So if there were really a large excess supply of labor, shouldn’t we be seeing wages plummeting?
And the answer is no—wages (and many prices) don’t behave like that. It’s an interesting question why . . . but it’s simply a fact that actual cuts in nominal wages happen only rarely and under great pressure. . . .
So there is no reason to believe that cutting wages would be helpful.
As with much of Keynesianism, this analysis applies at best to the special case of heavily unionized labor in closed markets rather than nonunion labor in more open markets. With regard to Europe, Krugman misses the most important point. The emphasis on sticky wages and pay cuts assumes the workers involved already have or had jobs. In Spain, Italy, Greece, Portugal, France, and elsewhere, millions of well-educated youth have never had a job. This labor pool does not have any anchored expectations about how much one should be making. Any job with decent working conditions, training, and possibilities for advancement will prove attractive, even at wages that an older generation might have rejected.
The second part of the efficient labor pillar of the Berlin Consensus is labor mobility. As long ago as 1961, Robert Mundell highlighted its importance to a single-currency area in his landmark article “A Theory of Optimum Currency Areas”:
In a currency area comprising many regions and a single currency, the pace of inflation is set by the willingness of central authorities to allow unemployment in deficit regions. . . . Unemployment could be avoided . . . if central banks agreed that the burden of international adjustment should fall on surplus countries, which would then inflate until unemployment in deficit countries is eliminated. . . . A currency area . . . cannot prevent both unemployment and inflation among its members.
Although this article was written almost forty years before the euro’s launch, the implications for the Eurozone are pertinent. When the terms of trade turn adverse to the periphery and in Germany’s favor, either the periphery will have unemployment or Germany will have inflation, or there will be a combination of the two. Since Germany indirectly controls the ECB and has so far been unwilling to tolerate inflation, rising unemployment in the periphery is inevitable.
Mundell, however, also pointed out that the solution to this dilemma is capital and labor factor mobility across national boundaries. If capital could shift from Germany to Spain to take advantage of abundant labor, or if labor could shift from Spain to Germany to take advantage of abundant capital in the form of plant and equipment, then the unemployment problem could be solved without inflation. EU directives and use of the euro have gone far toward increasing the mobility of capital. However, Europe has lagged behind the rest of the developed world in mobility-of-labor terms, partly due to linguistic and cultural differences among the national populations. This problem is widely recognized, and because steps are being taken to improve labor mobility within the EU, prospects for growth are greater than many observers believe.
This brings the analysis to the final element of the Berlin Consensus—a positive business climate. What economists call regime uncertainty is a principal differentiator between long, anemic depressions and short, sharp ones. Monetary policy and fiscal policy uncertainty can negatively impact an economy, as was seen in the United States during the Great Depression of 1929 to 1940, and as is being seen again in the depression that began in 2007. But policy cannot improve an economy if businesses are unwilling to invest capital and create the new jobs associated with such investment. Once the panic phase of a financially induced depression is over, the greatest impediment to capital investment is uncertainty about policy regimes related to matters such as taxes, health care, regulation, and other costs of doing business. Both the United States and the EU suffer from regime uncertainty. The Berlin Consensus is designed to remove as much uncertainty as possible by providing for price stability, sound money, fiscal responsibility, and uniformity across Europe on important regulatory matters.
In turn, a positive business climate becomes a magnet for capital not just from local entrepreneurs and executives but also from abroad. This points to an emerging driver of EU growth harnessed to the Berlin Consensus—Chinese capital. As the Beijing Consensus collapses and Chinese capital seeks a new home, Chinese investors looks increasingly to Europe. Chinese leaders realize they have overinvested in U.S.-dollar-denominated assets; they also know they cannot divest those assets quickly. But at the margin they can invest new reserves in diverse ways, including euro-denominated assets. China was in no hurry to prop up a flailing Eurozone in 2011, but now that the EU has stabilized, they find the euro an attractive alternative to dollar-denominated assets. The Washington Post reported on this phenomenon in 2013:
As Chinese companies and entrepreneurs have moved to invest more overseas, they have been drawn increasingly to Europe, where a two-year surge in foreign direct investment from China has eclipsed the amount flowing to the United States. Over the past two years, Chinese companies invested more than $20 billion in the European Union, compared with $11 billion in the United States.
The Wall Street Journal reported in July 2013 that the Chinese State Administration for Foreign Exchange (SAFE), which manages China’s reserves, “was an early investor in bonds issued by the European Financial Stability Fund . . . and has invested regularly since then in the bailout fund.” A sound euro is an important attraction for Chinese capital because a stable currency mitigates exchange-rate risk to investors. Indeed, capital inflows from China provided support for the euro—an example of a positive feedback loop between a sound currency and capital flows.
Increasing capital inflows to the Eurozone were not limited to those coming from China. The U.S. money-market industry has also been investing heavily in the Eurozone. After panicked outflows in 2011, the ten largest money-market funds in the United States almost doubled their investments in the Eurozone between the summer of 2012 and early 2013.
