capitalist economic life.


  2. What do you mean by "Germany gains an advantage". You are are using the term in a very technical jargon. The exporting country exports more and its workers are working longer or more number of workers employed, but they receive the same buying power or less, when the export at a lower price. That's not an advantage in the common use of the term outside of economics, so it needs an explanation to be consistent with explaining to an audience "not fammiliar with models."

    1. "Profits of German firms soar" is a better explanation of "Germany gains an advantage"?

    2. You make a good point. It is clearly to the advantage of German employers, which is I guess why it happened. In normal circumstances there is the trade off you mention. But in a generalised situation of deficient demand, it is clearly in Germany's overall advantage.

    3. Thanks for your article. However, for me there is at least question left: What happens if most countries INCREASE wages (and prices)to the countries with constant wages and what would be the equivalent to your "Its neighbours will lose competitiveness both within the union and to a lesser extent against the rest of the world."

      And, with all respect, you still dodge the question of quantitative contributions to the relative lossesof the southern countries in respect to Germany, how much was self-inflicted by wage increases?

    4. "It is clearly to the advantage of German employers, which is I guess why it happened. "

      I am very concerned your analysis is being driven by Model.

      You say it is to the benefit of German employers, have you asked, or seen research asking the views of German workers? Are German workers screaming out for higher real wages? Or do they feel their system works well for them? Do they look exploited? Also where does Germany export? Does its exports compete with countries in the rest of the Eurozone? Do non-Eurozone exports compete on world exports with German ones? Also what do you think of what Sargent et al says about monetary credibility and consistency ( I think it is tosh, especially in this case, and maybe we would agree here.)

      I also think you need to have a word with Krugman if you have access to him. It is not true the European project has always been unpopular. There are numerous reasons why it has become unpopular since the 2000s. I think the most important was the rapid expansion eastwards. In fact I think this has been the root cause of a lot of the problems. The convergence criteria made sense when it was a smaller group, and the aim was to go for fiscal and political integration. This was no longer possible when the EU rapidly expanded and we had decision making paralysis. There was also huge movements of labour westwards and the EU became entangled with the political dynamite subject of mass immigration. (If there was a ever a case why we should treat econometrics with absolute caution it was the forecast made by Christian Dustman. Now we find ourselves with the country exhausted from mass immigration in a situation where we cannot accept desperate refugees from Syria.) You also need to have a word with Krugman about the importance of trade finance: since Samuelson and Hicks ISLM these issues have been downplayed, but they were once considered very important. They still should be: the cost of printing a banknote is 17c; the cost of borrowing in another currency, especially if your currency is vulnerable, is much higher.

      A reduction in German competitiveness could lead to a further reduction in the European manufacturing base overall. And looking at the recent historical record, where do you think that production will go?

      There is more to this than the relationship between prices and exchange rates. It has more to do with the substitutability of production in Germany and the rest of the Eurozone. I do take your point about the deflationary impact. But I am sceptical that an inflationary policy that is purely macroeconomic and does not address structural problems (ie it needs government directed capital outflows from the core to the periphery to assist in industrial development) in the Southern Periphery is likely to succeed, but could make distortions and worse.

    5. @Ulenspiegel11 December 2015 at 05:08
      You repeat your question to SWL:

      "you still dodge the question of quantitative contributions to the relative losses of the southern countries in respect to Germany, how much was self-inflicted by wage increases?"

      SWL never gives numbers, so you will not get an answer.

  3. Thank you for this interesting article. At least there is some kind of instrument to prevent those macroeconomic imbalances. Although this instrument ("Macroeconomic Imbalance Procedure") does not compare inflation of the member states but their current account deficits / surpluses that arise due to different inflation developments in a monetary union.

    Of course it is nonsense that this rule provides to punish surplus countries from 6% and deficit countries already from 4%. But even this rule is not followed... keep in mind that the german surplus is about 8 %.

