Tuesday, April 25, 2017

Long Run Lira?

Luigi Zingales inaugurated a series of essays in Il Sole 24 Ore, an Italian newspaper, on whether Italy should stay in or get out of the Euro, and graciously asked me to contribute. My view, here in English, here in Italian.

To be clear, I kept to Luigi's terms of the debate. This piece is only about whether Italy is better off in the long run, with a common currency. Whether it gets anything out of an exit, a devaluation, a default now is for another day. And this is just about currency, not about leaving the EU, not about debt or austerity, not about whether europe needs a fiscal union, or the rest of it. (Some subsequent correspondence verifies the wisdom, but also the difficulty, of talking about one thing at a time.)

Return to the Lira? A long-run view (Not very good English title)
The euro isn't perfect, but it isn't bad. (Much better Italian title)

Should Italy have her own currency, and run her own monetary policy? For today, let's focus on the long-run question, leaving out for now the transition and any immediate benefits and costs. When contemplating a divorce, it is wise to focus on what life will be like when everything is settled, not just who will have to wash today's stack of dirty dishes.

Remember first that monetary policy cannot substantially improve long-run growth. Long-run growth comes from people and productivity, how much each person can produce per hour of work. In turn, productivity comes from innovation, new companies, new ways doing business, and new products. Like Uber, consumers benefit and existing producers are disrupted. Improvements in long-run growth come only from structural reform, not monetary machination. Money is like oil in a car. Bad monetary policy, like too little oil, can drag an economy down. But after a point more oil will not help you to go faster — you need a bigger engine.

In the short run, monetary policy can also “stimulate” an economy. It's like an afternoon espresso — good when you're feeling a little sluggish, but not wise to drink all the time, and in the end no substitute for diet and exercise. And that is the major advantage offered for an independent currency and monetary policy — the possibility that a wise monetary authority can offset bad shocks with occasional bursts of devaluation and inflation.

But “wise” is a major caution. When the central bank lowers interest rates, inflates, or devalues, that helps exporters, but hurts importers; it helps government finances, but lowers the real amount the government pays its workers, pensioners, and bond-holders; it helps borrowers but hurts those who lent money to the government, homes and businesses.

Once hurt, they wise up. Anticipating the next devaluation and inflation, workers and pensioners demand indexed wages and pensions. Bond investors demand higher interest rates.

So having your own currency really only works for a government whose finances are in sound shape, and whose public institutions are strong enough to resist the constant clamor for one more inflation. Just this once. Again and again.

Staying in the euro thus represents an important pre-commitment. By forswearing the ability to easily devalue and inflate ex-post, Italy benefits from much better credit and investment ex-ante. It is up to her to use this credit wisely, as Greece so notably did not.

Devaluing and inflating is said to work because prices and wages are “sticky,” and do not quickly adapt to inflation. Thus people are fooled into working harder than they would otherwise, or into accepting wage and price declines they would refuse if they could see them directly. But, if used often, they too will wake up and stickiness vanishes.

Furthermore, devaluation and inflation to exploit such stickiness can address an overall level of wages or prices that is too high, but it cannot address an industry or a region that is too high while another is too low. And variation across industries and regions is larger than variation across countries. If stickiness is the problem, it would be much better to remove all the policies that encourage sticky prices and wages in the first place. For Italy in particular, the arguments for one currency are really arguments for two currencies, one for the North and one for the South.

If that sounds unappealing, perhaps one currency is unappealing too.

Italy will face tight limits on what it can accomplish with wise monetary policy. Let us hope that having its own currency means Italy still somehow remains a member of the European Union, or at least its somewhat free-trade and free-investment area, like Denmark, Norway, or pre-Brexit UK. Let us hope that Italians can still buy and sell goods freely across Europe, they can conduct their business in euro or lira, own bank accounts in both currencies, freely buy and sell securities, work in Europe and hire whom they please.

Do not take all of this for granted. The first thing many governments do, faced with weak currencies and government debt problems, or noticing their monetary stimulus efforts have little effect, is to force their citizens to use that weak currency, to ban foreign bank accounts, to limit citizens' rights to buy and sell euros or to borrow or invest abroad. They limit foreign banks, in order to prop up domestic banks who must hold domestic currency and debt. They limit the interest citizens get at banks, and allocate bank credit.

All this passes under bureaucratic bromides like “capital controls.” Economists call it “financial repression,” which gives a better sense of its effect. This is the kind of monetary policy that, like removing oil from a car, really can slow it down. And it is not clear that Italy even can leave the euro without leaving the EU.

If Italy remains open, as she must to grow, monetary policy will always be constrained by the exchange rate and competition from the euro. Too much loosening will cut the exchange rate too much, and vice versa. Wild exchange rate fluctuations are bad for business and investment all around. Italians will just use euros instead, undermining the value of a domestic currency, leading to capital controls. Even Iceland is now thinking it should peg to the euro. Switzerland and to a lesser extent Denmark are fighting hard to keep their currencies from rising.

