Wednesday, September 25, 2013

Balance of Payments Adjustment and the Euro Crisis

It is worth remembering that according to Eichengreen (1996, p. 25) “the most influential formalization of the gold-standard is the price-specie flow model of David Hume. Perhaps the most remarkable feature of this model is its durability: developed in the eighteenth century, it remains the dominant approach to thinking about the gold standard” (for a critique go here).

The idea is that, at least in a fixed exchange rate regime, inflation and deflation do all the work of adjusting the balance of payments (BOPs). Modern versions add credibility and all that (which includes austerity) for the stabilizing flows of capital to work. Why do I bring this up? Because of Martin Wolf's column (subscription required) in the Financial Times today, which has the graph below.

Note that the countries in crisis, Greece, Ireland, Italy, Portugal and Spain have already adjusted their BOPs (in this case their trade balances). Yet the adjustment is more Keynesian than Humean, or to be more precise, it follows the analysis of A.G. Ford, who argued that peripheral countries, like Argentina, adjust their current account deficits with a good old recession not by lowering domestic prices. And yes, Wolf is right, the specie-flow would only work in a parallel universe.

1 comment:

  1. Hume's price-specie-flow mechanism assumes that money is neutral, and the logical extension is The Theory of Purchasing Power Parity (PPP), which states that long-run real exchange rates between countries are in equilibrium when the purchasing power of one nation’s currency is the same as the nation for which it trades with. The implication is that the process of international trade is that of arbitrage, that is, long-run real exchange rates between two currencies over any period of time are determined by changes in relative prices. In this sense, if nations have similar consumption and output baskets, in the long run, the exchange rates lead to common-currency price levels that are equal to a constant stationary mean, which implies that over a significant period of time, any standard commodity that is traded should sell for a similar price no matter where it is located in geographical space, once factors such as transportation costs, tariffs, and taxes are accounted for. Whatever the monetary or real disturbances in the capitalist world economy, because of 'transaction costs', the prices of a common basket of goods in will generally be the same at all times.

    The presupposition is that if one abstracts from various sources of capital flows and strategic government interventions in the foreign exchange market, the exchange rates will move in such a fashion as to reflect the relative price levels of the trading partners domestic economies. That is, the theory of Purchasing Power Parity (PPP) is a special case of the comparative advantage hypothesis known as the Law of One Price (LOOP); that is, long run real exchange rates move in such fashion as to automatically balance trade between freely trading nations, regardless of the differences in their levels of development or technology.



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