  4. Simon W-L wrote " The reason is that the exchange rate moves in a way that offsets this change. This is what economists might call a basic neutrality proposition, and there is plenty of evidence to support it." Unless I have misunderstood something, this basic neutrality proposition is what is often called the Purchasing Parity Proposition theory of the determination of exchange rates. I have not looked at the evidence for several years but, when I last did, the consensus seemed to be that PPP could explain most exchange rate movements over a longer period, but had very little explanatory power over a time horizon of say 2-3 years.
    When Simon W-L wrote "there is plenty of evidence to support it", has there been a lot of recent research revising the earlier scepticism or is he referring to effects only occurring after several years' time lag? For policy the length of the lag is crucial.


    1. PPP is different: tests for that, which do indeed fail in the short term, ask whether real exchange rates are constant at all times. There are many reasons why that may not be true, but the proposition that I make will is still true.

      The question you have to ask, if PPP does hold in the long run, why agents in the FOREX markets would not bring that change forward into the short run.

  5. does that mean if all countries had flexible exchange rate all trade deficits would be perfectly balanced? (assuming currencies like eurozone were split up into separate countries)

    1. No: current accounts can be non-zero for all kinds of reasons

    2. No, but employment rate could be ballanced.

  6. Quite some comments had got the idea, the post was to prepare the Nurnberg-trials all over again; it were a legal, not an economic post.

    If a monetary union is not a team, it does not work at all. You can have all sorts of teams, but if a team does not work, then "restoring order" - e.g. reconciliation - must get priority, and other tasks become subordinate. In December 2009 the EU got a problem and the high nobles did close the ranks and take the lead; the EU went into all directions. In May 2010 a kind of emergency-solution was arranged, and it got in the spotlight, but a politicologist - which I am not - will see in the shade London, Paris, and Berlin the lower barons, a court. Davies, Europe, 1997, page 1120 notes that a solid EU-team destabilises national teams like Belgium, Italy, Spain, and UK; an "Anglo-American consensus" would have a US-style union for ideal, but I think this is an American English speaking consensus. And on such a tricky matter the UK voter must make up his mind. There are pain-killers.

    The team is still young. It has to find its groove. Around 2003 Chirac-Schröder were in position to make the EU charge Germany and France to stimulate beyond 3%; they stimulated beyond 3%.

    Every other week changing course for a new long-term strategy is Wall Street, not Main Street. Just after a fixing things happen. The Berlin Wall may fall, or there can be a credit-crunch on subpime mortgages; you cannot react on every event. The exchange rates of GBP, USD, JPY, and EUR in [1999,2015] show Earth is round. EUR/USD had a ride of +86% and competitiveness of the eurosons at the skin (GIPSIs) must have felt it more than within. (For US-politics: the baby Bush boom needed an Iceland-size devaluation: -46%; Clinton and Obama paid for it. [There are good guys; they trade in it.])

    The inflation-compensation in exchange-rate is not perfect, but there is some of it, and there is no doubt that Luxembourg helped to get the average EU-rate at its level; if it were not for Luxembourg, it would not have been at that level! Every pupil knows that Luxembourg "ruins it for the others"; that was what you wanted to hear, didn't you?

  7. Speaking as one of the confused, I found this post indeed very useful. This blog is consistently illuminating.

    1. Thank you. This kind of positive feedback is helpful for me in deciding the content of my posts.

    2. Patrick, I received an email today, it started with the same phrase as yours; concerning today's John Redwood MP Diary post on "Helicopter Money". This may be a coincidence, anyway, the following was my reply.

      The central bank can't "print" NEW money into the economy unless it is financed by the Treasury. The Treasury, as the sovereign currency ISSUER, is the only agent that can increase by spending into existence NEW "money" (that is its Unit of Account; the Pound Sterling); and, decrease it by taxation. The difference between the aggregates of the two is dictated by the spending and saving preferences of the non-government sector. Call it the taxpayers' share equity (savings) in UK plc, it is not national debt as neo-liberals would have the taxpayers believe!

      The central bank can SWAP Treasury Gilts back into the "money" (government spending = central bank reserves), that bought those Gilts when, they were issued by the Treasury. BTW, Gilts have nothing to do with "borrowing" money for the government to spend. A FIAT currency Treasury does not have to "borrow" its own money from anybody. Every Pound it spends into existence is created, brand new, the moment it hits the send key on the Treasury keyboard. This swap is QE, it has increased asset prices which is what it was meant to do, to increase corporate values, to aid borrowing investment money. There is little evidence it has increased the aggregate spending by households, which is the driver of the economy. If it hasn't done that, it has failed.

