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.


Imagine telling Americans that they must endure a good deal of immigration to help solve some poor people problems in Ecuador and El Salvador.

Imagine a lot of Americans living in a very expensive city with lousy weather, like say New York, and then imagine them moving to a low-cost area with much better, like say Palm Beach. I think that's what Karl is getting at.

The difference is that people in Palm Beach and those in New York speak the same language and have pretty much the same culture. At least, they are far more similar than Berlin and Lisbon. And that illustrates a fundamental difference in the mindset of Eurozone inhabitants versus Americans. Oh, and there's not nearly as much resentment over rich New Yorkers coming and buying up all our property as there is in the German equivalent. Just see the uproar over the rumour of selling Greek islands to repay debt.

There is an extremely large difference between selling individual apartments and selling entire islands. Surely you can understand.

The premise of leaking to Germany is really the premise that bondholders and those who lent to problem banks will be beneficiaries to monetary expansion via ECB purchasing. If German bondholders are the primary bondholders of periphery institutions, the statement is correct. Otherwise, not. In fact, you could make the case that Italian banks, owned by Italian families and conglomerates, would be the beneficiaries; or Spanish elites for Spanish banks. But, the Irish have already been screwed, and some of their owners are now in jail. Too late for them.

Proceed with banking reform first, put in place and a EU bank default mechanism with teeth (meaning shareholders and bondholders take a hit before government bails them out), and then proceed. Otherwise, you are just transfering wealth from citizens to protect wealthholders.

'Proceed with banking reform first, put in place and a EU bank default mechanism with teeth (meaning shareholders and bondholders take a hit before government bails them out), and then proceed.'

And some people wonder why the City wants to the leave EU as quickly as possible.

Why are these results considered a "problem?"

A problem for whom - and why?

“Solves the problem”? “Helps Portugal only somewhat”? So you’re not interested in improvements that are “only somewhat”; you’re interested only in *solutions* to “problems”? And this on a blog called “*Marginal* Revolution”!

Well, the Marginal Revolution referred to in the title of this site is much more along these lines -

'This moment in the late 19th century marked a turning point in economy theory. With the introduction of these theories, the analysis of production and exchange turned away from social theory and towards the quest of a scientific objectivity. Classical economics had focused on the causal relations among social activities, which were connected with the production and distribution of wealth. Classical economists asked questions about the true basis of value, activities that contributed to national wealth, systems of rights, or about the forms of government under which people grow rich. But in the late 19th century, in response to attacks from socialists and debates about how society works, and as a means to escape the conundrums of value theory and to answer how values could become prices, economists developed the theory of marginalism. This movement in economics disengaged economics from descriptive and normative commitments with the aim to withdraw economics from debates about how society worked and what kind of society we wanted to live in, and escalate it to an objective and universal realm.' http://en.wikipedia.org/wiki/Marginalism#The_Marginal_Revolution

The amusing part being that the idea that the people who direct policy centers have any interest at all in withdrawing 'economics from debates about how society worked and what kind of society we wanted to live in,' while at the same time clinging to the claim that economics exists in 'an objective and universal realm.'

'Burger' (citizen/s) is probably better than Publikum (public/audience).

'Publikum (von lat. publicus „dem Volk, der Allgemeinheit gehörig“; vgl. coram publico „vor den Leuten“, „öffentlich“; res publica „Republik“) ist der Sammelbegriff für die Zuschauer und Zuhörer bei Aufführungen im Theater, Kino, Radio, Fernsehen, bei Gerichtsverhandlungen, bei Ausstellungen, Vorträgen, Konzerten, Zirkusveranstaltungen, Festivals etc. Außer der Zuschauer- und Zuhörerschaft bezeichnet man auch die Leserschaft literarischer Darbietungen als Publikum.' http://de.wikipedia.org/wiki/Publikum

Germans call such translation errors 'false friends' - and yes, in this region, the tendency is to use the English term, forcing a search for an apparently proper German term - 'Übersetzungsfalle,' or 'translation trap.'

So these countries created a monetary union without fiscal union, which all of the macro-economists over in the United States said was a horrible idea. And now they have a problem. But something that would help unemployment in Spain (25% now?) might lead to inflation in Germany over 2%. But we can't tolerate that.

I understand the rules governing the ECB may require them to behave this way, but it doesn't make it good policy. If you want a larger than it should be monetary union, you have to tolerate non-ideal monetary policy. And the preference should be for full employment. Not 25% unemployment in one country so another never experiences inflation above 2%. When German inflation is as high as Spain's unemployment minus 10% (a very high structural unemployment assumption), then they can complain. Or they can abandon monetary union. The current path is just bad policy.

Sticky wages? Update the text with "sticky lifestyle dreams" and "sticky entitlement beliefs." I had a Spanish neighbor at our vacation house provide me with a special "going out of my way for my foreign friend" explanation of what Spaniards, "unlike Americans," expect from their government. Another very old Spanish friend did the same a few weeks later, explaining to me that Spain would be fine because Germany was doing well. I tried to gently say "how can you collectively afford it?" and "has Germany co-signed your notes?" but didn't push it. Who wants to lose friends? I agree with Tyler's view on the German impact on, say, Portugal or Spain. It reminds me of the low GDP return on a new dollar of Treasury debt, pennies, for perceptible reasons.

Many of the things they expect from their government are much cheaper than what Americans get from the market, like medical care. So this argument is invalid.

An excerpt from Ryan Avent:

"But this, right here, is the heart of Mr Cowen's post:

Imagine telling Americans that they must endure a good deal of inflation to help solve some aggregate demand problems in Ecuador and El Salvador.

Americans would scratch their heads and wonder what the hell Mr Cowen was talking about. If either Ecuador or El Salvador had a demand-shortfall problem they could just devalue relative to the dollar. Mr Cowen's follow up points that Ecuador and El Salvador don't actually seem to be suffering from demand issues is a curious non-sequitur. The bottom line is that America has not made a deep political and economic union with Ecuador or El Salvador the central focus of its economic and diplomatic policy. The situations could not be more different."


They have a common currency, so inflation in Germany should help with euro devaluation. This WILL benefit the periphery, becoming more competitive compared to to non-Euro countries.

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