Understanding Currency Areas and the Eurocrisis

I’ve been quite perturbed that most analyses of the Eurocrisis is done by politicians and doomsayer journalists to the extent that most of the content out there centers on the least likely events and fails to capture the spirit of the intellectual debate. Nice thing about blogs is that you can make things as complicated as you like, though in this case I will restrict myself and not use formulas or graphs for the sake of clarity.

Some helpful background

Devaluation is used as a mechanism to reduce real wages. The reason devaluation works is that workers fail to notice or respond to the inflation by raising their money wage demands. If wages were all tied to inflation(also known as indexation), as many multinationals do, the process would not work, and if some did and others didn’t, the process would disproportionately affect those without this adjustment. This power of devaluation is much more prominent the more the cost of living is reliant on the outside world and hence more likely to provoke a response from the labour force. From that point of view this makes the case for much larger currency areas since devaluation is possible without provoking a response. Devaluation can occur not only through monetary means but also by decreasing the cost of doing business which includes a decrease in taxation levels;

I would recommend reading my Unit of account post and Unit of Exchange post to fully understand the functions of money because they are directly relevant to this post.

The benefits of monetary union

These are microeconomic in nature and involve helping out small firms remain competitive as well as alleviating consumer burdens.

Transaction cost

The first benefit is a reduced transaction cost. Though fees on large currency transactions are quite small, currency turnover is extremely high, so cumulative costs can be higher than one might imagine. Although it’s easy to say that the transaction cost of a single currency is reduced, it is possible to overestimate the magnitude by which this is so. This mistake might be enabled by ignoring the fact that not all foreign currency loans are simply hedging exchange rate risk, indeed some of these are favourable because the foreign loans have a lower interest rate. Even so the reasons for this lower financing rate could not be related to the exchange rates whatsoever, an example of which is a multinational borrowing in the domestic market because its reputational capital can be leveraged into higher credit ratings. Additionally many of the potential perceived costs of foreign trade are simply rents extracted by financial institutions exploiting their economies of scale. This allocation of resources not only has an opportunity cost in terms of human labour but also causes inequality between industries by funneling money into finance.

As an example let’s consider a bid-ask spread (buying versus selling currency) of 0.05%. To the individual this might seem insignificant, but this is a very deceptive way of analysing the situation. Given that 600 billion in currency transactions take place in London, such a spread would represent 300million in costs per day. Even so, this element is frequently ignored by politicians because the savings might be negligible from the narrow view of an individual country, especially since a great proportion of the trading is done on behalf of foreign principals, this means that although monetary union would be a considerable savings cost, the UK perceives it as a booming export sector. Even so, the savings potential from a UK resident’s perspective of an EMU would be limited to transactions within the Eurozone. Academic estimates with all this taken into account estimate that the cost savings in transaction costs would be about 1% of EU income.

Accounting costs

Foreign flows being converted into a common currency for the consolidated balance sheet inherently introduce greater variability in forecasts of share prices and increases capital market volatility.

When evaluating risks of currency splitting we must be able to partition the arguments for what it does and doesn’t do. Any individual entrepreneur is likely to be less enthusiastic of any prospect if an additional risk of currency fluctuation is introduced. However when dealing with multinational firms this risk is not necessarily as large as it appears since a true multinational would have flows in both currencies and opportunities to finance from institutions in both currencies and so the risk is likely to be overstated if we just look at the variance of the exchange rate. If the company has accurate forecasts of these future cash flows it may even hedge, but this is a return to the previous point that this process funnels money into the financial industry. Perhaps most importantly we may overstate the cost of the currency risk because even if the foreign currency value does depreciate, this will be partially offset by the fact that the foreign production will become more competitive and in the process, increasing prospective cash flows. However these options are not present for smaller companies, which have to rely on financial institutions ability to mimic these advantages and generally are likely to reduce competitive forces within the economy since it offers more than just an economy of scale advantage to bigger firms.

Insulation from monetary disturbances and reduced political pressure

Given multiple currencies, it’s possible that the domestic prices are sticky (don’t adjust fast enough). This stickiness might lead to unnecessary and temporary fluctuations in the real exchange rate due to speculative bubbles.

