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Can labour markets be too flexible?

Can labour markets be too flexible?

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Krugman has an interesting article in the New York Times. In it he suggests that when interest rates are at the zero lower bound and therefore (in an economy where physical cash is still important) unable to fall further, there is effectively no floor to aggregate demand. Here are his charts showing the difference between an economy where interest rates can fall and one where they can't.

Classical AS/AD model.

LRAS = long-run aggregate supply

SRAS = short-run aggregate supply

AD = Aggregate demand

The classic short-runlong-run picture

Krugman explains this chart as follows:

"Suppose aggregate demand falls for some reason, say a global financial crisis. Then what the textbook says happens is illustrated by the red arrows. First the economy contracts, then, over time, it expands again as prices fall. And this leads to the notion that demand-side stories are all bound up with the assumption of price stickiness......... you should think though the mechanism by which flexible prices supposedly restore full employment. In the picture I just drew, the answer is that you slide down the AD curve. But why is the AD curve downward-sloping? Any plausible story runs through interest rates: either you have a fixed nominal money supply, so a rise in the real money supply drives rates down; or you have in mind some kind of stabilizing policy by the central bank."

So either you have an automatically-stabilizing currency system*, or you have an activist central bank.

Classical AS-AD model with interest rates at the zero lower bound.


AS-AD with the ZLB

Krugman again:

 "Falling prices can’t reduce interest rates, so it’s hard to see why the AD curve should slope down....and in fact, because falling prices worsen the real burden of debt, it’s a good bet that the AD curve slopes the “wrong” way. "

For non-wonks, that means if real interest rates are too high and are unable to fall, falling prices and wages drive the economy into depression. Let me explain what that means in relation to the Eurozone periphery.

In most advanced economies, central banks have been using unconventional monetary tools such as QE to depress real interest rates. The jury is out on how effective these tools are at achieving that, but it is fair to say that countries such as the US and UK have not experienced the disastrous economic collapse that the Eurozone periphery countries are currently going through.

In contrast, the ECB has not eased monetary conditions for the distressed periphery countries. In fact it is currently tightening them as LTROs are repaid. The difference in real interest rates between core and periphery is substantial, and this has a direct bearing on the cost of finance for businesses, individuals and governments alike in periphery countries. Put bluntly, the periphery countries are experiencing a credit crunch - the cost of debt is very high relative to real incomes. The ECB claims that it can do nothing more to ease this situation.

Krugman's model assumes that real interest rates can't fall because of the zero lower bound. But in the Eurozone periphery, real interest rates are nowhere near the zero lower bound. They have considerable room to fall, but don't do so because of market perception of risk, a dysfunctional banking system, and ECB ineffectiveness. If the Eurozone periphery countries had their own currencies, we would expect their central banks to put downwards pressure on real interest rates by a variety of means including cutting reference rates, asset purchases and outright currency devaluation. But they can't do so because they are using the Euro. The ECB's refinance and deposit rates are already very low - the deposit rate is zero - so to ease further would require ECB asset purchases. There has been some discussion about whether the ECB should cut refi and depo rates further and/or do QE: but indiscriminate QE would also cut real interest rates in core countries, where they are already very low. What is really needed is bond purchases targeted at economies where real interest rates are too high - and that means OMT. OMT has extremely tight fiscal conditions attached to it, which is why it has never been used. But a central bank has no business dictating fiscal terms to sovereign governments. The job of a central bank is to support aggregate demand in the countries that use the currency that it issues. The ECB is using failure to comply with fiscal conditions as a reason not to support aggregate demand. Frankly that is disgraceful. The ECB is not acting as a central bank should.

So to adjust Krugman's model, there is effectively no floor to aggregate demand if real interest rates cannot fall, regardless of whether or not they are at the zero lower bound. If the central bank is ineffective, markets pessimistic and banks dysfunctional then interest rates will remain too high, aggregate demand will continue to fall and the economy will fail to recover - a self-reinforcing depression loop.

That's bad enough. Now add to the mix the structural reforms being imposed on Eurozone periphery countries to improve the flexibility of their labour markets.

