Karl Smith on the liquidity leak

What Tyler calls a liquidity leak, I call markets at work. The ECB provides enough stimulus to get all of the Eurozone going but it all leaks to Germany. Fine. The German market heats up. German wages and rents rise. Retired German doctors start considering the virtues of a flat in Lisbon overlooking the harbor. German consultancies hold seminars on “How to make your  Mediterranean town competitive in the new German Outsourcing Model.”

This is the way things are supposed to work. The idea that a more competitive and efficient Germany should not command higher wages and rents is bizarre; and is only called inflation because the Eurozone, in its heart-of-hearts, doesn’t actually believe its one monetary union where the richer parts are distinguished principally by the fact that they have more money.

The link is here.  The analysis of course is correct, but I think this illustrates rather than solves the problem.

First, Portugal and Germany are not directly competing in so many export markets to a high degree.  So raising German wages and prices helps Portugal only somewhat.  Furthermore, the marginal propensity of Germans to spend, or the marginal propensity of German banks to lend, is not mainly directed toward the periphery.  Therefore the gradient of “how much inflation are Germans tolerating to get some real output effects in Portugal” is a steep one, much steeper than you would find within a traditional, one-nation, single currency area with geographically mobile money.

Imagine telling Americans that they must endure a good deal of inflation to help solve some aggregate demand problems in Ecuador and El Salvador.  No one doubts there is spillover, but if the banking system in Ecuador is falling apart, many of the possible transmission effects may not easily stick, or would not if Ecuador used more bank money and less pure currency.  (Just fyi, right now inflation in Ecuador is higher than in the U.S.; here are numbers for El Salvador.  It doesn’t look like a tight belt of monetary transmission to me, and those countries do not have the same bank insolvency problems which we are seeing in the eurozone periphery).

Second, this mechanism solves (at best) only one of the core problems of the eurozone, namely incorrect relative prices between Portugal and Germany.  It helps less with the “Portuguese nominal wages are too high” problem, the “Portuguese banks are not sound” problem, and the “Portugal badly needs structural reform” problem, among other difficulties.  The inflation would be an easier sell to the German public if it really would set the rest of the eurozone right, but that is a difficult case to make.  Just try uttering this sentence vor dem Publikum: “It’s the leak that will make this work.”

Third, one effect of this policy would be that Germans buy up a lot of Portuguese assets.  “Not that there is anything wrong with that” I hear you saying and indeed that is right.  Still, solving the crisis by selling a lot of the country to the Germans is not exactly a popular policy in a lot of the periphery and we could expect political resistance from that side as well.

You can think of this all as a rather odd and stunted “price-specie flow mechanism,” where the specie itself has limited geographic mobility.  To be sure, this means the inflation would have worked much better had it been applied in earlier years, before various periphery banking systems saw so much trouble.

My initial post on the liquidity leak was here.


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