Seeking Alpha
Macro, long only, independent research
Profile| Send Message|
( followers)

I continue to be surprised at how many arcane concepts I learned in school turn out to be true and relevant. The example I have in mind now is my study of the international adjustment mechanisms under fixed and floating exchange rates. The conclusion I took away from that study was that “fundamentally” “ideally” or “ultimately” the adjustments required are the same, but that sticky prices, and especially wages, cause frictions that make that adjustment under fixed rates to be more painful than under floating rates. This morning, riots in Greece demonstrate that conclusion very graphically.

Greece has been living beyond its means, running up substantial deficits. The conditions for assistance by the European Union and the IMF include measures to reduce Greek real income as measured in Euros. This has put downward market pressure on the Euro relative to other currencies. However, since Greece shares the Euro with 15 other nations and is a very small portion of eurozone economic activity, most of the real income adjustment has to come through declining money wages, benefits, etc.

At the Euro’s inception, I foresaw that these problems would come.

If Greece still had its own currency, it would depreciate substantially against other currencies and much of the necessary reduction in Greek real income would take place via that currency depreciation. Ultimately, the real income changes are comparable under the two systems, but the currency depreciation option does not require money wages and benefits to decline, where stickiness leads to unemployment. The decline in real income would be spread more equally among the population rather than be concentrated among the unemployed.

This is not necessarily an argument for flexible exchange rates. Some countries may want to give up the option of easier adjustment for the discipline of fixed rates. However, a country that makes that choice will be obliged to make domestic policies consistent with the chosen exchange rate. Its monetary and budgetary discipline must be approximately the same as those in the other Euro countries. Fixed rates are like imposing a constitution on yourself to prevent bad behavior.

If a country is unable or unwilling to impose monetary and fiscal restrictions on itself, then a flexible rate makes the necessary reduction in real income only as painful as it has to be–not more painful because of sticky prices and wages during a deflationary period.

I understood this principle in school, but I never thought I would see it demonstrated on the TV as riots in the street. Dropping out of the eurozone would be a drastic solution to the Greek tragedy, but it would be a clean solution.

Disclosure: No positions

Source: The Greek Tragedy: Significance of Pegged Exchange Rates