Tuesday, November 29, 2011

Euro and Free Trade

No two countries are exactly the same.  One would think this would be obvious, but to many politicians and economists it is not.  Economists "assume" that they are to simplify certain models where the differences are irrelevant to what they are studying, but then forget to "unassume" for others.  No where was this more obvious than in the design of the Eurozone.

I explained before one of the reasons that the Euro failed was because it failed to take into account recessions.  Sometimes a country needs to run a currency deficit, and there is nothing wrong with that when done for the right reasons and at the needed level.  This is the primary reason the entire region is failing.

A secondary reason that the Euro is failing is because it provides no ability to account for trade deficits between regions.  Trade deficits occur, and there must be a mechanism to correct them when they start occurring.  Think of it as some kind of  regulator gauge.  Let's look at 3 popular ways of balancing out a trade deficit.

  1. The first way is my preferred method.  To have a floating currency between the two regions so that as goods and services flow to one region(which means currency flows to the other) the value of the currency in that region goes down.  At that point it is now cheaper to produce in that region and they will start producing and selling more to the other region until the currency is brought back to even. Rinse & repeat.
  2. Another way of dealing with a trade imbalance is for the countries to implement protectionist trade policies to encourage exports and encourage imports until the trade deficit disappears.  This runs the risk of a so-called "trade war" erupting.
  3. The third method is the most popular method by market fundamentalists:  Wreck the economy through draconian cuts to government and have across-the-board tax increases.

Number 3 is the favored option by members of Europe.  Especially when it's not their own country that must go through with it.

Let us take a look at a hypothetical eurozone country running a trade deficit.  If it is running a trade deficit, then that means Euros are leaving the country.  If the government makes no attempt to accommodate the loss of currency within the country, it can cause local deflation.  As we all know, deflation is bad for an economy and unemployment rises until the economy is so bad, people quit buying items and the trade deficit disappears, but only after rampant unemployment and other recessionary ills.

In a Eurozone country, a country's government might try to accommodate a trade deficit by running a government deficit.  That way the local economy won't deflate by keeping the same amount of currency in the local economy.  This creates an "unfair" condition, because it means the country can continue to import more goods and services than it exports.  The whole reason that Eurozone countries aren't allowed to run perpetually high trade deficits.
Notice though, that the only alternative for a Eurozone country to fix a trade imbalance is through wrecking the economy.  This is what happened in so many of the Eurozone countries.  Greece, Italy, etc...  The other countries made them practice austerity which caused recession and unemployment.  That recession and unemployment causes a spiral because of reasons discussed before.

This is among the reasons why so many MMT economists predicted that the Euro would fail.  Besides having no mechanism to deal with recessions, it has no mechanism for dealing with trade imbalances that doesn't wreck a local economy.
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