Monetary union and economic flexibility

The question whether the euro will in the long term benefit Europe or harm it cannot be answered at this point with any certainty. I have been skeptical about monetary union in Europe as it is constituted now, as there are serious divergences undermining EMU. There is no agreement between economists (is there ever?) on whether even in theory it is better to have fixed exchanged rates or floating ones. And the split goes right down the middle of the free market camp too, with both views represented by the Big Names of Economics.

So I was very interested to find a discussion between Milton Friedman and Robert Mundell on this very issue. (I came across it via Arnold Kling, whom I found through this post at Asymmetrical Information). The discussion goes around in circles to a certain extent, but in the end it boils down to the issue of economic flexibility. As exchange rates are prices, they convey information on supply and demand of currencies, which again is based on numerous other factors in the real economy. By shutting down a mode of expression for the information by fixing currency prices, you can't make the information go away. It will have to express itself by other means, and that's where economic flexibility comes into play.

Mundell argues that having a sound monetary policy is of vital importance, and that economic benefits will follow if only there's stable money. In fact, he takes the argument to its logical conclusion and advocates having a world currency. The larger an area a currency covers, the greater the stability will be. Mundell does say he does not advocate a single world currency, but just a world currency; the difference though seems to be semantic rather than substantive. He says:

My ideal and equilibrium solution would be a world currency (but not single world currency) in which each country would produce its own unit that exchanges at par with the world unit. We could call it the international dollar or, to avoid the parochial national connotation, the intor, contraction of “international” and the French word for gold. Everything would be priced in terms of intors, and a committee—in my view, say, open market committee designated by the Board of Governors of the International Monetary Fund—would determine how many intors produced each year would be consistent with price stability. Every country would its currency to the intor following currency-board system principles.

This is different from having a single world currency only in that it retains the option of re-floating national currencies, which would be harder if they were abolished altogether. And the practical difficulties are enormous too, as its ultimate viability would depend on the proposed "G3 Open Market Committee" being able to determine the right amount of intors to issue. In effect, this creates a single fiat currency for the whole world. I get nervous with three fiat currencies being dominant. The art of central banking has not evolved to the point where one would wish to bet the world's economic future on central bankers getting it right.

Friedman argues for flexible exchange rates, arguing that they provide an important escape valve for the adjustment of prices within an economy. Mundell counters that the same adjustment can take place by changing domestic price levels, and that it can be done more effectively that way. In theory, Mundell is right, but in practice it does not work that way, and this is what Friedman argues too. The case of Argentina is instructive in this regard, as it had a fairly orthodox currency board which ultimately failed. The discussion between Friedman and Mundell took place before the Argentinian currency board collapsed in late 2001, so there are no port-mortems of this event, nor do they spend much time discussion the Argentinian situation.

By tying the peso at parity to the US dollar, Argentina did get the immediate benefit of vastly improved monetary policy in 1991, just as Mundell argues. It also introduced thitherto unheard-of macroeconomic stability, and the Argentinian economy prospered. But Argentina was pricing itself slowly out of the market by maintaining convertibility with the dollar. It simply wasn't producing enough economic added value to justify charging the prices in a convertible peso, nor did it have the productivity gains that would allow the economy to remain competitive internationally. The 2001 collapse in Argentina came after Brazil had unpegged the real from the dollar in 1999, which added to the competitive pressures on Argentina. At this point, Argentina had the choice of adjusting its domestic price level downward, or achieve a similar result by devaluing the peso and thus breaking the currency board. In a very messy process that exacerbated the outcome manifold, it ultimately defaulted on its debt and devalued the peso. It sank from parity with the dollar to 4, essentially wiping out 75% of Argentina's wealth if measured in dollars.

The key again is economic flexibility here. Had Argentina possessed an economy flexible enough to adapt quickly to competitive pressures by improving productivity and reducing the domestic price level, it would have been able to keep the peso convertible to the dollar at parity. Looking at a single dimension of productivity, it might have had to reduce aggregate labor costs by, say, 25% in the mid-1990s. Firing 25% of all workers is one way of doing that, or by all workers taking a 25% pay cut. Neither is very appealing.