      The central bank can LEND new "money" (reserves) only against an asset conservatively valued (haircut) to cover the loan, to keep its balance sheet, balanced. It can't create new money like the Treasury. Hence, only the Treasury can do a HELICOPTER DROP. The central bank would have to have collateral / a loan agreement, thrown back into the helicopter to keep its balance sheet balanced.

      However, you can camouflage a Treasury FISCAL stimulus, which is what a helicopter drop is, by making it look like a central bank monetary operation and not directly impacting the budget deficit. The exemplar for this is the Funding for Lending scheme. An exquisite system of smoke, mirrors and virtual financing, that ever came out of the Treasury DMO and the BoE. Remember that the Treasury and the BoE are consolidated as one and the same in the WGA Accounts. That is, when the BoE buys in a Gilt and gives reserves in exchange, it is the same as if the Treasury had never issued that Gilt at all and kept its spending as reserves at the BoE.

      See Appendix A in

    3. Yes, it's a coincidence. I haven't read the other post, much less emailed anyone about it. Thanks, though. I promise I'll try and understand your argument. I hear the phrase 'modern monetary theory' a lot. Is this what it means? I'm not expert enough to judge but it appears to mainly involve putting words in inverted commas.

    4. As promised, I've been thinking about this. Am I right in thinking that the take home point is that gilts are effectively more money and that as such there is no substantial difference between a government 'borrowing' money and a government 'printing' mney? I'm not clear, I should confess, about what is meant by the treasury 'financing' the central bank.

  8. While I understand the basic concept, I don't really agree with the conclusion.

    First it's not obvious to me that the German trade unions were trying to increase competitiveness... You could read those agreements as job sharing proposals, rather than simply trying to push the internal "exchange rate" down.

    Second, even if they wanted to increase their competitiveness, I find it hard to condemn such behaviour. Wages are only half of the equation. You can achieve the same result by trying to improve productivity: are we going to complain if states start to encourage investment or education? This is likely to improve their competitiveness as well...

    I don't think you can complain that someone is working too hard/too cheaply... That's just part of his basic freedom. It happens all the time inside a country as well, doesn't it? I just don't really buy the unfair competition argument at all... If you are behaving honestly, simply offering your labour at a lower price can never be morally wrong.

  9. As an economist who hopefully understands the models, I thought this was an excellent simple account of the problem--the clearest I have read. I thought that the main thing that is missed out is why other EZ countries cannot simply respond by lowering their wage costs. This is important because otherwise one might respond by telling other EZ countries that they should follow Germany's example and cut their wage costs too.

    I would pick out three things. (1) Institutions are critical to the whole process of wage adjustments, and changing institutions can be far more difficult than changes to macro policy. (2) Even if prices and wages fall together, deflation has consequences for the distribution of income across households (different levels of indebtedness) raising issues that may differ from country to country; (3) Such adjustments are a lot harder in a stagnating economy than in a prosperous one

  10. Now I'm reminded of the Dutch disease with Germany as the export-heavy 'industry'. So the solution would be to weaken the Euro which is what I would do. However, I still think that this problem didn't manifest itself before 2008. That's when the housing and service-based economic growth models of the mediterranean states were refuted.
    The "stealing jobs" from other european countries doesn't pass the reality test anyway because german unemployment kept increasing until 2005 whereas the mediterannean countries, especially Spain, were flourishing. Yes, yes, the usual argument is that german banks fueled the boom. Very true, but then german banks also fueled part of the American housing bubble and they kept buying mortgage derivatives until the bitter end. And the reason was this: The belief in the rating agencies and the general "decency" of the markets. And that's also what happened in the Eurozone. The mediterranean states suddenly issued "safe" debt with very low risk premiums. It was the time where the markets couldn't do wrong. And most mainstream economists agreed in 2005.
    Personally, I think there was a huge influence of economic "narrative", which drove many of these inequalities and the policy steps behind it. The german status of being "the sick man of Europe", which entered public opinion in the late 90s, lingered on until the Hartz reforms in the mid-2000s. Then Germany did textbook economics and reformed itself in times of economic boom (bubble). And it actually worked excessively because just as the narrative about german economic weakness pushed it to record unemployment, wage restraint and fiscal reforms, Germany received excessive "blessings" by the market post-2005. It was a perfect timing because the Hartz reforms came just exactly when the housing bubble was losing steam and the manufacturing sector made a renaissance in public opinion. Germany was perfectly positioned to enjoy that wave, just as it was excessively punished before for not having a housing bubble (Germany was still hungover from its own excessive version of the dot-com bubble).

