Thursday, January 5, 2012

Should Greece Devalue?

Two weeks ago I wrote the following in a little Bloomberg column about the Euro 
Defenders [of devaluation] think that devaluing would fool workers into a bout of “competitiveness,” as if people wouldn’t realize they were being paid in Monopoly money. If devaluing the currency made countries competitive, Zimbabwe would be the richest country on Earth. No Chicago voter would want the governor of Illinois to be able to devalue his way out of his state’s budget and economic troubles. Why do economists think Greek politicians are so much wiser? 
This paragraph set off a little kerfuffle in the Cochrane-is-a-moron section of the blogosphere. I won't respond in detail, because I presume you're more interested in economics than what anyone thinks of anyone else's intelligence.

But the paragraph was mighty distilled, and the evident interest in the question suggests a little fuller examination of whether devaluation is a good idea or not for a country like Greece, and trying to understand why people come to such different views.

I think I can sum it up this way: Devaluation is like a cigarette. The Keynesian camp basically says, "Boy, a cigarette would perk me up right now."' Modern macroeconomists (I'm looking for a good name -- "Dynamic?" "Intertemporal?" "Equilibrium?" Really everybody else, including new-Keynesians) basically say "Maybe, but smoking is a really bad lifestyle decision." We think of policies as rules, not decisions.

The following discussion resembles that between a teenager and the parent who found a pack of cigarettes. It sounds like facts are at issue -- just how good does it really feel, just how long does it take to get addicted, how bad are the long-run effects -- but there is a deeper difference in perspective, which is why the arguments are a lot more heated than the simple facts suggest. 

So, just how good is a cigarette anyway?

Devaluation works if prices and wages don't adjust. If the Drachma goes from 1:1 Euros to 2:1 Euros and Greek prices and wages double, nothing happens. On the other hand, if prices and wages don't change, then Greek goods are cheaper and Greece will produce and export more. Similarly, inflation can goose output a bit. For example, if prices go up faster than wages, then companies will hire more workers and make more goods. (Standard disclaimer: I'm simplifying dramatically. Don't write that I'm an ignoramus because I can't get the whole modern theory of the Phillips curve into one sentence of a blog post written for a popular audience.) 

So, sometimes devaluation or inflation work, at least temporarily. We've known this for a long time. In his Nobel Prize address, Bob Lucas cites Hume in 1752.  "Temporarily" is an important qualification. We all agree (I hope) that money is neutral in the long run. Inflation eventually catches up to devaluation. Wages eventually catch up to prices. So even here, the question is just how long the high lasts before the hangover sets in.

And devaluation and inflation often don't work, or are indeed counterproductive. The US and many other countries in the 1970s experienced stagflation -- devaluation and inflation accompanied by worse economic performance. Most economic basket cases -- Zimbabwe was my example -- are junkies, continually inflating and devaluing. Most really successful countries -- Switzerland -- are famous for strong currencies. We've known that for a long time as well.

When does devaluation work? The most important consideration suggested by modern macroeconomics is whether the devaluation or inflation is expected or unexpected. This is the heart of Milton Friedman's famous AEA presidential address, and Bob Lucas' and  Edmund Phelps'  Nobel prizes. (Standard disclaimer.)

This will likely not work: the Greek government declares that on January 1 2013 it will change from Euros to New Drachmas at 2:1. I think we would all predict that "devaluing" in this way would have exactly the same effect on real prices and wages as joining the Euro did: none. On Jan 1 2013, prices, wages, contracts, bank accounts, etc. are just multiplied by 2 and a "D" replaces the "E" in front of the number. Whatever "price stickiness" means, this isn't it.

If the Greek government went on, "and then we will devalue the Drachma relative to the Euro by 5 percent per month," it still would have little real effect. With that announcement and a year to plan, Greece would simply return to an economy familiar to anyone who lived through the 1970s, steady 5% wage and price inflation.

The trick for Greece, in its current situation, is to change to a New Drachma, and convince everyone that new Drachma will have a stable value. Then, it has to surprise everyone by devaluing, or devaluing more than they expected.