Finally without the option of protectionist policies from myopic politicians, we reap the benefits from the most agreed upon economic policy of all: free trade.

Costs of monetary union

These are macroeconomic in nature (more about patterns of adjustment to disequilibrium) and would hence be up for rigorous debate. Some schools of thought, like the Austrian school of economics might even dismiss them completely and blame this thinking for the business cycle by enabling the allocating of resources to be done in a manner that does not reflect the preference of consumers, implying an inevitable crisis.

Monetary flexibility

This is perhaps the main cost being referred to. Currency union makes regions less able to respond to macroeconomic imbalances through specific monetary policy. This belief is mostly credible in the monetarist sphere of thought since fiscal stabilization is a very plausible alternative to most interventionists (and perhaps the only choice when interest rates hit the zero bound, ignoring of course the more unorthodox methods being suggested).

Monetary flexibility also includes financing government spending via inflation, by reducing the burden of public debt (e.g. if your currency is worth less, government bonds are worth less and easier to pay back). Though some would question such indirect measures of taxation as not being transparent it is an important option for extreme times such as wars. However EU wide tax and transfer systems reduce the need for this. Similarly seigniorage revenue in a common currency area (the ability of new money to buy goods and services) would need to split in very equitable ways.

Labour mobility is king

These arguments are all rendered irrelevant by one thing, a sufficiently high labour mobility (people willing to move across the currency zone).

To give an example lets imagine the price level dropped in a country by 10% and that foreign goods are responsible for 50% of the cost of living, so real wages have increased by 50*10%=5%(since you can now afford your previous lifestyle with less money). However given that the people can now buy more but their productivity has not changed this will make firms less competitive and apply downward pressure on the economy which will increase unemployment, bankruptcies and so forth. With sufficient labour mobility, employment will be restored without transitional unemployment because people will fleet to the new high wage country until the supply of people brings wages back to equilibrium.

The question as to how the existence of labour mobility comes about is of course a different one. Although Economists usually perceive it as a requirement for an optimal currency area, it is likely that action must first be taken to increase the labour mobility. Indeed since the Euro was introduced an increase of labour mobility has occurred within the Eurozone and the crisis has further fuelled this trend.

However it is obviously still insufficient and more could be done to encourage this trend, reforms to this end would include: a single language being used in business, transferable pensions, lower transportation costs(from country to country), standardized unemployment benefits, common legal systems…etc; This encouragement is not only important for Europe but also for the US where empirical estimates show that about six years are required for labour mobility to substitute the failure of wage levels to fall. From this point of view you could argue that even the US should be a candidate for monetary disintegration. I would also add that policies that encourage home ownership, which are taken by most governments are likely to reduce labour mobility.

Of course there is also the matter that entering a common currency usually leaves countries open to speculative attacks by investors. Though this has already been experienced by the EU in the early 1990s and paying any attention to this now is merely a sunk cost fallacy.

Expectations and Politics

Fixed exchange rates could theoretically offer many of the benefits of union without the costs. Though the assumption here is that the countries can keep this indefinitely, and if it would have been done indefinitely they would have just joined the monetary union. So in practice fixed exchange rates have a problem of credibility, how long will they keep doing this? In some cases the market will use immense capital to attack these fixed exchange rates and break down the regime.

Although this analysis is economic, it is impossible to ignore the effects of political framing on the markets. From the very outset the framing of North versus South has had an enormous influence on the markets and has greatly impeded the ability of governments to take action. When it was presented that the crisis is a result of Greek fraudulence and profligacy, it becomes difficult to aid them from a political point of view. If the crisis was framed in terms of economic interdependence and not of morality aka, helping the lazy Greek (some economists disagree with that stereotype) it is likely that bond spreads within the EU would not be as high as they are now and more credibility could have been given to weaker governments, as it is now stronger governments are able to retain market confidence. The more these benefits are spread out, the more consumers of these advantaged countries will lose out in terms of an increase in cost of living.

The idea that monetary union requires fiscal union has been spouted enough but it doesn’t go far enough. In addition to the measures that would encourage labour mobility, common deposit insurance, financial regulation, true lender of last resort abilities from the ECB and a federal constitution that overrides state power would all go a long way to unifying Europe.