  11. How would you assess a situation in which an EMU country improves its productivity; say, Italy makes its administration much more effective? Would you call this a case where "...the Eurozone as a whole gains nothing: the gains to [Italy] are offset by the losses of its union neighbours"? Clearly not! In this case the whole Euro area would eventually gain, right?

    Same thing with Germany. There was no agreement between employers and employees to cut wages and to, thus, gain a competitive advantage. Instead, the German government abolished socially inefficient labour market and social security regulations to increase employment. That made the country more productive as fewer people chose to remain in unemployment and, thus, wage growth was dampened. Potential output increased first in Germany and over the longer term also in the rest of the Euro area.

  12. I wanted to concur with the positive comments, I found the post helpful. I have no formal training in economics (I am, I think, vaguely intelligent) and have picked up everything ad hoc. As such, this kind of thing is very helpful.


  13. Does the idea of a fiscal rule based on inflation differentials also count as standard macro? I have not heard it before as an alternative to the SGP. Sounds like a great idea.

  14. Thanks for this note. You and probably most macro and international trade economists understand this basic idea. The folks who set flexible exchange rates obviously understand it. Do governments in or out of the EZ understand it? If they do, then why do EZ members besides Germany accept this rather clear exploitation? They are either being played for fools or they are so relatively weak and dependent upon Germany they are afraid to act. Yes, I know what many Germans will say -- their economy is driven by "rules" and others aren't. This claim doesn't have the same force today as it did before the VW scandal came to light. So, what is to be done? It seems to me that only Germany can save the EZ. But, to do it, Germany would have to recognize the consequences of its economic policies for other EZ members. Otherwise, the deficiencies of the euro as a common currency will eventually lead to the collapse of the EZ.

  15. You claim that a country with a flexible exchange rate cannot gain price competitiveness by cutting national wages and prices. The exchange rate, you claim, would counteract the change in domestic prices, such that the original configuration of international relative prices would be restored. You call this mechanism the basic neutrality proposition, and your language suggests that it is an immutable truth.

    Indeed, that is what textbooks preach, excuse me, what textbooks teach. But how is this mechanism supposed to work, according to textbook? The simplest textbook model presumes that the only factor behind the demand for foreign exchange is the demand of domestic residents for imports of goods and services. The only factor behind the demand for domestic currency is the demand of foreign residents for exports of goods and services. Foreign currency demand and domestic currency demand are in balance if imports and exports are in balance; if the trade balance is zero, there is no force that would cause the exchange rate to change.

    Once you introduce short-term financial flows, this model of exchange rate determination no longer predicts balanced trade. An increase in exports still increases domestic currency demand, and increase in imports still increases foreign currency demand, but in general the moment of rest is no longer associated with balanced trade. Short-term financial flows generate currency demand and move the exchange rate independent of trade flows.

    Textbooks tend to stress that cross-country interest rate differentials are one factor behind financial flows and, indeed, there is evidence that the “covered interest rate parity condition” holds in reality. But covered interest rate parity is about the only theory of exchange rate determination that has ample empirical support. Your claim that there is plenty of evidence in support of the basic neutrality proposition is debatable, to say the least.

    For the basic neutrality proposition to hold, a) international relative prices must be the principal determinants of trade flows, and b) trade flows must the principal determinants of the exchange rate.

    Again, there are many articles by now which argue convincingly that the German wage moderation played a minor role in the export success; what really drove the German export success are non-price competitiveness factors and foreign demand growth. Proposition a) cannot and should not be taken for granted.