The effect of structural rigidities in labour markets is to prevent wages and employment adjusting to economic conditions. On the face of it, therefore, structural reforms aimed at removing these rigidities should be a good thing. After all, in the classical model (the first of Krugman's charts), if wages and employment can adjust downwards, that enables prices to adjust downwards too as business costs fall, and once prices fall to levels that people are prepared to pay, then demand will rise and the economy will start to recover. But in the second of Krugman's charts, there is no price level at which demand starts to rise. And if real interest rates can't fall - as appears to be the case in the Eurozone periphery - then the second chart applies. In which case structural reforms to improve labour market flexibility will make matters worse, not better, because by encouraging wages to fall and unemployment to rise, they increase the pace at which aggregate demand falls. As Krugman puts it (my emphasis):

"In this context price flexibility doesn’t lead to full employment. In fact, the more flexible prices are, the worse the economic contraction."

Structural rigidities, although they distort labour markets, at least put a floor under wages and employment, and therefore support aggregate demand. In the absence of other forms of support for real incomes, removing them means that the economy cannot recover. Prices and wages will continue to fall. The slump is never-ending.

There is, of course, a "get-out" clause - and it is this that the Eurozone paymasters have been relying on. That is the role of exports. The theory is that if a country can cut its production costs enough, it will compete effectively against other, more expensive economies for exports, and its economy will recover as exports rise - an "export-led" recovery. And when the world is reasonably balanced between imports and exports, it is indeed possible for individual countries to bootstrap their recovery off others in this way, as Germany did after reunification. But that's not the case at the moment. Most countries are trying to reduce imports and increase exports. And that makes export-led recovery virtually impossible. It's the fallacy of composition: when everyone is trying to increase exports and cut imports, no-one can. Sure, the Eurozone periphery economies have shown considerable improvement in trade balance, and some are even running surpluses. But if the entire world moves to tighten imports, this improvement cannot continue. And even in the present climate it is highly unlikely to compensate for continuing collapse in domestic demand due to tight money and fiscal contraction.

Recently, perhaps recognising that export-led recovery is looking less likely, Eurozone leaders have adopted a different strategy. They are encouraging migration from periphery countries. Now, if you have a product that is in demand internationally, but of which you have an excess supply, then exporting it should be a good way of rescuing your economy, especially if warehousing that excess supply is expensive. Eurozone periphery economies currently have an excess of labour, particularly young people. When there is little international or domestic demand for domestically produced goods & services (so unemployment is high), but there is international demand for cheap labour, people will move. Indeed they are already doing so. So the theory is that migration should eventually enable Eurozone periphery economies to recover, as labour supply falls to the point where it meets demand and wages stabilise. But it's not that simple. Aggregate demand depends on people. When the population falls, unless real incomes rise, domestic aggregate demand also falls. Unless people who migrate send substantial amounts of money back to support those left behind, exporting labour will only make the economic problems of the Eurozone periphery worse.

And so, to answer the question I asked in the title to this post. Can labour markets be too flexible? The answer is yes, under some circumstances. When real interest rates are unable to fall and the fiscal stance is unsupportive, flexible labour markets make depression worse. However, this is not really an argument for maintaining structural labour market rigidities over the longer term. As I noted above, they distort labour markets - typically making employment prospects worse for young people, which amounts to mortgaging the future to support the present. Rather, it is an argument that reforming labour markets is the wrong thing to do when wages and prices are collapsing, unemployment is rising and real interest rates are too high. The priority is to support aggregate demand so the economy can recover: whether this is by monetary or fiscal means is frankly irrelevant, although personally I am in favour of both. Labour market reforms can, and should, wait for better times.


Related links:

Models and mechanisms (wonkish) - Paul Krugman (NYT)

The movement of people (and its consequences) - Coppola Comment

The zero-sum trade in people - Coppola Comment

Unfortunately, monetary policy is now ineffective in the Eurozone - Flash Economics (Nataxis)


* Many people will immediately think of the classical gold standard as a self-balancing currency system. But it was never really self-balancing. In "Golden Fetters", Eichengreen showed that in fact it depended on the active cooperation of governments and banks (including central banks where they existed) to maintain it. The role of the banking system in balancing the economic cycle is much misunderstood.


