Classical economists don’t understand real people or real economies.

There is at last some evidence that the political mainstream is coming around to the idea that  “places {in the same currency zone -PM}  in deficit have to be easily financed by places in surplus”. At least there is,  if we can consider John Redwood, a British Conservative MP,  to be representative of the mainstream. He, himself, may well question that assertion, but nevertheless this  recent quote  shows that it isn’t just Greece’s Syriza and the political left who are making the argument.

John Redwood is, of course, meaning Germany although the same argument would apply to Holland who run an even bigger surplus, as a percentage of GDP than Germany. The Germans were always happy to finance their customers when they used the DM. They’d buy up the treasury bonds of the deficit countries, like the UK and US, and that way their surpluses were recycled to their customers by the process of government deficit spending. So why the problem now? From their POV now, they should be even keener to do that. It would keep “their” trade zone healthy. They could impose conditions , of course, but there would be no reason to impose such stringent conditions as they do.

They seem wedded to the idea that internal devaluations are now needed in the peripheral countries of the Eurozone. General devaluations are no longer possible within the common currency zone. But can internal devaluations work? We know external, or general, devaluations can work. Recently the Canadian dollar has fallen by about 20% against the US dollar. This isn’t particularly noticeable to Canadians until they cross the border into the US. Then they realise that their wages and salaries are now worth 20% less, in terms of US$, than before. Canadian prices, at least the ones unaffected by import costs, such as rents, in are now 20% less too. Imports from the USA are now 100*(0.2)/(1-0.2) =25% more expensive.

This shift is necessary for the Canadian economy to adjust to changing world conditions. But what would have happened if Canadians used the US$? Theoretically,  if Canadians had reduced all prices and all wages by the same amount, and IF spending patterns were left unchanged,  the outcome would be the same. I’ve used the big IF because IF prices were falling fast then the real level of interest rates would be very high, even if they were nominally zero, and which would make it irrational for any individual to spend more than they had to.

But would that have really happened? If Canadian companies had faced falling demands for their products, they would do what all companies do. They’d cut back. But there wouldn’t be pay cuts and price cuts. Maybe just no pay rises and no price rises. They’d lay off some of their staff and stop recruiting others. They would adjust to being 20% (or close to it) smaller in this way. That would be repeated right through the Canadian economy which would end up 20% smaller too. Unemployment would skyrocket and the US media would no doubt be making negative comments about the Canadians, especially if they’d dared say it was even partially the USA’s fault.

That’s exactly what’s happened in Greece, Spain and elsewhere. Except of course it is the Euro not the US dollar which is causing the problem.  Economists, of the classical variety, will argue that this should not have happened.  Some will be in complete denial and will argue that it can’t have happened, or if it has, it must be due to some other factor. Lazy Greeks maybe? They can , of course, show nice mathematical models of how an ideal economy would be able to restore its competitiveness if only people would just behave rationally – according to their definition of rationality. But real people behave rationally as they themselves see it, not how anyone else might see it. That needs to be understood by real economists too. Including real German ordo-liberal economists!

So instead of imposing austerity on countries like Greece and Spain, to force internal devaluations, the Germans need to find some new economic advisers who can come up with some other way to equalise the money flows. Otherwise, their dream of a united Europe will become ever more nightmarish as time passes.