One of the architects of the Argentinian currency board, Steve Hanke, defended the currency board against the critics (such as Paul Krugman):

And how did the Argentine economy fare during the Menem decade? As Table 1 shows, Argentina responded with a growth spurt that left its neighbours in the dust. All this is not an anomaly. Since 1950, countries with currency boards have realized average GDP growth per capita that is 54% higher than comparable countries that had central banks with discretionary monetary powers.

This is not to say that a sound currency is everything. Indeed, Argentina desperately needs a good dose of supply-side economics. Unemployment is high because labour market regulations are burdensome and taxes are too high and complex. Bring on deregulation and a flat tax. Clone Hong Kong, please. And that's not all. The government apparatus needs a complete overhaul. The only way to attack the endemic corruption spawned by the state is to shrink it. Those reforms, on top of its sound money, would put Argentina back on a high-growth track.

The table at the bottom of his article shows that Argentina's economy grew by 230% in the years 1989-1999 in US dollar terms. The devaluation of the peso (now trading at about 3 to the US dollar) means that all that growth and then some has been wiped out if measured in dollars. In fact, in dollar terms the Argentinian economy contracted about 25% in the period of 1989-2002. Hanke actually sees the seeds of demise for the currency board when he argues for structural reforms. (As an aside, the picture for the Asian economies he mentions would now be different, as some floating-rate countries like South Korea have done pretty well since the crisis of 1997.)

Using the currency board as both the carrot and the stick in Argentina failed to get the necessary structural reforms get implemented. The members of the European Monetary Union are no Argentinas, but there are a number similarities. Structural problems are contributing greatly to the current economic weakness in the entire Eurozone. The problems are the same as in Argentina, although probably not as severe: rigid labor markets and high non-wage costs are preventing European companies from adjusting to the weak global economic environment (and the strong euro too). Mundell's argument is that the single currency will be a driver of reforms, making it more likely that these structural problems will finally get tackled. Are reforms a necessary precursor for monetary union, or is monetary union a catalyst to bring these changes about?

There has been some progress in Europe on structural reforms, but overall far too little has been achieved. While there is a reasonable single market now in goods, the services sector is still highly fragmented. And even the European directives establishing the single market for goods are poorly implemented, with France being one of the biggest offenders. Not very surprising, that. It does show that there is a difference between the Single Market on paper and the reality on the ground. But the intentions here of the EU are good for a change, and Brussels will be trying to create a true single market for services. It's not going to be easy:

A commission report published last year listed 92 barriers encountered by businesses wishing to offer their services in more than one EU country.

The report found problems began with the founding of businesses, which can be hindered by local and national requests for several authorisations.

The distribution of services was also made difficult by laws forcing the provider to have a physical base in the country.

The advertising industry was hampered by a maze of different national regulations.

Belgian electricians have to pay three times the Belgian rate to register with the authorities in neighbouring Luxembourg for a one-day job. And Austrian bakers need eight different licences if they want to set up in Italy.

If the euro is to become successful, it is vital that the internal market be as free as possible. This still does not address the issue of structural reforms within member countries, though. Eurosclerosis is a problem that won't go away easily. Having a true single internal market will make cross-border competition more intense in many more areas than is possible now. This could be one of the great strengths of the European Union, by allowing countries to experiment with their domestic economic policies by competing against one another. Competition is an essential tool in the economic discovery mechanism of what works and what doesn't. But competition is scary to those who like the status quo, and especially those who like the power they wield in their own countries. So plans are afoot to stifle competition between countries, because it's so unfair:

Plans to scrap the national veto on tax to eliminate "unfair" tax competition in Europe will this month be proposed by Valéry Giscard d'Estaing, the man drawing up a new EU treaty.

His plan, designed to stop some EU members poaching inward investment and savings by setting very low tax rates, has the backing of most member states, including France and Germany.

According to aides, Mr Giscard d'Estaing is determined to press the issue, even though Britain and Ireland are opposed to deciding any EU tax issues on the basis of majority voting.

The former French president believes that without reform, the EU's single market will be distorted as countries embark on a damaging race to undercut one another's company tax rates.

It's the same old argument against capitalism and competition, but transported into a different context. It shows that the European elites still don't understand why an economy works and prospers. It's not a new insight, but it's the statists of d'Estaing's ilk who are drawing up the new EU constitution. That does not bode well for the future, but that's not news either.