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Thanks for the response Frances.

YOU SAID: I don't accept your argument ... to clear out all the older people with poor skills and replace them with bright talented youngsters.

- first that is not my argument. I am saying companies need labour flexibility to make it easier for them to lay off people who lack the skills to support a restructured business model and, in their stead, employ people who do. It is just common sense to me that any organisation or body has a better chance of success if it has the best people. Yes, laying people off is not nice, but nor is denying people the opportunity of a job. Yes, there is a correlation between age and lack of skills, and yes it may be unpalatable, but that does not mean we can just pretend that it doesn't exist - the fact is that in Southern Europe, older employees are more likely to lack education and skills and are the best protected in their jobs by legislation and the most expensive to lay off.

I am not calling for a campaign of mass redundancies which target old people. I am saying let's recognise the mismatch of skills, lets recognise what the obstacles are that prohibit companies from addressing this mismatch and let's find a more economically constructive balance where the opportunity to be employed has more basis on qualification and merit and is based less on length of service and incumbency. Let's just level the currently very biased playing field.

YOU SAID: older people are more likely to have dependent children (so are more important for demand)

- true, but younger people are more likely to start families, spend money, buy houses, start businesses. You are ignoring the impact on demand of having a generation of 20-30 something sitting at home doing nothing. Indeed youth unemployment is a bit of myth. Jobless under 25s make good headlines, but it is a crisis that is creeping up through the age groups - I don't see a youth unemployment problem but a problem for people under 30-35 and rising, while for people in their 50s absolute employment has risen (Spain, Portugal and falling only very slightly in Greece). I see the employment situation in S. Europe like a lake in a drought with the young at the edge and the old in the middle -as the lake evaporates (as the recession continues), the water (the jobs) shrinks to the centre and the edge of lake dries out. In Southern Europe, we have basically had 5 years of no recruitment as employers and especially the public sector reduce staff through attrition and hiring freezes. The young unemployed at the start of the crisis are now getting into their 30s, and they still don't have jobs. In Spain you have 2 million people under 40 who've been unemployed for more than a year, half a million unemployed under 40 who have never had a job. These are people who will likely never recover. I don't know how long you think it prudent to delay the reforms necessary to address this situation, but Spain, Portugal etc. are creating huge problems for themselves in the long term, in terms of people not getting married, not having children (Spain - birth rate fallen by 10% since 2009: impact on demand?), people not starting pensions, a stagnant workforce not passing down or refreshing skills. These countries are in decay.

YOU SAID: I think there could be initiatives to offer support for companies that need to retrain staff, particularly to close the gap on IT skills.

-these kinds of initiatives are already there - but they don't work. e.g. In Portugal, employers provide Government approved training by law - but there is so much to be done, and it just doesn't make sense to invest money we don't have training someone 5 years away from retirement to use Email when you've got unemployed 20 year olds who see email as something from the stone age. This is a problem that should have been dealt with years ago. It's just too late now as a solution to the current crisis.

YOU SAID: You seem to think that the problem is entirely supply-side - fix the inefficiencies and aggregate demand will recover.

No - there are problems on both sides - though while you may be able to end the recession by pumping up the demand side, you will not fix the problem sustainably without addressing the supply side. The problem is that by pumping up demand you forgive lack of action on the supply side. These are reforms that Southern Europe will find any excuse not to undertake.

YOU SAID: You make no mention of the extremely tight credit conditions for SMEs in the Eurozone periphery

Would you lend money to a Spanish construction company or to a Greek retailer? While there is a problem with credit, there is also a problem with unviable business plans. As I did in fact say "If you want banks to lend to SMEs - first allow SMEs to adopt business models that banks can have confidence lending to". I should also mention that just the EIB has made 20 billion euros available to Italy and Spain alone for SME credit lines since 2010. Where has that money gone? Meanwhile in Spain we see state SME lending schemes reporting repayment arrears reaching 32% in some recently constituted credit lines.

YOU SAID: at the moment, implementing those reforms would make the situation worse

I get what you are saying about tight monetary policy and fragile demand - I am not questioning your theory. What I am saying is that labour reforms cannot wait. If you are right in your theory, then it is not the reforms that are wrong, but the policy that is preventing them that is wrong.