The Berlin Consensus is taking root in Europe, based on the seven pillars and directed as much from the EU in Brussels as from Berlin, to mitigate resentment of Germany’s economic dominance. The consensus is powered by a virtuous troika of German technology, periphery youth labor, and Chinese capital. It receives its staying power from a farsighted blend of low inflation, sound money, and positive real interest rates. The new Berlin Consensus has the potential to replicate the Wirtschaftswunder, Germany’s “economic miracle” reconstruction after the Second World War, on a continental scale.
German chancellor Angela Merkel was born during German reconstruction in the 1950s, grew up in Communist East Germany, and had firsthand experience with German reunification in the 1990s. Few political leaders anywhere have her experience in facing such daunting development challenges. She is now turning those skills to the greatest development challenge of all: growing the European periphery and preserving the euro at the same time.
■ The Euro Skeptics
Europe may have the will to preserve both its unity and the euro, but does it have the means? Events since the 2008 financial crisis have raised considerable doubt in many quarters about Europe’s capacity to deal with successive crises, notwithstanding the overriding political objectives of the Berlin Consensus. A close examination reveals that these doubts are misplaced, and that the euro project is considerably more durable than the critics suppose.
Foreign exchange and debt markets have existed in a state of continual turmoil since the global sovereign debt crisis erupted with the announcement of default by Dubai World on November 27, 2009. Any visitor to Dubai in the months leading up to the default could see the real estate bubble forming, in the shape of a skyline with miles of empty office buildings and luxury condos for sale. Investors assumed that Dubai, with oil wealth provided by rich neighbors in Abu Dhabi, would muddle through, but it did not. Its collapse became contagious, spreading to Europe and Greece in particular.
By early 2010, serious fraud had been uncovered in G
reece’s national accounting, enabled by off-the-books swaps provided by Goldman Sachs and other Wall Street banks. It became apparent that Greece could not pay its debts without both massive structural reforms and outside assistance. The sovereign debt crisis had gone global and would soon push Ireland and Portugal to the brink of default, raising serious doubts about the public finances of the much larger economies of Spain and Italy.
Fears about sovereign finances spread quickly to the banks in those countries most affected, and a feedback loop emerged. Since the banks owned sovereign bonds, any distress in the bonds would impair bank capital. If the banks needed bailouts, the sovereign regulators would have to provide the funds. But this meant issuing more bonds, further impairing sovereign credit, which hurt bank balance sheets more, spawning a death spiral of simultaneously imploding sovereign and bank credit. Only new capital from outside sources, whose own credit was not impaired, could break the cycle.
After three years of on-again, off-again crises and contagion, the solution was finally found in the troika of the IMF, the ECB, and the EU, backstopped by Germany. The IMF obtained its funds by borrowing from nations with healthy reserve balances, such as China and Canada. The EU raised funds by pooling member resources, largely from Germany. Finally, the ECB created funds by printing money as needed. The troika members operated under the central bankers’ new mantra, “Whatever it takes.” By late 2012, the European sovereign debt and bank crisis was largely contained, although rebuilding bank balance sheets and making the required structural adjustments will take years to complete.
Despite this turmoil, the euro held up quite well, to the surprise of many analysts and investors, especially those in the United States. In July 2008 the euro reached a peak of $1.60 and remained in a trading range between $1.20 and $1.60 during the sovereign debt crisis. Throughout the turmoil, the euro always traded at a higher dollar price than where it began in 1999.
The euro has also increased its share of global reserves significantly since its issue date. The IMF maintains a data time series showing the composition of official foreign exchange reserves broken down by currency. Data for the first quarter of 1999 show that the euro comprised 18.1 percent of global allocated foreign exchange reserves. By the end of 2012, after three years of crisis, the euro’s share had risen to 23.9 percent of global reserves.
Such objective data is at odds with the histrionics produced by the Euro skeptics, and that helps explain why, by early 2013, the prophets of Euro-doom were mostly mute on the subject of a Eurozone breakup. The skeptics had committed a succession of analytic failures, easily seen even at the hysteria’s height in early 2012. The first analytic failure involved the zero-sum nature of cross exchange rates.
Beginning in 2010, the United States initiated a cheap-dollar policy, intended to import inflation from abroad in the form of higher import prices on energy, electronics, textiles, and other manufactured goods. The cheap-dollar policy was made explicit in numerous pronouncements, including President Obama’s 2010 State of the Union address, where he announced the National Export Initiative, and former Federal Reserve chairman Ben Bernanke’s Tokyo speech on October 14, 2012, in which he threatened trading partners with higher inflation if they did not allow their currencies to strengthen against the dollar. Since the United States wanted a cheap dollar, it wanted a strong euro in dollar terms. In effect, the United States was using powerful policy tools to strengthen the euro. Why this obvious point was lost on many U.S. analysts is a mystery, but a permanently weak euro was always contrary to U.S. policy.
The second analytic failure had to do with the tendency to conflate the simultaneous crises in debt, banking, and currencies. Analysts looked at defaulting sovereign bonds in Greece and at weak banks in Spain, then breezily concluded that the euro must weaken also. This is superficial: economically, there is nothing inconsistent about weak bonds, weak banks, and a strong currency.
