Shocks, fairies, and automatic destabilisers

I’m currently reading Joseph Stiglitz’s ‘The Euro: And its Threat to the Future of Europe’. I still have over 200 pages left to go, so it’s not a time for a review of the book just yet. 

But when going through Part II (When can a single currency ever work?) I felt compelled to slow down and simplify some of the ideas presented. The result are the two infographics below. As its impossible for me to get Adobe InDesign at the moment, I had to work through what the Office package has to offer. I’m not thrilled but I guess it’s better than nothing.

The ideas presented are very simple and straight from a basic undergraduate economics course. I felt like it’s always good to go back to basics, though.

slide1

Following a shock to an economy, the government can manage the economy through monetary and fiscal policy. I included recent ideas about expansionary austerity, too, but few people believe in the confidence fairy anymore.

At the same time, economies are equipped with automatic stabilisers – adjustments requiring little to no intervention, which are aimed at boosting aggregate demand.

The story is a little different for a country in a currency union, or more specifically – in the Eurozone.

Slide2.jpg

Monetary policy is delegated to the ECB and hence cannot be conducted on a national level. An asymmetric shock impacting one economy more than another is not simply followed by the fall in the exchange rate, as the exchange rate adjusts to average shocks in the currency area. As pointed out by Stiglitz, fiscal policy is also constrained due to the various rules and pact governing the sustainability of public finances in EU countries.

What is left is the confidence fairy – and we all know how that turned out – and internal devaluations. An external valuation puts the burden of price falls on foreigners, an internal devaluation means that the price is paid by the citizens, as their wages and spending ability is affected. But that’s not the end of the story.  Internal devaluations also breed instability; while a fall in prices may help exports, the fall in wages means that people will cut back on their spending. This is likely to affect both the demand for foreign and domestic goods. The former will help the trade deficit, the latter will further depress aggregate demand.

Does this spell doom and gloom for the Eurozone? I’m not sure yet. More musings about Stiglitz’s book are likely to follow.

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Shocks, fairies, and automatic destabilisers

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