There is some evidence that the euro has indeed spurred greater economic integration and flexibility in Europe. But this enforced discipline has not extended very far, nor is it making much of a difference in the discussions about structural reforms. My view remains that European Monetary Union is currently doing more harm than good.

Meanwhile, in Latin America, the idea of monetary union seems to be catching on. Brazil and Argentina have floated the idea of moving to a joint currency. Coordinating economic policy is one thing, but moving to a joint currency at this stage seems foolhardy in the extreme. Moreover, one report quotes deputy foreign minister Martin Redrado as saying:

"The currencies are worth almost exactly the same, this is the time,"

Yes, the exchange rate between the real and the peso happens to be close to one at the moment, but that is utterly meaningless. You could multiply either currency's nominal value by a constant and it would not change underlying economic reality one bit. If they're going to base a single Latin American currency on this kind of reasoning, it's doomed before they even start.

Chile and Argentina

There seems to be a war on, but it's largely passed me by. I simply haven't had time to read blogs, watch much news or even read newspapers, so I only have the most cursory knowledge of what is going on with the war, other than that it's not over yet. The reason for all of this is a lot of travel, with my days being crammed with meetings from breakfast till dinner, and even on the weekends my time has been seriously limited. Hence the limited blogging. I should be back in Amsterdam in a week's time, after which normal blogging is likely to resume.

Meanwhile, a canceled meeting has left me with some time to catch up on my work email (866 unread messages), and now I even have a bit of time to write this, sitting in the lobby of my hotel in Buenos Aires. I'll be flying to Sao Paulo later today, so that's where I'll be posting this from if all goes well. My two experiences with Latin America thus far have been fascinating in their contrast. The sheer difference between the drive into town from the airport into Santiago de Chile and Buenos Aires is remarkable. In Santiago, there's a crowded road that passes scrapheaps (sometimes with people living in them) and shiny new office buildings, leading onto jammed winding highway that goes over hills into Santiago. Coming out of Buenos Aires Ezeiza airport the contrast couldn't be bigger: a gleaming six-lane highway, that could have been lifted straight out of Germany. It spills out onto the wide and spacious avenues of Buenos Aires, including the 9. de Julio, the widest avenue in the world (or so the Argentinians claim). Santiago is a town that started small and has been growing into a big town, with all the concomitant problems. They're currently building a highway under the river that flows through town in an effort to fix the traffic problems at least partially. Buenos Aires has the feel of an imperial city, planned to be big, and planned to impress. The rich 19th century architecture fits in perfectly with the idea of wide avenues and luscious parks.

Looks deceive in this case. Santiago is the more dynamic city in the country with an economy that actually works, whereas Buenos Aires is suffused with a wistful yearning for past glory and still hurting from the wounds of the devaluation that was forced on the Argentine economy. After a very promising start in the 1990s with macroeconomic reforms, the government never quite got its act together on the fiscal side as especially the provinces continued to be profligate in their spending. The peg which had kept the peso at 1:1 convertibility with the US dollar had to be let go, and it's amazing that it survived for as long as it had. The peso was horrendously overvalued at $1, and the economy was simply not producing enough economic added value to justify that exchange rate. Meanwhile, the inflexible labor markets and somnolent corporate management never made the adjustments necessary to maintain competitiveness in the face of the strong peso. Put simply, the price level in Argentina was too high, and deflation was the alternative to devaluation. But cutting wages was politically impossible, so in the end it was the devaluation which achieved essentially the same effect, reducing Argentina's labor costs dramatically. It also resulted in a massive impoverishment of the country as suddenly the value of all peso assets was reduced to a quarter of what it had been previously. Then again, the underlying value of assets in Argentina should not have been as high as it had been in dollar terms anyway. The ridiculous price levels still have their repercussions today, although at 3 pesos to the dollar it's becoming affordable for foreigners with hard currency. But restaurant and hotel prices were pre-devaluation on a par with London or Tokyo, and that was completely unreasonable.

