The curse of size
Small countries have numerous advantages. For instance, they are less likely to get drawn into a trade war. The Netherlands and Germany have roughly the same size current account surplus (as a share of GDP), and yet it’s Germany that attracts all the criticism. Singapore’s current account surplus is far larger than China’s (as a share of GDP), but the US goes after China. Yes, there are now other issues with China beside trade, but at the beginning it was the Chinese CA surplus that people like President Trump were focusing on.
If every country in the world were as small as Singapore, Switzerland, and Belgium, it’s likely that global trade would be freer. Countries would have no incentive to adopt protectionist polices, as it would more obviously be just shooting oneself in the foot.
But today I’d like to focus on something else—monetary policy. It occurred to me that the decision to create the euro was even worse than I had thought. It certainly caused problems for Eurozone members, especially countries along the Mediterranean. But it also acted as a sort of black hole for the global economy. To see why, we need to back up and figure out why the first deflationary trap was in Japan, and not some other East Asian country.
When I did research on the interwar gold standard, I reached the conclusion that the so-called “liquidity trap” was actually a gold standard trap. Countries that stayed on the gold standard were prevented from adopting expansionary monetary policies. For this reason, I didn’t expect liquidity traps under fiat money, and I was caught off guard when Japan fell into this situation in the late 1990s.
In retrospect, it’s clear that Japan was trapped in something very much like the gold standard. When they tried to devalue the yen to stimulate their economy, the US would pressure them to back off. That’s not to absolve the Bank of Japan of mistakes, but US pressure made their job much harder. Here’s Paul Krugman in 2001:
For the real tragedy right now is that however innovative and open-minded Mr. Koizumi may be, he will fail unless other important players — mainly the Bank of Japan, but also the U.S. Treasury Department — are prepared to learn from Andrew Mellon’s mistake. And all the evidence is that they are not. The head of the Bank of Japan insists that the country’s continuing slump is the result of inadequate reform — that is, insufficient purging of the rottenness. And although the details are in dispute, the U.S. Treasury secretary, Paul O’Neill, appears to have warned Japan not to let the yen weaken too much.
Poor Japan. It is the victim of those who refuse to learn from the past, and thereby condemn others to repeat it.
In contrast, smaller economies such as Singapore use the exchange rate as a monetary instrument. They are too small to attract attention. Importantly, if all countries were to simultaneously depreciate their currencies they cannot all reduce their real exchange rates, which average out to one, by definition. But they can all simultaneously depreciate their currencies against goods and services, even when using exchange rates as a policy instrument.
Japan and the Eurozone are the two black holes of the modern global economy, pulling the global real interest rate ever lower. The Eurozone is much larger than even Japan, and hence even less able to inconspicuously use exchange rates as a policy instrument.
If Greece and Italy had had their own currency in 2011, they obviously would have devalued. Most people understand that fact, but they don’t understand the full implications. The analysis is often presented in zero-sum terms, with the assumption being that the euro was too strong for Greece and too weak for Germany (based on Germany’s big CA surplus.) Actually, during the Eurozone double-dip recession (2008-13) the euro was far too strong for Greece and even slightly too strong for Germany. Even in Germany the inflation rate was too low.
The euro didn’t just create a one-size-fits-all problem; Europe’s reliance on interest rates as the only policy instrument gave it a deflationary bias that doesn’t exist in smaller countries that can use exchange rate depreciation, and hence don’t face a zero bound problem. (There’s no zero bound for the price of foreign exchange.)
The world now has 4 currency zones regarded as “big”, and that’s a problem. China grows fast enough where it doesn’t face the zero bound problem . . . yet. The US has flirted with the zero bound problem. But Japan and the Eurozone are a major drag on the world economy. It would be better if the euro didn’t exist and if Japan were viewed (by the US) as a small country.
That’s not to say smaller countries cannot fall into negative interest rates. But that’s their choice. Denmark is free to devalue its currency against the euro. Switzerland is free to go back to the pre-2015 euro peg. The Danish euro peg and the post-2014 Swiss currency appreciation were (conservative) policy choices.
For the most part, however, small countries are free of the zero interest rate trap. If they are at or below zero, it’s because that’s where they want to be. (The Swiss like low inflation.) The creation of the euro made the world more susceptible to deflationary traps in two ways. One is well known—the fact that the ECB was structured to have a low inflation bias. Less well known is that large size itself results in a deflationary bias. Large central banks can create inflation if they are determined enough, but to do so they may have to engage in activities that will be viewed as more “controversial” than what is required in small countries. Size matters.