    Why is this important? Because the notion that former deficit countries could launch an episode of export-led growth simply by moderating wages is misleading and perhaps even harmful. If wages play only a minor role in the determination of the export competitiveness of euro area countries, or play a large role only in certain industries, then wage moderation will generate no discernible effect on foreign demand while, quite possibly, it will exercise a dampening effect on domestic demand. Wage moderation then contributes to stagnation in the periphery.

    Part b) of the basic neutrality proposition is questionable too, even if one accepted part a). In the age of financial globalization, international financial flows are much larger than trade flows. A more reasonable analytical starting point, compared to the textbook fantasy model, is the idea that the exchange rate is an asset price, its value is determined in financial markets, and financial flows can drive the exchange rate far away from the value that would ensure balanced trade.

    The basic neutrality proposition is a misleading guide to current affairs.

  16. Acctually, since entering Labor's Economic Team i find it that topics and descriptions became very usefull. And terminology is also more down to earth, street linque so that majority can understand.
    Even some posts seemed like it switched from holding the line to accepting most of my complaints and making it central to the problem. I am a bit confused but glad to see more laiman friendly and on the side of the laborers.

  17. I am on board with the whole content of the post. Great post btw.
    I would like to point out about this finding about what inflation is and how neccessary it is concerning private debt.

    From a german economist Dirk Bezemer:

    Now, what about price of money across EZ and differences in equity values in periferies from the core.
    Large private equity holdings were allowing for much more available leveraging in perifery while core were already highly leveraged. While price of money was similar acros EZ, private subjects in perifery had to accept high interest rate(comparable to core's rate ) because their Central Banks were preventing fast leveraging and curbing inflation by raising rates for private borrowers.

    It is a huge problem in EU perifery when increase of private debt stoped and took demand down with it, high interest rates for debtors is still taking liquidity out of the economy at the higher rate then in the core. Interest rate for private borrowers in my country, Croatia, is still around 6% tough it's been falling since we got junk rating and Mario Draghy announced QE. High rates comparing to core's is taking a lot of liquidity out of the system and also loans in Swiss Francs are catastrophic.
    Banks do not offer official rates to private borrowers bellow 3% even tough official rate can be negative.

    Competitivness is destroyed by having different price of money between core and perifery no matter productivity and exchange rate changes.

  18. In response to your previous post, Anonymous, commenting on 3 December 2015 at 07:03 asserted that German wage restraint was adopted to forestall the 'export' of jobs eastward, to Poland, the Czech Republic, Slovakia, etc. It is also my recollection that this fear was real. Your answer simply reiterated that, nevertheless, the policy hurt the EZ periphery. In the absence of German wage restraint, and if in fact German firms had chosen to expand production in the (low-wage) former Warsaw Pact countries, would the EZ periphery not have been similarly disadvantaged?

  19. I keep thinking about *who* benefits in this situation. Existing (safe/secure) workers in Germany don't benefit (much) as their wages are suppressed. Marginal works benefited because they have a job they wouldn't otherwise have. I guess exporting company share-holders benefit from more sales and lower (than otherwise) wages. Does the Germany government financial position benefit? Higher employment with lower wages in a progressive tax system should mean less tax revenue. But higher employment in a welfare state means less expenditure. I'm not sure how that works out net. If the competitiveness advantage pulls in net demand, then I'd expect a net benefit for German government finances, and an overall net social income advantage (mostly to those workers who would otherwise be unemployed). Of course those "otherwise unemployed" might well be Spaniards who migrated for the job, so perhaps Spaniards (but not Spain!) benefited?

    SWL - I'd love a post on the distributional effects of a low-wage policy in Germany. Who actually ends up with more income/wealth/taxes/benefits?

  20. Disagree. One would certainly WANT Portugal's inflation to be higher than Germany's, AND wages to go up faster, just as the Balassa-Samuelson hypothesis describes; it's ludicrous that a two-course meal with drinks for a family of 4 in the Algarve can cost much less than half of the equivalent meal in Luxembourg. You're off track here......


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