That will be difficult to arrange. It could easily backfire. People could expect much more inflation and devaluation than the Government had planned. Money could fly out of the country, interest rates spike, and a panic wage and price inflation take off. Then Greece would get stagflation, not a boom.

Devaluation also "works" by engineering wealth transfers, from lenders to borrowers.  But you have to surprise the wealth in order to transfer it.

So, devaluation is not an "always and everywhere" proposition. Yes, if the US were to announce that we are pegging the dollar at $2 per euro, and the ECB went along with this policy, it's a good bet that prices and wages would not adjust overnight. Dollar goods would be cheaper in Europe, and the US would export more and import less for quite a while. Countries, who already have their own currencies, a good reputation, and stable values, can devalue unexpectedly and boost exports and output.  It does not follow that a return to the Drachma and devaluation will work for Greece.

The experience of small countries around the Eurozone is also not immediately applicable. They already have currencies. The combination of leaving a currency union, establishing a new currency and immediately devaluing it does not have much precedent. And for every Iceland, where devaluation helped, there is a Hungary, where it does not seem to be producing riches.

I don't deny that it could be done. But it's not so easy as the devaluation camp makes it sound.

But that's not even the main issue. How did I let the teenager drag me in to talking about how good it feels to smoke that first cigarette? Back to the nagging parent: is smoking a good lifestyle decision?

Is it better over the long run for a country like Greece to have its own currency, and routinely resort to devaluation and currency depreciation when its economy is in the doldrums or the government is discovered to have overborrowed? Or is it better to stick with the Euro, and rule that option out? Greece has plenty of experience with inflation, devaluation, and default. Much of the world was on a binge of inflation and depreciation in the 1970s. It didn't work out so well.

This is where modern macroeconomists and Keynesians start talking different languages. Modern macro discussions are full of words like "precommitment," "rules vs. discretion," "dynamic efficiency" that are absent in the cigarette-by-cigarette, live-for-today-for-in-the-long-run-we're-dead mode of Keynesian thinking.

Just one example: Before Greece joined the Euro, it paid very high interest rates. When it joined the Euro, all of a sudden it was able to borrow at German interest rates. It did, massively, as we know. Porsches went South, and pieces of paper flew North. Greece boomed. If the money had been properly invested, Greece would still be booming. The money was wasted, but the opportunity was there.

Now, why did joining the Euro give Greece this opportunity to borrow at low rates? Cynics say, because the Eurozone meant eveyrone thought Germany would bail them out, as people correctly expected the US to bail out Fannie and Freddie. But even I am not that cynical. The Eurozone was set up, remember, specifically denying sovereign bailouts.

A second explanation seems more plausible to me: by joining the Euro, Greece precommitted against devaluation.  It could no longer take the easy way out. If the economy got in trouble, Greece would feel much more pressure to fix it, not to rely once again on a quick bout of devaluation. If the government got in trouble, it would have to deal with a messy default, not a quick depreciation. And the Eurozone makes that default harder than Greece's many previous sovereign defaults.(A short history by Benn Steil here.)

Nonsmokers get lower health-insurance premiums. Non-devaluers get cheaper loans.  Precommittment has real benefits. We've known that for a long time too, at least since Ulysses had himself tied to the mast so he could hear the sirens.

Furthermore, countries like Greece with chronic devaluation and inflation routinely resort to capital controls, price controls, exchange rate controls and other interventions to prop up their currencies. Junkies start stealing. These steps ruin small open economies. 

There is still room for debate. At least now we have both views on the table, and you see that national currency with occasional devaluation vs. precommitting against devaluation and staying in the Euro is not such an easy question. Reasonable people can disagree. Unreasonable people can disagree more.  

A lot of the answer is also political, not purely economic. Does a country have solid enough political institutions so it will use devaluation only when really necessary, and not to get out of stupid policies which it really ought to fix instead? Does the teenager really have the willpower to only smoke occasionally?  Do you trust the patient to self-administer the morphine? That's part of a bigger political worldview on whether you trust the benevolent discretion of politicians or whether you think they need to be constrained by strong rules and institutions.

I come down on the latter side of the fence, but mine is most assuredly an opinion, based on thinking through all these considerations, not a Fact Of Nature.

Whew, I tried to get a lot in those 4 sentences!