So let me suggest a compromise - don't ask: Can labour markets be too flexible?, ask what can be done to make labour reforms possible? Because Labour market reforms absolutely cannot wait.

First, let's do away with this vindictive and superficial austerity - I see no problem in short-term deficit increases (though not just for the sake of stimulus) provided that real things are being done "under the bonnet" to reduce structural deficits and to improve public and private sector efficiency and quality over the medium term. That, at least in part, addresses some of your justified concerns about demand. And yes, support aggregate demand, but target it to mitigate the pain of structural reform or to incentivise structural reform. Do it together, in tandem, not one after another - i.e. facilitate early retirement, help companies with redundancy costs (perhaps, as a compromise, based on a "one out / one in" scheme), yes, ensure that companies which somehow do find opportunities are able to borrow at reasonable rates, reduce social security charges, help people who want to move house, finance training even or provide extra help for the unemployed - especially those who have zero state assistance. There are thousand ways support can be provided, but fix things structurally too.

I will end (while wondering quite unconfidently if you have got this far) by reiterating the political reality in Southern Europe as I see it- the fact that we agree that labour reform is necessary, actually puts us on the same side and puts us at odds with prevailing opinion in Southern Europe. Not a fraction of what I would like to see or what you are arguing against is ever going to be implemented, especially if things do start looking less dire and especially not in the short-term, making our argument over timing somewhat irrelevant. As I said in my first response, there is such a lot of work to be done - I suspect that even the reforms you would like to see, but delayed as you argue, would take such a long time to be implemented, that in fact, if you were to agree with me and say they should be implemented now, it may just turn out that execution takes place on the delayed time-scale that you are suggesting (in a best case scenario).

Frances,

Some more ideas - at least that’s what I like to call them…

There are two ENTIRELY separate phenomena here. First, there is the fact that falling prices probably have the “debt deflation” effect to which you and Krugman refer (although that effect might be ameliorated or not materialise at all if debtors or potential debtors were in a boyant mood and were HAPPY to incur more debt). Second, there is the fact that falling prices in the periphery improves periphery competitiveness.

The big question is: which effect predominates? The optimistic argument is my earlier argument, namely that the debt deflation effect is temporary, whereas the improved competitiveness effect is permanent. Ergo falling prices will ultimately solves the problem. (And I’m not suggesting that competitiveness convergence of itself raises demand – only the ECB can do that).

The pessimistic argument is that the debt deflation effect predominates, and scuppers a country before the beneficial effect of improved competitiveness kick in. Moreover, refusing to accept falling prices is not a solution to that problem because the refusal to accept or go along with falling prices means competitiveness won’t improve (unless the country concerned can implement improved competitiveness by some other means – improved education or whatever. But I think that’s unrealistic).

And to make matters worse, as I pointed out earlier, prices in the periphery are not even falling all that much relative to the core. So the above argument is a bit theoretical. Ergo the outlook for the periphery is bleak.

Frances Coppola

WEAYL

I don't accept your argument that the solution for the Eurozone periphery is to clear out all the older people with poor skills and replace them with bright talented youngsters. Replacing one set of workers with another may improve supply, but it does absolutely nothing for aggregate demand. In fact as older people are more likely to have dependent children, throwing them out of work has social costs that make the burden on the state greater and reduce aggregate demand further. We've tried this in the UK: in the 1980s and 90s we shunted a lot of people with poor skills out of employment by misusing disability benefits. Now we are desperately trying to cut the cost of maintaining these people long-term at the state's expense.

If businesses have staff whose skills are out-of-date they need to train them, not dismiss them. I think there could be initiatives to offer support for companies that need to retrain staff, particularly to close the gap on IT skills.

It all boils down to whether you think the main problem in the Eurozone periphery is lack of aggregate demand or supply-side inefficiencies. You seem to think that the problem is entirely supply-side - fix the inefficiencies and aggregate demand will recover. The point that Krugman was making, and that I have extended to apply to the particular circumstances of the Eurozone, is that aggregate demand cannot recover regardless of what is done on the supply side if monetary and fiscal policy are both too tight. Hence my castigation of the ECB for its ineffectiveness (and I agree with you about the pointless and painful austerity, too).

