Sunday, March 16, 2008

EMU And Ireland's Problems

There has recently been an argument in the Swedish blogosphere over Ireland and the European Monetary Union. It started with neocon blogger Dick Erixon approvingly quoting an article in Swedish news paper Dagens Industri (not online) which basically said that because Ireland is part of the euro area, it faces problems because this disables them from lowering interest rates and thus also lowering the value of its currency. To this libertarian (or libertarian-leaning) bloggers Wille Faler and Johan Ingerö criticized Erixon and pointed out that such inflationary policies is not healthy.

Economics has never been Erixon's strong side, and he is certainly dead wrong when he implies that Ireland needs more inflation. However, while Faler and Ingerö are on the right track, I do not find their answers fully satisfactory, so I will therefore go to the bottom of this issue.

There is nothing wrong with monetary unions, per se. Quite to the contrary. It is likely that under a free market monetary system (i.e. a gold standard) we would basically have a single currency in all countries with this free market system. So in this aspect, monetary unions represents a replication of free market conditions even if it is paper based and run by a central bank as in the case of the euro. Because it creates more market like conditions, a monetary union will also be associated with increased trade, and therefore increased specialization and higher structural growth.

However, the issue is more complex than this. Because the euro is paper based and run by a central bank it is not certain that for all countries, it would be preferable (i.e. more similar to free market conditions) to join the euro rather than to have its own monetary policy. That is only the case if an independent monetary policy would be less sound, equally sound or only slightly sounder. If on the other hand an independent monetary policy would be significantly sounder than the policy pursued by the ECB, than it would certainly be preferable to have an independent monetary policy*.

Contra factual speculation always involves a degree of uncertainty, but it seems likely that in the case of Ireland an independent monetary policy would have indeed been significantly sounder. For years, Ireland has had high inflation and a housing price bubble because of the low interest rates set by the ECB. Had Ireland had an independent monetary policy it seems likely they would have had higher interest rates which would have contained these excesses to some extent and thus meant that Ireland would have had less problems now.

The problem here is not the principle of monetary unification, but rather that the ECB have pursued a too inflationary policy. This has hit Ireland disproportionably hard because their economies have boomed for other reasons. These strong economic conditions have made the Irish much more willing to respond to the ECB's low interest rate policy by increasing their debts than in for example Germany and Holland, where people have been reluctant to borrow more. Or to use, more technical economics terminology the price elasticity with regard to interest rates have been much higher in Ireland than in Germany and Holland.

There are thus good reasons to blame Ireland's problems on EMU (given the ECB's inflationary policies), but not because it stops them from inflating more now but because it has compelled them to inflate too much in the past. They thus arguably should not have joined in 1999, but withdrawing at this point is not a good idea. But in order for EMU to work for all members, the ECB must try to replicate the non-inflationary conditions of a gold standard as well.


Anonymous Anonymous said...

going to play devil's advocate here: in today's environment of competitive currency devaluation, surely the consequence of one single country constraining its money growth would be a massively strong currency, and, as a consequence, collapse of its export sector.

i can't think of one central bank whose broad money isn't growing at double-digits.

5:27 AM  
Blogger stefankarlsson said...

You're right that there is a problem with the rather drastic exchange rate fluctuations we see today, and this does indeed weaken the case for going alone with sound policies. Still, I think that is a lesser evil compared to the negative effects of inflationary policies.

And as for your second point, I am surprised you would make the assertion that there aren't any country which hasn't double digit monetary growth given that I know you are a regular reader of this blog and given the fact that I have repeatedly pointed to Japan and Switzerland as two countries with moderate money supply growth.

8:30 AM  
Blogger Lasse Pitkäniemi said...

you forget one more downside with the EMU: it brings a single fiat currency union and each currency union (because of it's central bank's inflation) will approxmiately inflate at an equal rate thruout the union. So even if countries within one currency union start out at a different phase on the business cycle they will eventually end up in the same cycle. This leads to the fact that booms and busts happen in one larger currency area at the same time, meaning that the global business cylces become far worse. Without ECB each member state would have their own business cyles and thus experience busts at different times and could therefor lift up their neighbours economies faster after the bust. Also competition with these fiat currencies would ensure that no single area could inflate too much - or then face the consequences...

2:16 PM  
Anonymous Anonymous said...

mea culpa! in fact bloomberg gives yoy broad money under 10% for canada, germany, france, japan and switzerland - careless error on my part.

yes, i know you like yen and sf.

any opinion on the $aud? m3 growth near 23% yoy, and yet our currency is still strong against most currencies. we're running a bop deficit of around 7% (off the top of my head). bill futures are anticipating another 75bp interest rate rise.

4:03 PM  
Blogger stefankarlsson said...

Lasse,read my post again where I pointed out that the degree of inflating have not been uniform throughout EMU. Compare credit expansion in Ireland and Germany and you'll see a dramatic difference, something which was basically the point with the post.

And the currency competition argument simply does not hold as long as each government has a monoploy within each area. In fact, governments in general tend to like if currency traders respond to inflationary policies by lowering the exchange rate as this give advantages to their export industry and limits import competition.

10:55 PM  
Blogger stefankarlsson said...

Newson, I'll probably soon analyze Australia in a more systematic and detailed way. For now, suffice to say that based on other factors it is long overdue for a downturn, but that the commodity price boom is keeping the Aussie boom going, and as long as the commodity price boom continues so will the Aussie bbom.

11:04 PM  
Anonymous Anonymous said...

Hi Stefan!

Newson, I'll probably soon analyze Australia in a more systematic and detailed way.

Welcome to Down Under. We are from Australia, by the way.

If you want to know more about Australia's debt problems, I recommend you take a read at our local contrarian, Professor Steve Keen's DebtWatch web site.

But note, Steve Keen, though he is a contrarian economist, he is not from the Austrian School. Take at his last comment at his article, where he said,

You appear to subscribe to the Austrian theory: “money growth IS inflation”–if I’ve remembered a statement by Contrarian [that's us!] earlier. While money growth is a factor, to me, this Austrian perspective is rather like a quote that I’m currently using in an academic paper:

“If you call a tail a leg, how many legs has a dog? Five? No, calling a tail a leg don’t make it a leg.” (Abraham Lincoln)

For those empirical reasons, I am more persuaded by the Post Keynesian theory of inflation–which is that it is driven by struggles over the distribution of income, and cost pressures from commodities that cannot be reproduced (minerals) or finely controlled (agricultural goods).

The money supply is then “accommodating”–it expands to suit these pressures, rather than causing them via “too much money” in the first place.

Therefore, though his diagnosis of Australia's debt problem is in agreement with the Austrian School, his cure will run against the Austrians. Basically, Steve recommend more inflation because at this point in time, he reckon deflation is a more dangerous threat (i.e. like cancer, in his analogy) whereas inflation should not be the focus of attention of the Aussie central bank (RBA).

Therefore, Steve is against raising interest rates though he agreed the RBA should have raised interest rates long ago to prick the debt bubble i.e. it is too late to raise interest rates now because deflation is inevitable.

6:16 AM  

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