Questions On Whether Internal Devaluation Will Work For Europe

While most people are tuned in to the failure of the ruling coalition in Germany to get their man Christian Wulff elected president, there are other more important numbers out today. Unemployment in Germany fell to 7.5% in the last month. This is one of the best unemployment figures in all of Euroland. The drop owes principally to the falloff in unemployment in the former east Germany where the rate fell to 11.6% from 12.9% in the previous month.

Yet, what you should notice is that the former West Germany has an unemployment rate of 6.5%.

See my post "The Soft Depression in Germany and the Rise of Euro Populism" where I talk about the origins of eastern German unemployment in the botched German currency union of almost twenty years ago. The BBC has a story on eastern Germany from a good five years ago. It’s still a great read today (click here for story). Unemployment is declining in the eastern states, yes. But given the fact that unemployment is still ridiculously high in the former east twenty years later, it makes me sceptical about good outcomes to the Euro crisis which now suffers from the same problems.

Countries like Greece, Spain and Ireland have lost the productivity race over the past decade (see Edward Hugh’s "Chart Wars" for the numbers. They are pretty stark.) With the currency fixed, this means you regain competitiveness through internal devaluation via lower wages, suffer high unemployment or both. But, look at eastern Germany and see what happens in a currency union between two unharmonised economies with very different productivity profiles. In Germany’s case, there have been massive subsidies to mask these problems. In the case of Greece, Spain and Ireland, this will not be the story.

Here’s my question: where does this productivity gap emanate?  Recently, Claus pointed to technology as one determinant. But he believes other factors may be at play.

Technology and productivity are famously assumed exogenous in the Neo-Classical tradition while New Growth theory as it was developed in the 1980s and 1990s emphasised the need to specifically account for the evolution of technology. Today, I would venture the claim that there is a consensus that productivity and technology is a function of what we could call, broadly, institutional quality which encompass almost anything imaginable from basic property rights to the level of entrepreneurship. Indeed, a large part of research is still devoted to pinning down exactly which determinants that are most important here both across countries and through time.

Demographics and Macroeconomics – Part 1 (Wonkish)

Because of the euro fixing exchange rates at unfavourable terms for Greece, Ireland and Spain, right now the productivity differences in Europe have to be addressed through labour cost adjustments – so-called internal devaluation (see the other Edward’s "Much Ado About (Some Of) The Wrong Things"). It would be nice to think that internal devaluation could solve the euro zone’s problems but the continuing divide in eastern and western Germany suggests it may not.

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