The argument in the post - and I have repeated it in the first paragraph of this comment - is that labour market reforms when both monetary and fiscal policy are too tight can actually make aggregate demand fall even more. The supply side inevitably shrinks if aggregate demand is unable to recover. We would normally expect that labour market reforms might cause a temporary fall in aggregate demand which would recover as the supply-side improved. But in the particular circumstances of the Eurozone periphery, the fall isn't temporary. It's a vicious deflationary spiral where falling wages and unemployment depress spending power, which depresses the incomes of companies, forcing them to cut wages more and lay off more staff. Flexible labour markets actually make this worse.

I do agree that reforms are necessary. Indeed I said that in the post. But at the moment, implementing those reforms would make the situation worse. I know it sounds perverse, but with things as they are, allowing companies to "restructure staff" may actually drive them out of business.

You make no mention of the extremely tight credit conditions for SMEs in the Eurozone periphery, caused by the ECB's tight monetary stance and the dreadful state of the European banking system. But to me this is a much bigger issue and urgently needs fixing. If SMEs can't get finance at sensible interest rates, the supply-side is in big trouble and no amount of labour market reform is going to improve it.

Your reasoning, theoretically sound as it may be, misses the point of why labour flexibility in Southern Europe is so important and why persistent labour rigidity is so harmful. Labour rigidity is preventing employers from adapting to new economic realities. Rigidity is not harming big companies which can afford redundancy payouts (especially in terms of cash-flow) and which can make use of natural attrition to restructure staff - but crucially it is harming 1. small companies and 2. the yet more rigid public sector.

The burden of redundancy payments means many smaller companies in Southern Europe cannot afford to cut staff (and especially often cannot afford to cut the right staff), they delay and procrastinate, while their businesses slowly decay. You call it putting "a floor under wages and employment" - but someone has to pay the bill. And in the end, when companies inevitably close, jobs disappear regardless.

The crisis in demand is not just a vertical drop, as would give basis to your assertions, but also a horizontal shift between sectors. Even in Greece, there are still some people spending money and there are still sectors with opportunities. Recovery will come in part from companies being able to give up on declining sectors and focus their efforts on emerging sectors. Maintaining labour rigidity hampers that natural process and so hampers recovery.

Meanwhile, labour rigidity, and the consequent catch 22 of "can't afford to close, can't afford to carry on", drives many SMEs in distress to irrational behaviour, weakening eventual survivors by exposing them to artificial and distortive competition. At worst, labour rigidity encourages law breaking and exploitation (as is most evident in Greece): wages not being paid, taxes not being declared - all of which contributes to no recovery. And would you lend to a company that is being suffocated by the costs of paying staff it cannot use? If you want banks to lend to SMEs - first allow SMEs to adopt business models that banks can have confidence lending to.

Then there is the unpalatable question of skills. In Southern Europe, a significant number of people that are in employment, and are most protected in employment, lack skills and education - while young talent is left unemployed or emigrates.

It is tragic, but in countries such as Portugal and Spain, there is an undeniable correlation between lack of skills and age, and it is brutal, especially away from big cities and middle class (a natural consequence of appalling Southern European education in the 1970s and a failure by successive Governments, employers and employees themselves to rectify the damage). This also means a correlation between lack of skills and length of service (and therefore redundancy costs and contract rigidity).

For example, in Greece, only 12% of people aged 55-64 have ever sent an email with attachments (Eurostat 2011); 70% of Portuguese workers (active population) in their 50s have no more than basic primary or lower secondary education vs. less than 40% of people in their 20s; yet people in their 50s enjoy much higher rates of employment. Employment rigidity, that tends to make older staff significantly more expensive to lay off, is, like it or not, forcing companies to maintain lower skilled and less educated staff who are less acquainted with new technologies. In the public sector, where blanket hiring freezes have been imposed and where potentially transformative developments in e-government have inevitably led to changing demands in terms of staff skills, the problem is perhaps yet more acute - for instance in Portugal, 27% of all public sector employees have primary education only. Labour rigidity is maintaining ill-equipped staff in place, while keeping talent on the streets.