Of course in ordinary times it is true that countries are able to borrow more than they would have otherwise due to the credibility of their neighbours, creating an incentive for governments to be unsustainable. In turn this increased spending creates inflation and boosts real wages (and hence, standard of living) to levels that don’t reflect the competitiveness of the country.

However, in another light all this talk about restricting countries from defaulting and requiring German taxpayers to bail out other sovereigns is nonsense. US states and local governments have defaulted in the past as John H. Cochrane’s puts it: “A currency is simply a unit of value, as meters are units of length. If the Greeks had skimped on the olive oil in a litter bottle, that wouldn’t threaten the metric system.” Too much is done to enable bailouts either in more direct manners (ECB buying government bonds in the secondary markets) or indirectly (ECB lending to banks that lend money to the governments), which is not helping sustainability and will require hoards of EU taxes to fix or the Euro will be inflated away.

Governments and the ECB have been pressuring banks to keep buying their debts, the ECB is more of culprit since it gives conditional liquidity injections. These banks become more and more dangerous as this effect continues, Cyprus’s recent bank troubles are but a demonstration of this instability.

Possible endings

We could possibly kick the can down the road with just more bailouts but eventually wishful thinking will end and the true choices will emerge.

One of these is fiscal and monetary union, federal government issuing controls on government budgets and allowing for some of the above frictions for labour mobility to be eliminated.

The other is monetary union only, this would mean governments need to be able to default like companies, and banks would be allowed to treat sovereign debt like any other debt (something BASEL 3 doesn’t help with).

And the most costly option is the breakup, probably after a crisis and inflation. This would be seriously debilitating to all contracts that would have to be converted to a currency that doesn’t exist and would lead to immense capital flight and economic damage. Once again in the words of Cochrane: “The euro, like the meter, is a great idea. Throwing it away would be a real and needless tragedy.”

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links 08/10/2012

Articles:

When do economists agree?(fun)

Exponential Economist meets finite physicist(fun)

Bernake and student conversation(fun..ish)

What came first, the chicken or the egg? Empirical Evidence!(fun…ish)

What are the key functions of Asset management?

What is the price of going short volatility?

Bestiary of Economists!(fun)

The economics of video games(fun..ish)

Gravity and international finance

Foreign banks and financial development

Corporate governance in financial institutions

Too crooked to fail? (fun…ish)

With Mitt Romney having released his effective tax rate and it being below 15% there has been a debate about optimal capital taxation. Here’s a good academic paper on it, and a slightly more comprehensible article on it, there is also an unsmoothed graph presented after that article.

Videos:

Want to be a crony?

Should we end the Fed?

Do Indie Video games have a competitive advantage?

Random economics knowledge bites:

Lecture on macro0-economics(includes stuff on optimal currency area)

Marginal Revolution Site for economics

Fed lectures series

Shut up Romney, here’s why trickle down doesn’t work!

So you often hear right wingers advocate for cutting tax rates on the rich. Bush did this and so were born the “Bush Era” tax cuts. And now you have Romney advocating for the same thing if he is to be elected.

The logic they apply is probably not bad at all at face value. If you cut taxes on the rich then they will spend that money to create jobs by investing in society.

What it does miss however is one of the first things you read in an economics text books: a company will hire an employee if it can extract more value out of them than it has to pay them. So this means that the only thing that matters is how productive the employee is. The minimum wage creates a minimum level of productivity required so after a certain level of productivity is reached, then a company would hire. All of this is of course under the conditions that the markets the company is operating in are expanding or that it thinks it can steal market share with these new employees.

But maybe an employee isn’t productive the moment you hire them, but they have to take training and will learn on the job, so the company has to take a loss, and maybe the company can’t afford the loss(even though companies are sitting on record levels of cash in their bank accounts). And in some countries/states interning for free is illegal, so they can’t get rid of that loss or reduce their risk by evaluating candidates with on the job testing.

