Was the Euro a mistake?

After much brouhaha about who will bailout Greece (some news reports alluded to the possibility of China coming to Greece’s rescue) the dust had settled when EU decided to put-together a rescue package (so we thought!). Today, the German Finance Ministry said it is unaware of any agreement by euro zone members to bail out Greece.

The Germans are wary - what signal would Greece’s bailout send to the other EU members who are facing similar problems? Would Portugal and Spain be next in line for a bailout?

Germany has been a big “paymaster” to the EU, contributing 60% of EU’s annual budget. Germany has gained significantly from the Euro. Almost half of German exports go countries in the euro-region – these countries have lost out because they can no longer devalue their currency to remain competitive. However, German taxpayers seem to be losing their patience – too many of their neighbors have rigid labor markets and little discipline when it comes to public spending.

I think the underlying issue is much bigger and more fundamental. The arguments in favor of the European Monetary Union were free trade, better labor mobility and enhanced competitiveness. However, many skeptics believed that a common currency made little economic sense. Economist Milton Friedman said in 2001 “As time went by, there would be serious differences in the EU over the policies the European Central Bank should follow”…. "You know, it's an ironic thing in a way," he said, "the euro was adopted really for political purposes, not economic purposes, as a step toward the myth of the United States of Europe. In fact I believe its effect will be exactly the opposite."

Friedman’s prognosis seems to be slowly coming true. By adopting the euro the member countries gave away their monetary policy freedom to the European Central Bank. This makes it extremely difficult for the member states to deal with asymmetric shocks and tailor monetary policies to suit local needs. Spain is a very good case in point. Spaniards could not use monetary policy tools to control the housing bubble – now the bubble has burst. Spain’s labor market has traditionally been too rigid, making it difficult for employers to hire and fire workers. Today Spain’s unemployment is at 20%. The construction boom of the last few years attracted so many workers from Eastern Europe who now stay put in Spain even during the economic downturn, making the unemployment problem in Spain much worse.

A country in the EU region can afford to lose its monetary policy and fiscal policy independence only when labor mobility within the EU region is near perfect (i.e. if unemployment increases in Spain, labor can move to France or Germany) and the potential for big local shocks get mitigated through a common regulations and fiscal policy. Both these conditions are difficult to meet! Labor mobility in the EU region will not be high because of language and cultural barriers. Common fiscal policy and common labor regulations are possible in the US because most of the policies are set by the Federal government but is very difficult to replicate in Europe.

So, is the euro a mistake? A common currency for the euro region appears premature, if not an outright mistake. The costs, at least to some countries, are much higher than the benefits.

Wrong Problem, Wrong Solution Mr. Krugman

Nobel prize winning economist Paul Krugman had commented in his recent New York Times article that the world should indeed be worried about China's currency policy. Krugman quotes Paul Samuelson to argue that China has stolen jobs from other countries through its currency policy.

I agree with Krugman on his comments so far, but Krugman also argues in favor of protectionism and "trade confrontation" by the developed world to get China to revalue the yuan.

I think there are a couple of flaws in Krugman's argument:
a) Currency is not the only factor which makes China competitive. Speak to companies that import stuff from China - they would tell you that currency is important, but one cannot ignore factors like labor availability, infrastructure and to some extent regulatory (health / safety / working conditions / minimum wages etc) arbitrage which makes China’s manufacturing competitive.

b) Krugman, through his "back-of-the-envelope calculation", has pegged the extent of job loss in the US because of China's currency policy at 1.4 million. I think Krugman has overestimated the ability of the US and other countries to competitively manufacture most of the goods that are currently imported from China. What might happen with yuan appreciation is just a rise in inflation and inflationary expectations in the world and not job creation. At a time when unemployment is high and economies are growing at a slow pace, high inflation can cause a lot of trouble.

c) Protectionism and trade confrontation are easy to recommend but extremely difficult to implement. I had argued in my earlier post that under WTO rules it would be difficult to force China to revalue its currency. The only way out would be to bypass the WTO and erect trade barriers against China. However, the US and the EU will be shooting themselves in their foot if they undermine the WTO.

This takes us back to the question - How should the US and EU deal with Chinese currency "manipulation"?.... My answer is still the same - China 's currency policy is clearly unsustainable and market forces will eventually force China to revalue its currency. The developed world should leave the timing of yuan revaluation to market forces.