I do not say that it is right to discard people. But nor is it right to jeopardise the whole economy to protect an arbitrarily select group of people - the tragic policy errors that led to this situation are in the past and appear irredeemable. Unpalatable as the concept may be, an aging and relatively unskilled workforce that is out of touch with modern technology and working practices is not conducive to recovery and reform; such a workforce is not helping Southern European companies compete and grow, and is not helping the public sector engage in the reforms that are so necessary. Labour rigidity is excluding the new ideas, enthusiasm and risk-taking of youth from the economy. And while big companies may have the resources (and expertise) to retrain, public sector and SMEs do not.

While, based on a graph, it may appear logical to say that now is not theoretically the right time for labour reform, on the ground Southern Europe's companies and its public sector is screaming out for flexibility, not as a means of reducing wages, but as an opportunity to adapt, reform and engage the future - and not selective, discriminate reform, as we have seen previously in Spain and Portugal, creating different tiers of contract and employee status (or effectively an employee underclass and caste system) but an across-the-board simplification of rules and a blanket reduction in costs of hiring, firing and maintaining staff.
Maintaining labour rigidity, as you are calling for, pending some magical economic alignment, will continue to decimate companies and their ability to compete and grow, and more alarmingly, will continue to decimate a generation that is not just unemployed but becoming unemployable - creating a workforce that is unfit to face the future and a section population that, regardless of merit, has been arbitrarily barred from opportunity - in Spain, you already have over 2 million people unemployed for more than two years.
The labour rigidity you want to preserve is preventing unhealthy companies from self-healing and preventing the public sector from reforming and leveraging the efficiencies of technology and the skills and fresh thinking of the young; it is creating zombies, forcing irrational and disruptive behaviour - it is condemning the economy to a slow death and forestalling the natural processes of recovery.
And yet - despite all these arguments, I will end by conceding to you. It is an argument that you have won. There is no interest in Southern Europe in implementing the reforms that are needed (not urgently, not over the long-term). Indeed, political credibility and goodwill is so desperately weak after so much pointless austerity and fudging, and the economy so desperately fragile, the optimal time to start has passed, while conversely, economic recovery will lessen what political appetite there is to confront the "acquired rights" and "dignities" that labour rigidities protect or to question the system that enshrines them. The pressure will be lifted and what little sense of urgency there is will evaporate.
If, as you say, you do not support maintaining structural labour market rigidities and you do support reform over the long-medium term then it is important to understand how much work that involves and how much time it will take, to understand the impenetrable cultural shift it will entail. The trick is not timing, but getting reform started at all - so that purposefully delaying reforms is not just senseless, it is reckless.

re debtors and creditors. If a debtor has a term bound debt of 20 years at 0% interest then he/she has to pay back in 20 years, but until then has no interest payments and thus no problems.
Almost any normal human would accept a large loan to be paid back in 20 years time - might be dead by then.

Re the “inane drivel currently emanating from the IMF..” to which I referred earlier, I put the wrong link in. It should have been:

http://bilbo.economicoutlook.net/blog/?p=24922

1) I would like to see some empirical data showing how AD is reduced by a flexible workforce as Paul K and Frances C both agree. My intuitive feeling is "perhaps, but not much change in AD in practice would be down to emigration in many countries"

2) It pays to hold onto to cash at the ZLB/deflation and buy when things are cheaper. A negative interest rate is supposed to rebalance it out, but its not allowed by CBs, so it can just get worse.

Play around with unemployment rates for empirical ideas here: (its not an Ad!) http://www.tradingeconomics.com/italy/unemployment-rate

Frances Coppola

Sorry, that should be "wages are FALLING", of course.

Frances Coppola

Ralph,

We've crossed swords before over your idea that forcing down wages and prices in the periphery will eventually bring them to a point where the market clears and demand starts to rise. The whole point of this post is that when real interest rates are too high and unable to fall because of tight monetary policy and an inflexible currency, there is no point at which the market clears: prices and wages carry on falling and competitiveness is never restored. That's what Krugman's chart shows and that is what I have argued in previous posts.

To take some of your points in order.