It shows the danger of relying on a pegged currency to conjure up macroeconomic stability. It can work, but it requires a flexible and open economy to survive. The exchange rate is the external price of the currency, and as a price it is subject to supply and demand pressures. Changing prices convey economic information, and if you take away the flexibility to convey economic information through the exchange rate, it will find other avenues to assert itself. The underlying economic information is still there and fixing the exchange rate does not make it go away. A currency peg can work if the economy is flexible enough to respond to economic information in other ways, for instance by lowering the domestic price level. But that is painful to the people, who don't like seeing their wages cut and their house prices drop. A weaker currency does the same thing, but it feels very different. Hong Kong, which has its currency pegged to the US dollar too, is experiencing deflation and as a result the price level in Hong Kong is declining. But Hong Kong is able to respond more flexible than Argentina ever could.

It is sad to see how a once-great country and economy has fallen so far. At the beginning of the 20th century, Argentina was one of the ten richest nations in the world, and the lavish architecture from those days still reminds the current generation of the former glory. As one Argentinian told me, "all the nice things you see were built by our grandfathers, and we have been destroying them ever since." A sense of despairing, fatalistic hopelessness lurks in the background here, but there is also a worrying sense of entitlement, the sense that Argentina deserves better. It would certainly deserve better, but it won't get there without doing something to get it. Magic solutions are not going to fall out of the sky. Coming to terms with former glory is a hard thing to do, and current-day Argentina still hasn't entirely vanquished the ghosts of its own past.

Chile is doing much better. It's not as flamboyant as Argentina, the people are more conservative and scared as hell about the instability in Argentina and Brazil. The Chilean economy has been plodding along without major mishaps for a long time now, and is slowly moving away from its dependence on copper. It's attracting investment from Australia and Asia as a manufacturing base for shipping exports into the Americas. It has reasonably well-developed capital markets and a fully funded pension system (which will be the topic of a future blog entry). There's also an inflation-protected accounting unit, called the UF. Chilean bonds are quoted in UF, and other prices, such as rents, are also expressed in UF, making it almost a parallel currency (more on this later). One question that many Chileans had as the war was starting was about the relationship with the US. The Chilean president had spoken out against the allied military action in Iraq, and Chileans wondered how that would impact US relations. The people I spoke to were unhappy with their government's stance, but then again, these people were not a representative cross-section of the population. Being there on business, I generally avoided commenting too much on the war other than in generic terms, but some of my interlocutors did express their distaste for France, which I found interesting.

Argentina is the flamboyant and overconfident member of the Latin American family. Its little brother Chile is far less conspicuous, but has plodded along calmly without pretension to build a surprisingly solid economy. The price level in Chile is far more appropriate to an economy that's still not quite fully developed, certainly compared to prices in Argentina. The wines in both Chile and Argentina are pretty good, although I still have to give the edge to the Chileans. A big discovery was also the national drink in Chile, Pisco Sour. It's somewhat like alcoholic lemonade, although that description does not do it justice. I wish they would export it, as I never had the time to buy Pisco Sour while in Chile. As it was, I almost missed my flight to Buenos Aires.

It is time to leave for my final meeting in Argentina; more blogging perhaps over the course of the weekend, which I'll spending in Rio (without too many meetings I hope).

From slum-dweller to citizen

In the rocky and uneven path to globalization, it is usually the macroeconomic reforms that take center stage. Privatization and liberalization are big and easy concepts to grasp, even if their implementation leaves much to be desired. Fixing the macroeconomic framework is a necessary, but not sufficient condition for generating economic growth and prosperity. The macro-level reforms need to be complemented by progress on the micro-level. Building the grass-roots structures that establish civil society and a productive economy are just as important, but often neglected. That's why it's good to see stories like this one about how the slums of Rio de Janeiro are turned into neighborhoods with paved streets, sewage systems, gas and electricity. The favelas of Rio de Janeiro are the archetypal third-world slums, huge expanses of rickety shacks built on muddy ground on the outskirts of the Big Town. Impoverished rural populations come to see work and riches, and end up scraping together a meager existence on the perimeter of society. Past attempts to "solve" the problems of the slums usually involved building enormous expanses of pre-fab housing and resettling the population there. This never worked. Now they're trying a new approach, in which the city is providing the slums with the amenities of civilization, such as roads, sewage and electricity. The most important aspect is that the slum-dwellers get legal title to their shacks. They move from being illegal squatters to home-owners. The recognizes de iure the ownership that had been established de facto. The effects of this transformation are dramatic, as the article explains:

The noise of children at play resounds from a new, two-story building; anyone who wishes, may enroll a baby or young child at the child care center. The streets are clean, with the La Grota Residents' Association organizing garbage disposal itself. A small wooden sign reminds residents: "Não jogue lixo" (Don't litter). A couple of men sit out in front of a small bar, playing cards; next door, a small shop has opened for business. On a front lawn, seedlings lovingly planted in old plastic containers are sprouting despite the searing sunshine. A woman has nailed a tin sign to her house: "Faço concertos em roupas" (Clothing repaired here).

