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.
READER COMMENTS
Brian Donohue
Sep 26 2019 at 5:19pm
Very good Scott. The idea that a currency devaluation is good for an economy and bad for other economies is mercantilist claptrap of course.
But it’s a mercantilist world. Japan, Germany, China all think in mercantilist terms. And now the USA has its own mercantilist in chief.
Not sure about China, but all the other big boys would benefit from looser monetary policy right now. The right response from the USA to other economies running looser monetary policies is to run a looser monetary policy of our own. Even mercantilists can see this.
Krugman used to be very good.
nobody.really
Sep 26 2019 at 6:14pm
How does the relationship between Greece and Germany compare to the relationship between New Mexico and California? Would New Mexico benefit from cutting loose from the dollar and having its own currency?
Lorenzo from Oz
Sep 26 2019 at 7:14pm
We know that monetary union without fiscal union does not work so well (see Euro). Fiscal union without monetary union seems also somewhat problematic.
If New Mexico is going to also give up the fiscal union, it is giving up a significant risk management and stabilising mechanism. Which leads one to suspect that, no they wouldn’t be.
Scott Sumner
Sep 26 2019 at 11:09pm
I agree that fiscal policy is part of the reason why the Euro hasn’t worked a swell as the US dollar system. There might also be a few other factors, such as the fact that the US is more of a single market—The Economist magazine just did an excellent extended article on this issue.
ChrisA
Sep 27 2019 at 4:56am
I would add that no-one really cares (or even knows) if the inflation rate in NY state was higher than that in New Mexico – people focus on the overall inflation rate in the US. So New Mexico doesn’t suffer too much. The problem in the Euro area is Germans care mostly about inflation in Germany, not in the Euro area as a whole, so inflation targets get set not by the average for the zone, but the maximum in one country in the zone.
John Hall
Sep 26 2019 at 6:45pm
Fantastic post.
I was a little confused by this line: “But they can all simultaneously depreciate their currencies against goods and services, even when using exchange rates as a policy instrument.” Could you make that a little clearer? Is that equivalent to “But they can all simultaneously depreciate their currencies against Nominal GDP, even when using exchange rates as a policy instrument.”
Scott Sumner
Sep 26 2019 at 11:12pm
Yes, it is equivalent. If all try to inflate at the same time, they can’t all achieve currency depreciation against other currencies. But they can cause prices and NGDP to rise, thus reducing the value of their currency in terms of the share of NGDP it can buy, or the basket of goods it can buy.
But big countries seem limited to a policy instrument with a zero bound problem, although unlimited QE would eventually get the job done in even the largest economy.
Lorenzo from Oz
Sep 26 2019 at 7:11pm
Very enlightening, ta. Thomas Sargent pointed out how much the Euro was like the gold standard (only, of course, much harder to leave).
Also, the Maastricht Treaty strikes again.
Sir John Curtice, the BBC’s polling guy and political scientist, takes us through the opinion dynamics of Brexit very clearly.
https://www.youtube.com/watch?v=WPEFp9oIZ-0
Keeping the UK in the Common Market was not so hard. Keeping the UK within the Ever Closer Union was always going to be inherently difficult.
But the Euro was always fundamentally a political project. Just with some awful economic consequences.
Scott Sumner
Sep 26 2019 at 11:19pm
Yes, I agree with the gold standard aspect of the problem. But I was also making another point—the eurozone is very big. Say you had 10 tiny African economies get together with one money—for instance I seem to recall there was a West African franc of some sort. You’d still have the one size fits all problem. But the entire currency union would be small enough to devalue the franc without negative pressure from the US and others. Europe is too big to simply rely on crude devaluation.
Thaomas
Sep 27 2019 at 6:26am
But why would the EU want/need to use “crude devaluation” (direct sales of the Euro against other currencies in foreign exchange markets?) when it can sell Euros against Euro-denominated assets — QE? Would this have produced any pushback from the pre-Trump US, or Japan, or China?
This still seems like a one-size-(mis)-fits-all exchange rate problem with the ECB not allowing high enough zonal inflation for overvalued real exchange rate countries to devalue for “domestic” political reasons, Germany’s and some others’ aversion to inflation.
Pyrmonter
Sep 26 2019 at 7:26pm
All institutions adapt. The questions, surely, is not ‘is there a deflationary bias’ but, given a deflationary bias, why disinflationary institutions haven’t emerged. If a real devaluation was necessary and nominal exchange rates fixed (as they are within the eurozone), it has always been possible for the ‘laggards’ to devalue by allowing their price levels to fall. But they haven’t. Why? Picking up on Lorenzo’s references to Sargent – I’d have thought the lesson from ‘The end of four big inflations’ was that institutional arrangements matter, but that they adapt …
Scott Sumner
Sep 26 2019 at 11:14pm
Pyrmonter, Prices have probably fallen a bit, but in general prices are very sticky in precisely the countries that most need flexibility right now—in the south.
Benjamin Cole
Sep 26 2019 at 8:45pm
Great post.
Next, we need to ponder if monetary policy can be executed when limited to the credit channel.
Getting banks to extend more loans is perhaps worthy, but if the only way to stimulate an economy results in mounting debts…
Stanley Fischer is now examining what are essentially helicopter drops, joining such people as Michael Woodford or Adair Turner.
Due to the political sensitivity of this topic, we are hearing terminology such as “fiscal-monetary coordination.”
Michael Pettis recently commented that the problem with China is not a shortage of loans or credit extension, but rather a shortage of demand. Have Beijing and People’s Bank of China become too Westernized?
Indeed, when one ponders the world, there is plenty of capacity in, say, the automobile industry, much more than the demand, and this situation repeats in smartphones, steel even agricultural commodities.
The only sustained shortages appear to be in housing.
Benjamin Cole
Sep 27 2019 at 1:23am
I hate to mention this, but….
Europe has rules on how much fiscal stimulus is allowed, I think a max of 2% of GDP for any nation….
Japan is decreasing budget deficits in relation to GDP….
Scott Sumner has described Japan-Europe, see above…
The US is running trillion-dollar national budget deficits and has stayed out of negative interest rates and deflation….
The annoying question persists: How does a lone central bank increase demand within the geographic confines of a given nation?
The US central bank can take a stab of lowering interest rates but longer tern rates seem to be set globally,,,and the Fed can buy bonds on global asset markets, in which money is a fungible commodity….but how does that generate demand inside the US?
Thaomas
Sep 27 2019 at 6:12am
I do not see how the Euro per se causes a ZLB problem for the zone. The ECB, just like the Fed, has QE at its disposal to achieve a higher PL trend. It’s the same as Denmark and Switzerland; ECB, heavily influenced by Germany, has a revealed preference for low inflation over higher real growth.
Scott Sumner
Sep 27 2019 at 1:13pm
I agree with your “per se”. It’s the size combined with the dysfunctional use of monetary instruments. Devaluation is an easier way for central bankers to manage expectations.
marcus nunes
Sep 27 2019 at 9:56am
To the US, the yen was always “too strong”!
https://thefaintofheart.wordpress.com/2014/10/11/poor-yen-its-always-too-low/
Thaomas
Sep 28 2019 at 7:02am
Don’t you mean “weak,” their cars too cheap here and our beef to expensive there? The dollar too “strong?”
Floccina
Sep 27 2019 at 12:50pm
Great post.
This is purely theoretical but, Do you think that the USA and the world would be better off if the USA had 4 or 5 currencies and regional Reserve banks? So that a mistake in any one is not big enough to bring down the world economy.
Scott Sumner
Oct 1 2019 at 10:50am
No.
Comments are closed.