- The ECB is the central bank of the entire Eurozone. Its job is to support aggregate demand in the entire Eurozone, not in selected bits of it. It is not the job of a central bank to dictate or interfere in fiscal policy. The ECB should do whatever it takes to support aggregate demand in the entire Eurozone, and if that means it buys junk Greek bonds, then so be it. It is simply not acceptable for a central bank to do nothing to support aggregate demand.

- Creditors may be better off, but that does not mean they necessarily spend their earnings. They don't have to, after all. And if they do choose to spend them, they may not spend them in the country where they have lent the money. That's the beauty of a common currency. You can spend your money anywhere without incurring exchange risk.

- A swift glance at the debt metrics in the Eurozone periphery demonstrates quite clearly that deleveraging is not proceeding nearly as smoothly as you seem to think. This is because it is not just prices that are falling, it is real incomes - wages are rising, taxes are rising and benefits are being cut. Cutting real incomes prevents people paying off debt even if prices are falling. It also stops them spending, which clobbers domestic demand, hitting business income. The result is reduced tax revenues, which prevents governments getting their debt under control.

The debt deflation spiral has been well documented. I suggest you read Irving Fisher.

There is another problem with the idea that price flexibility is undesirable, and as follows.

If falling prices do in fact have a deflationary effect because debts in real terms rise, that effect will be TEMPORARY. That is, the effect will be to induce debtors to repay their debts quicker. Once they’ve repaid them, the deflationary effect comes to an end.

(To be wonkish, Steve Keen I think claims that the deflationary or stimulatory effect of debt reductions or increases only comes when there is an ACCELERATION in the rate of debt increase or reduction. And if that’s right, the deflationary effect of a bout of debt repayment would be even shorter than suggested above.)

Anyway…in contrast the above temporary effect, the “internal devaluation” effect of reducing wages and prices in the periphery is PERMANENT. E.g. if country A devalues its currency relative the currencies of countries B,C,D… then the beneficial effect on X’s balance of payments lasts as long as that change in relative currency values lasts.

“The ECB is using failure to comply with fiscal conditions as a reason not to support aggregate demand. Frankly that is disgraceful. The ECB is not acting as a central bank should.” What, so the solution to Greece’s problems is for the ECB to buy yet more dodgy Greek debt? You might as well lend money to a drunk.

The problem with that idea, as every German understands, is that the ECB is a central bank JOINTLY OWNED by Euro countries. If the JOINT central bank prints money and buys debt of just one or a few countries, and that debt is not paid back (which it might well not be), that’s effectively a gift from core countries to the periphery: not something that core countries signed up to when joining the Euro.

As regards Krugman’s claim that falling prices lead to economic “contraction” that’s based on his point that falling prices puts debtors further into debt. But what he fails to mention is that falling prices also make CREDITORS BETTER OFF, and that will tend to INCREASE DEMAND because creditors will spend more. So it’s far from clear as to what the NET EFFECT would be there.

In fact the population’s desired level of indebtedness regularly bobs up and down: e.g. debts rose prior to the crunch, while currently, all and sundry are deleveraging. Thus Krugman’s point is just one of those variables that’s constantly changing: i.e. it’s near irrelevant in the total scheme of things.

And that makes Frances’s claim about labour markets being too flexible look a bit weak.

The CENTRAL PROBLEM in the EZ is the divergence in competitiveness as between core and periphery over the last decade, as explained in these two articles (amongst others).

http://www.invesco.com/pdf/IFICFIM-INSI-1-E.pdf

http://www.worldfinancialreview.com/?p=2303

Once wages and prices (in Euro terms) fall in the periphery, that makes the periphery competitive, which solves the whole problem. Unfortunately, they aren’t doing so to any great extent, as is shown in the first chart at the first above link. Actually there are some even more pessimistic figures on competitiveness convergence here:

http://epp.eurostat.ec.europa.eu/portal/page/portal/exchange_rates/data/main_tables


On that basis, austerity in the periphery will last another decade, unbeknown to the twits that make up the Euro elite and the IMF.

For details about the utterly inane drivel currently emanating from the IMF on the subject of Greece, see: http://www.worldfinancialreview.com/?p=2303

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