So will Italy be better off in the long-run, back with her old sweetheart, the Lira? A well-managed currency within an economy open to trade, capital, and people, can have some benefits. The experience of pre-Brexit UK, Denmark, Switzerland, Norway, or Sweden offers small advantages, some challenges, and no particular disasters so far. The experience of pre-euro Italy is less encouraging, that of pre-euro Greece less so, and that of many small countries challenged by debt and growth less so still. Round after round of inflation and devaluation did not produce prosperity, and capital and exchange controls hurt growth substantially.

In the end, no monetary machination can substitute for a dynamic real economy. The Euro, while not perfect, is pretty good, and it offers an important pre-commitment against bad policy. The dangers and temptations of a Lira do not, in my view, compensate for the loss of an occasional afternoon espresso of stimulus.


  1. I do not understand the whole "sticky wages" argument for inflation. It seems to me that the argument assumes that there is some group of workers whose real wages are so high as to be a material drag on the whole economy but who lack sufficient bargaining leverage to protect their real wages from inflation.

    The question for me is: who are these mysterious wage earners who are overpaid but lack leverage?

    1. I think the argument is - inflation will drag down the real cost of workers and thus prevent layoffs. Its implied that layoffs are to be avoided since purchasing power drops substantially when a worker is unemployed. I'm pretty sure its a broad assumption that the majority of the labor force in the US works in sticky non-inflation adjusted wages.

      I personally don't buy these arguments either, especially when an overwhelming amount of unemployment in the US and Europe seems structural.

    2. I think the argument is that you can generally creep wages down across the board through inflation. That of course assumes that workers have little bargaining power. A consequence of ongoing inflation of this nature is often that workers decide they need bargaining power to fight this creeping devaluation of their standard of living. This bargaining power can come from unions or it can come from the ballot box.

  2. I love how you have to open with so many comments about what your article is not about. Too many trolls saying, "yeah, but you failed to discuss...?"

    I also like how you reference the actual size of the relevant monetary base when assessing the "value" of inflation seniorage in your earlier post. That puts you in the 1%!

  3. Good post.

    Here's a challenge. Keeping to Luigi Zingales' terms of the debate, is *Germany* better off in the long run with a common currency?

  4. "Remember first that monetary policy cannot substantially improve long-run growth. Long-run growth comes from people and productivity, how much each person can produce per hour of work."--Cochrane.

    Seems to me though that bad monetary policy can cripple output for so long, that "long-run" might apply.

    Many say the U.S. Great Depression was aggravated by tight money.

    On the other hand, Japan followed a money-financed fiscal program (helicopter drops) in the early Great Depression, and escaped the Great Depression, despite having been an exporting nation.

    The ramifications of the US tight-money and Japan's helicopter doors played out over years, although the experiment was interrupted by WWII.

    Another thought: Suppose tight-money cramps growth over a decade. If an economy can grow only in relation to itself (say 3% maximum) but you hold growth flat for 10 years through bad monetary policy, then you will never regain the lost ground.

    Something like this may be happening in the US today. There are people crying about labor shortages in the construction industry, despite housing starts being lower than 1960s levels and half of peak pre-2008 levels.

    The economy atrophied?

    I suspect tight-money can atrophy an economy, and recovery is measured in generations, if ever.

    And, of course, for many people (who live human life spans, with even fewer working years) the recovery will come posthumously.

  5. Italy manifacturing productivity has not gotten worse compared with Germany, what has gone done is total productivity because the share of manufacturing in Italy has contracted more
    http://gennaro.zezza.it/?p=2015 (he computes added valute at constant prices per employee)
    Why ?
    1) because of the collapse of internal demand by -12% betwenn 2008 and 2013 due to austerity
    2) a contraction of credit to firms from 900 billions down to less than 800 billions from 2008 to now (largely connected to 1)
    Was austerity needed because of public debt of 118% of GDP in 2010 ? First austerity has caused debt/GDP to shoot up to 135%. Second Italy has paid about 3,300 billiond in interest since Bank of Italy was forbidden to buy gov bonds in 1981, so the whole public debt is due to interest expenses. Italy is the only country on the planet to have had a primary surplus around 1,5% of GDP for 20 years in a row. And of course Italy has total debt (banks+gov+families+corporation) a bit lower than the OCSE average
    Sorry to bring up allo those data that my disturbe the pretty narrative of "it is just productivity, the monetary system is just fine"

    1. "First austerity has caused debt/GDP to shoot up to 135%." Causality is not an easy thing to establish. There is always the counterfactual. And the counterfactual could have been even worse. Assuming the counterfactual would have been better is wishful thinking.


Comments are welcome. Keep it short, polite, and on topic.

Thanks to a few abusers I am now moderating comments. I welcome thoughtful disagreement. I will block comments with insulting or abusive language. I'm also blocking totally inane comments. Try to make some sense. I am much more likely to allow critical comments if you have the honesty and courage to use your real name.