However companies can also borrow money, either from banks or by giving out bonds or whatever. And these days the cost of borrowing money is ridiculously low, a company should easily be able to find a 1% interest rate. But Romney is right, he will create jobs, it will just be the jobs that previously could not work because the company was not able to extract more than 1% value out of that employee. An example is someone who’s going rate at the job market was 70k but with the current interest rate they would only have been able to pay them 69.3k… a very rare occasion indeed, somehow the company could not afford to pay 700 dollars/pounds/whatever more, which would be much less with average incomes. So the jobs will ONLY be generated for cases where they can spare 69.3k but can not 70k, and these tax cuts are only for the richest, who are likely to have millions… so whats the probability that people with over 100k(in all likelihood, people who are millionaires) income, can’t afford to spare 700 dollars? not very high…

Economics vs Politics. Is free trade any good?

Economics experts fight over numerous of things, it’s the shame of the profession. The fact is that anything can be proven if you use the right econometric techniques, the right time-period and the right data set. So coherent theories are in fact in many ways more important than empirical evidence. Regardless of the dichotomy in economic debate there is at least one thing that would be in the economic bible and that is Free trade.

Free trade just means allowing products in and out of the country without imposing tariffs. The rationale for tariffs is that you want people to buy products that are made inside the country so that money stays in the country and develops the domestic industry. However from the consumer’s point of view, why should he/she care where the product is made? Since if even if the Japanese car industry thrives, they will export their great cars to your country and raise his/her standard of living. Whilst putting tariffs on their cars would either mean the consumer has to either accept a lower quality domestic car or accept to buy the Japanese car anyway at a higher cost, which either way reduces your standard of living because you either have an inferior product or because you have less dispensable income.

The part the Economics profession usually forgets is the politics aspect of tariffs. The reason you might not want to have free trade is if you believe instabilities between two countries will occur. You don’t want Japan to be providing all your cars for you because if they decide they no longer like you and want to go War with you, they can block all their products from coming into your country and helping you. Depending on how good the environment in the country is for setting up businesses, it is likely that either another country will provide the products or domestic industry will emerge, however if the Japanese industry was dominant chances are that your new supplier will not be as proficient, and depending on the product it could have devastating effects on the economy, such as if the product was food, that domestic workers tried to replace without enough expertise and end up selling toxic food.

So tariff’s are rationalized as a bargaining chip between governments, if you believe that relations with two countries are not likely to fall then then free trade is without doubt the route to go. This would probably be the US and Israel or Cyprus and Greece. So China making everything nowadays is not likely to be problematic, unless one believes that they might one day use it against other countries.

Links 16/03/2012

I can’t just favourite links I like anymore… navigating through my browser is a logistical nightmare… that’s what blogs are for I guess! Reminds me of that trick Dumbledore did in Harry potter where he removed his memory and put in that bowl.

So Greg Smith, a Goldman Sachs executive quit and had some things to get off his back, it wasn’t too controversial in my opinion since he didn’t go into much detail about the how the evolution happened. However some interesting commentary on the piece emerged. The bloomberg piece is also surprisingly entertaining and so is Tyler Cowen’s. But the best part are the spin off’s, Darth Vader leaves the empire and a Muppet themed one from bbc(its funnier if you’ve seen the movie). It also goes well with this graph(its clearer if you click on it):

A man who predicts how many Olympic Medals each country will get!

This 1min video on Patents

Here’s a earnings and the 1% picture:

A model predicting celebrity marriages! Here’s a sneak peak!

Another post by Cowen on the effects of Porn Watching!

More Star Wars! How much does the Death Star cost to build?  Its about 13 thousand times the world’s GDP!

A fun TED talk on political  irrationality:

Who rules the world?

Is the government an efficient charity? 

Eight things we know about extending unemployment insurance

Seven things you learned about the transition from communism to capitalism!

And finally a stand up economist!

Picking out conservative Presumptions: A Daniel Hannan Story

I still don’t generally check everything i post up here… but I should… it’s the bloggers responsibility to do so…just because you’re not misinforming your readers about what the other person said, doesn’t mean he wasn’t misinforming his own.

Nothing quite convinces me like a solid econometric model… i will eventually start doing my own but for now… i ran into this famous guy here… a very loud conservative who has been boasting lately about how he was right with his warnings about quitting the euro. I don’t really label myself as a liberal or conservative, i mostly just want a society where people are happiest… and I can defend that in a number of ways.

