22 January 2008

CITIZEN OF EUROPE: Do Central - Eastern European countries need their own Gordon Browns?

I have recently come accross an interesting piece in Financial Times. As Martin Wolf writes in his column, the sterling is about to follow the dollar in going abruptly down:

Like the US, the UK has had buoyant credit growth, huge rises in house prices, low private and national savings and a sizeable current account deficit. Like the US, it also absorbed the surplus savings of much of the rest of the world in the 2000s. It is, in short, one of the canonical “Anglo-Saxon” economies.

And furthermore:

Yet, until recently, sterling was a very strong currency. (...) Such high valuations were unlikely to last and have not done so. The strength was driven by the country’s stable economy, open capital markets and the highest nominal interest rates in the Group of Seven leading high-income countries. But now growth seems likely to slow sharply, short-term interest rates are set to fall and capital markets are suffering credit-crunch blues

So it seems that a potentially falling sterling will be the sign of a necessary economic adjustment. Surely, high current account deficit, rising housing prices and low levels of saving cannot last too long.

And what's even more important, Wolf makes a comparison to Spain, member of the Euroarea. In Spain, the booming economy led to rising wages and, as a result, to a surging inflation. That in turn contributed to the loss of exports competiveness and economic slowdown.

But in Spain, the adjustment cannot be made through exchange rate devaluation - no, Spain's monetary policy decisions are made in Brussels and the ECB will not devalue Euro, thus risking higher inflation!
So the only way for Spain, as Olivier Blanchard from MIT argues, is to go through a painful disinflation period and high unemployment (higher unemployment means lower pressure on wages and, thus, lower inflation).

I personally investigated the issue during my stay at Berkeley (together with my friend Ethan Lutske and under the guidance of Prof. Barry Eichengreen) and our solution to the problem was labour flexibility. Moreover, one of my friends (a student from Amherst College, name withheld) suggested in a private conversation that Spain should have foreseen the problems and done something to cool down the economy (e.g. curtail budget deficit drastically).

The question is why these solutions are or were not used? Can Europe afford to have flexible labour markets? And more importantly: should it?

More importantly: is Martin Wolf right in praising Gordon Brown for "saving the UK from Euro"? And do Central - Eastern European countries need their own Gordon Browns?


With this post, we start the first DEBATE on Econ Int'l - it is a completely new feature (and not the only one to come!). Soon other posts on the topic will be published and you will be able to track the debate with the use of a special tab on the right!

1 comment:

Jan Jablonski said...

So what is actually your point concerning Eastern European Countries (EEC)? Could you clarify that?
If I’m not mistaken your text makes two major points. Firstly, the fact that the UK stays outside the Eurozone allows it to make a necessary economic adjustment through currency depreciation rather than through “painful disinflation”. Secondly, as an opposite case, Spain didn’t have freedom in altering the exchange rate, therefore the adjustment had to be done through prices. It actually all boils down to the question about whether it pays to join the Eurozone or not. The discussion on this topic is already humongous starting from “the optimum currency area theory”. For the case of the UK the famous Five Economic Tests for assessing the UK's readiness to join the Eurozone can be mentioned. On the course of the discussion it does not become clear whether floating exchange regime helps dealing with shocks and adjustments or is in fact an another source of a shock. Additionally, Spain did not enjoy the benefits of having semi-world currency as the UK does (which brings substantial income), so giving up peseta was easier in that sense.

“In Spain, the booming economy led to rising wages and, as a result, to a surging inflation. That in turn contributed to the loss of exports competitiveness and economic slowdown.”

you are talking about business cycle. Was a monetary policy in Spain an efficient tool in smoothing a business cycle before joining the Eurozone? Maybe it was not? Maybe fiscal policy is a more efficient tool? Of course it is efficient only in case of a proper budget discipline, giving space for the automatic stabilizers to work.
Even if adopting euro was not really helpful to deal with the situation in Spain, is it also the case for EEC? As I already mention you are not really clear about how do you relate the UK and Spanish example to the EEC, but the first question to ask would be about business cycle synchronization. How much are the cycles of EEC synchronized with their biggest EU trading partners. Is it to the similar extent as in Spain? In case it is more synchronized, “loosing” monetary policy for ECB would be less painful for the EEC than it was for Spain.