Lehman Brothers is a case in point. In 2008 Lehman defaulted on billions of dollars in bond obligations. This default meant the end of the bonds but not the end of the dollar, since the currency in which bonds are issued has a different dynamic than the bonds themselves. A currency’s strength has more to do with central bank policy and global capital flows than with the fate of specific bonds in that currency. Analysts who treated European banks and bonds and the single currency as subject to the same distress made a fundamental error. The euro could do quite well despite the fate of Greek bonds and Irish banks.
The third analytic blind spot was a failure to recognize that capital flows dominate trade flows in setting exchange rates. Too much emphasis was placed on Europe’s perceived lack of export competitiveness, especially in the Eurozone periphery of Ireland, Portugal, Spain, Italy, Greece, and Cyprus. Export competitiveness is important when it comes to growth, but it is not the decisive factor in determining exchange rates. Capital flows to the euro from the Federal Reserve in the form of central bank swaps with the ECB, and from China in the form of reserve allocations and direct foreign investment, placed a solid floor under the euro. If the two largest economies in the world, the United States and China, did not want the euro to go down, then it would not go down.
The fourth blind spot had to do with the need to lower unit labor costs as part of the structural adjustment required to make peripheral Eurozone economies globally competitive. Euro skeptics suffer from the legacy of misguided Keynesian economics and the sticky-wage myth, technically called downward nominal wage rigidity. Keynesians rely on a theory of sticky wages to justify inflation, or theft from savers. The idea is that wages will rise during periods of inflation but will not decline easily during periods of deflation; they will tend to stick at the old nominal wage levels.
As a result, wages fail to adjust downward, employers fire workers, unemployment rises, and aggregate demand is weakened. A liquidity trap then develops, and deflation becomes worse as the cycle feeds on itself, resulting in impossibly high debt, bankruptcies, and depression. Inflation is considered advisable policy because it allows employers to give workers a nominal raise, even if there is no raise in real terms due to higher prices. Workers receive raises in nominal terms, while wages adjust downward in real terms. This is a form of money illusion or deception of workers by central banks, but it works in theory to lower real unit labor costs. As applied to Europe, the Keynesian view is that the quickest way to achieve the needed inflation is for member nations to quit the euro, revert to a former local currency, and then devalue these currencies. This was the theoretical basis for the many predictions that the euro must fail and that members would quit to help their economies grow.
In twenty-first-century economies, all aspects of this theory are flawed, starting with the premise. Sticky wages are a special case, arising in limited conditions where labor is a predominant factor input to productivity, labor substitutes do not exist, unionization is strong, globalized outsourcing is unavailable, and unemployment is reasonably low. Today all those factors are reversed.
Capital is the predominant factor input, robotics and outsourcing are readily available, and the union movement is weak in the private sector. Consequently, workers will accept lower nominal wages if that enables them to retain their jobs. This form of lowering unit labor costs is known as internal adjustment via lower wages versus external adjustment through a cheaper currency and inflation. External adjustment may have worked in the 1930s in the U.K., when Keynes first advanced his ideas on sticky wages. However, under twenty-first-century globalized conditions, internal adjustment is a far superior remedy because it treats the problem directly and avoids the exogenous costs of breaking up the Eurozone. As a case in point, on July 2, 2013, Greece’s Hellenic Statistical Authority (ELSTAT) reported that private-sector salaries in Greece had dropped an average of 22.3 percent since the first quarter of 2012, a clear refutation of the obsolete sticky-wage theories of Keynes and Krugman.
The sentiment that stickin
g with the euro is desirable, despite contracting economies and falling wages, is widely shared among everyday citizens in the Eurozone periphery despite the pretensions of academic theory. In 2013 Marcus Walker and Alessandra Galloni did extensive reporting on this topic for The Wall Street Journal and revealed the following:
Across Europe’s southern rim, people recoil at the idea of returning to national currencies, fearing such a step would revive inflation, remove checks on corruption and derail national ambitions to be part of Europe’s inner circle. Such fears outweigh the bleak growth outlook that has prompted many U.S. and U.K. economists to predict a split of the currency.
Only 20% of Italians say leaving the euro would help the economy. . . . Strong majorities in Spain, Portugal, Greece and Ireland also reject an exit from the euro, recent polls show. . . .
“Europeans who now use the euro have no desire to abandon it and return to their former currency,” according to a survey by the Pew Research Center. In Spain and Portugal, 70% or more of people want to stick with the euro, recent polls found.
The fifth and final analytic blind spot of the Euro skeptics was a failure to understand that the euro is—and always has been—a political project rather than an economic one and that the political will to preserve it was never in doubt. A true understanding of the euro is summarized by leading French intellectual Guy Sorman:
Europe was not built for economic reasons, but to bring peace between European countries. It is a political ambition. It is the only political project for our generation. We’ll pay the price to save this project.
In sum, the euro is strong and getting stronger.
■ The Euro’s Future
This tour d’horizon of the Euro skeptics’ analytic blind spots not only rebuts their criticism of the euro but reveals the euro’s underlying strengths and future direction. These strengths are part of a larger, emergent worldview of how to prosper in a highly competitive, globalized economy.
The Death of Money Page 15