With the link posted above Daniel Hannan tries to convince his readers to follow his conservative path… let’s see if I’m conservative by the end of this post. So here we go:

1. Free-marketeers resent the bank bailouts. This might seem obvious: we are, after all, opposed to state subsidies and nationalisations. Yet it often surprises commentators, who mistake our support for open competition and free trade for a belief in plutocracy. There is a world of difference between being pro-market and being pro-business. Sometimes, the two positions happen to coincide; often they don’t.

I would have liked a clearer explanation between pro-business and pro-market, though so far it’s fairly neutral… I have always had difficulty buying Keynesian’s arguments.

2. What has happened since 2008 is not capitalism. In a capitalist system, bad banks would have been allowed to fail, their profitable operations bought by more efficient competitors. Shareholders, bondholders and some depositors would have lost money, but taxpayers would not have contributed a penny (see here).

How much does the central bank guarantee from deposits anyway? I think in the US its $85,000 per person. Now about this allowing to fail thing… it seems to me that these banks are profitable again… and it’s not like GM (which was also bailed out and profitable again) where the pieces and set up could just be bought by other entities should it have gone under, since the unique selling point of banks is their people, and going under probably means restructuring and firing, which would eliminate the only unique selling point of the bank. Also i would like to see a complete study on what could have possibly happened to various stakeholders with and without the bailout to make up my mind.

3. If you want the rich to pay more, create a flatter and simpler tax system. This is partly a question of closing loopholes (mansions put in company names to avoid stamp duty, capital gains tax exemption for non-doms etc). Mainly, though, it is a question of bringing the tax rate down to a level where evasion becomes pointless. As Art Laffer keeps telling anyone who’ll listen, it works every time. Between 1980 and 2007, the US cut taxes at all income levels. Result? The top one per cent went from paying 19.5 per cent of all taxes to 40 per cent. In Britain, since the top rate of income tax was lowered to 40 per cent in 1988, the share of income tax collected from the wealthiest percentile has risen from 14 to 27 per cent.

Now this is where i start getting skeptical, the link has no source to back up his point… it’s just someone agreeing with him. Also the numbers he quoting (apart from not knowing his source) are ridiculous, assuming they are true… they don’t tell us jack shit. Could it be that during that period, which is about when real wages started stagnating, the rich were paying a higher proportion because corporations were making record breaking profits? The rich weren’t paying more of the taxes by the magic of flat tax, they were EARNING ALOT MORE.

4. Those of us who believe in small government are not motivated by the desire to make the rich richer. We’re really not. We are, in most cases, nowhere near having to pay top rate tax ourselves; our most eloquent champions over the years have been modestly-paid academics. We believe that economic freedom will enrich the country as a whole. Yes, the wealthy might become wealthier still, but we don’t see that as an argument against raising living standards for the majority.

I’m not sure what to say this except… this, it’s not good enough to just get people out of poverty. What people care about is their relative wealth, and making inequality go higher will cause misery. We always unconsciously compare ourselves to the top, and with the globalized era being televised, it’s even more obvious.

5. We are not against equality. We generally recognise the benefits in Scandinavian-style homogeneity: crime tends to be lower, people are less stressed etc. Our objection is not that egalitarianism is undesirable in itself, but that the policies required to enforce in involve a disproportionate loss of liberty and prosperity.

Loss of liberty and prosperity for whom? The rich obviously right? The video at the end of the link he posted is the most ridiculous thing i have seen this week. If you’re really worried about the small business owner AND about inequality… how about you set up a new system and Tax accumulated wealth, this would mean that if you have a really good year, the high tax rate would not eat it up, there see? Protect the masses, protect the small business owners! Also studies show that well paid workers are more productive workers… imagine if everyone in the economy was well motivated? That would be real prosperity.

6. Nor, by the way, does state intervention seem to be an effective way to promote equality. On the most elemental indicators – height, calorie intake, infant mortality, literacy, longevity – Britain has been becoming a steadily more equal society since the calamity of 1066. It’s true that, around half a century ago, this approximation halted and, on some measures, went into reverse. There are competing theories as to why, but one thing is undeniable: the recent widening of the wealth gap has taken place at a time when the state controls a far greater share of national wealth than ever before.