[...]And being listed in the land register, which turns the tiny plot of land each of the residents once illegally occupied into their legally owned property, lifts them out of the state of illegality. As a favela develops into a residential neighborhood, each "favelado" develops into a citizen.

As the infrastructure expands, says Sandra Miguel Nogueira, president of the La Grota Residents' Association, the social structure slowly grows stronger. She points out that the small community building on the new village square, for example, was built by the residents themselves. The city did not need to contribute even a centavo. Ms. Nogueira's modest office, with just a wooden table and a folding chair, is in the building's lower floor. At their last meeting, the residents decided that a small medical practice is to be established on the upper floor. And at its next meeting, the Residents' Association will pick names for the new streets.

This kind of scheme has Hernando de Soto's fingerprints all over it even though he's not mentioned anywhere in the article. Lifting people out of illegality and giving them a stake in society is the theme of his book The Mystery of Capital, which has the subtitle "Why Capitalism Triumphs in the West but Fails Everywhere Else." You can read the first chapter of his book online at the website of his organization, the Institute for Liberty and Democracy in Peru. The insight de Soto offers in the book is that the reason why capitalism fails in the third world is because the poor are shut out of the legal property system. The poor aren't completely destitute, for they possess their shacks and some items, such as TV sets. But the property they de facto own is dead capital, as they have no legal title to their dwellings or anything else. Unlocking this dead capital, by giving the people legally what's already theirs in practical terms, opens up new possibilities for them. Once you have clear title to a piece of land, you can sell it or use it as collateral. Dead capital becomes productive capital. People don't want to live and work illegally, but often the costs of going legal are prohibitive. In his book, de Soto chronicles the steps necessary to formalize a legally obtained home in Peru. It consists of 5 stages, with stage 1 alone taking 207 steps (bigger version). There are similar graphs in his book about formalizing informal urban property in the Phillipines (168 steps, 13 to 25 years), procedure for gaining access to desert land for building purposes in Egypt (77 steps involving 31 entities) and obtaining a sales contract in Haiti (111 steps, 4,112 days).

So even if people wanted to "go legal," the obstacles are insurmountable to all but the most determined. The process advocated by de Soto of legalizing already existing extralegal ownership claims turns out to have ample precedent in the west too. We now only see the end result of the long historical process of assigning property rights in the west with little memory of what happened a century or two ago. For instance, de Soto describes how land in the Great Plains entered into formal possession of the pioneers who ventured West. The Homestead Act of 1862 was mostly a post-facto acknowledgment of what was going on on the ground anyway. Likewise, the California Gold Rush also led to grass-roots delineation of claims once the number of prospectors rose dramatically. Again the law of the land came later, fixing into law what had been practiced on the ground. De Soto advocates exactly this kind of process for bringing the third world economies into the capitalist system, in order that at the grass roots level people be given the opportunity to move from extralegality into the formal system of property rights and ownership.

The biggest resistance to this comes from the established elites in third world countries. After all, they're living very comfortably under the current system, and tearing down arcane laws and bureaucracy not only endangers their jobs, but it also extends the imprimatur of respectability onto the unwashed masses. Trusting the people is a hard thing to do, which is why I am skeptical that de Soto's program will be implemented by all those leaders who praise it. But projects such as this one in Rio de Janeiro show that de Soto's ideas can be implemented, and can be succesful. More importantly, de Soto offers a vision that provides a powerful alternative to socialists. By stressing private property and private enterprise, it builds on the existing extralegal structures that exist in the slums anyway. It is no surprise that the ILD become of the main targets of Sendero Luminoso, the Maoist terrorists who tried to bomb Peru back into the stone age in the early 1990's.

Seeing De Soto's ideas applied successfully is gratifying. Theory and ideas can take you only so far before the pudding must be cooked and tasted. Now we need more cooks who're willing to try de Soto's recipe.