It’s easy to make such a statement but there’s no evidence of causality, these presumptions are terrible… imagine setting up a policy based on this… read Krugman on this… it’s not voluntary state intervention, the state is taking a larger share because people are suffering…

7. Let’s tackle the idea that being on the Left means being on the side of ordinary people, while being on the Right means defending privileged elites. It’s hard to think of a single tax, or a single regulation, that doesn’t end up privileging some vested interest at the expense of the general population. The reason governments keep growing is because of what economists call ‘dispersed costs and concentrated gains’: people are generally more aware the benefits they receive than of the taxes they pay.

At the expense of the General population? I’m glad he doesn’t use the word Majority because… oof that’s a close one. Let’s be theoretical about this, there’s over a thousand Billionaires in the US. Some of them have more than 1 billion too, that’s a trillion dollars… the cuts they were discussing of making the other day would save 50 billion(just to put it into perspective), with that kind of money you could send 5 MILLION people to higher education(purely theoretical of course).

8. Capitalism, with all its imperfections, is the fairest scheme yet tried. In a system based on property rights and free contract, people succeed by providing an honest service to others. Bill Gates became rich by enriching hundreds of millions of us: I am typing these words using one of his programmes. He gained from the exchange (adding fractionally to his net worth), and so did I (adding to my convenience). In a state-run system, by contrast, third parties get to hand out the goodies.

The state isn’t running the system, its correcting it… its VERY contradictory that he talks about, property rights and free contract… when those are in themselves government intervention.

9. Talking of fairness, let’s remember that the word doesn’t belong to any faction. How about parity between public and private sector pay? How about being fair to our children, whom we have freighted with a debt unprecedented in peacetime? How about being fair to the boy who leaves school at 16 and starts paying taxes to subsidise the one who goes to university? How about being fair to the unemployed, whom firms cannot afford to hire because of the social protection enjoyed by existing employees?

At a time in history the difference between private and public pay weren’t so big… but ever since the private sector started not sharing profits, this has changed. Also the public sector does have job security factored in… The capitalist system is the one filling in debt; private education is draining the poor… Capitalism created poverty which the government tried to correct (admittedly not well done) by subsidizing sub-prime loans and reducing debt.

10. Let’s not forget ethics, either. There is virtue in deciding to do the right thing, but there is no virtue in being compelled. Choosing to give your money to charity is meritorious; paying tax is morally neutral (see here). Evidence suggests that, as taxes rise, and the state squeezes out civic society, people give less to good causes.

See my previous post for this one

Anyways if your still… hope you enjoyed it or at least learned something about critical thinking!

Why tax them? they are humanitarians after all!

edit: the original article is here

The NYT had a nice and shiny article telling us about how many butterflies circle around the rich with their humanitarian contributions. There was a moment where i thought the tone of the article would change…

Officials in New York and Newark say the money from private sources will not replace existing public programs

But then the rest of the sentence had to follow

but will instead allow rapid experimentation with new approaches to old and seemingly intractable problems,

Yes of course these Billionaires are the new innovators and help us out a lot. But wait they get tax benefits… actually…do you know who was complaining when Obama was trying to end Bush era tax cuts? take a wild guess…no? Charities! Because they know that these billionaires aren’t doing these contributions out of the goodness of their hearts, and it would signify that less money would be donated.

Additionally contributing to charity in public and loud ways creates media attention, and if every person had a balance sheet, that would increase the “intangible assets”. Its not unilateral the benefits they obtain are substantial, heck i bet companies would pay(if they haven’t already and i am not aware of it) Zuckerberg millions to be in their adverts in the hope that his good name will rub off on them.

Here’s the piece de resistance of that sentence!

at no cost to taxpayers.

It might be true that these billionaires might discover more efficient ways of using the money, but if they are really worried about efficiency I imagine that people with their statures can easily advise government on effective uses, but the approach they are taking is one that attacks democracy, as few non-elect people decide how to best help the many. You don’t buy it? Well here’s another interesting thing i read here

Depending on the relevant tax rate, the dollars contributed to philanthropies by the wealthy could lead to losses of government revenue of as much as 50 percent of the money contributed.

It does harm democratic governance… if then the government is getting less significant sums of money from these loopholes, then who can make up the difference? that’s right the Taxpayer.