Tuesday, October 25, 2011

Spot the Euro effect

The role that the Euro plays in the current crisis in European countries is a source of debate. Some see the Euro as the main reason why we find ourselves talking about sovereign default in Europe. Brad DeLong goes as far as saying that "A Greece can only happen to a country that does not control its own currency" (although he knows well that history is full of sovereign defaults of countries that controlled their own currency). Paul Krugman mentions the experiences of Iceland or the UK as examples to Ireland or Greece or Spain where a currency that is allowed to devalue can help GDP grow, which will help making debt sustainable.

I will not dispute the theoretical argument that a flexible exchange rate can be a tool to smooth business cycle fluctuations but I fail to see that the data speaks so much against the Euro experience. I can entertain the argument that some of the constraints of the Euro are not helping Europeans to find a solution, but when I look at the data, it is not easy to see a dramatic effect coming from the fact that the exchange rate is not allowed to move.

We could compare GDP growth rates but there are too many factors that affect GDP. What if we simple focus on the contribution of exports to GDP? Why exports? Because we normally think about exports as being affected by foreign conditions (which are similar for all these countries) and the real exchange rate. If we were to look at imports then domestic conditions would matter as well and we would have to control for other factors. If the exchange rate is a significant part of the crisis we should expect countries that are constrained by Euro membership to show a worse exports performance than those that let their currencies depreciate.

The first chart below plots growth of exports (volume) for Portugal, Greece, Ireland and Spain (countries that are part of the Euro) as well as Sweden and the UK (countries that decided to stay out of the Euro and saw their currencies depreciate during the crisis). The second one simply aggregates growth rates over time to compare levels of exports where 2005 is equal to 100.

It is not easy to see the Euro effect in these pictures. While it is true that Greece is the worst performer and Sweden one of the best in this sample, the same is not true for the other Euro countries. In comparison to the UK, exports growth in Portugal or Spain or Ireland are similar. In addition, if we were to choose 2008 as the starting date, there will be even more similarities in the sample. To transform these charts into a proper test I would like to control for the mix of exports of each of these countries but I do not have a strong prior why this should bias the picture in our or another direction.

So I remain less pessimistic about the Euro than other econ-bloggers out there. Not that I deny the constraints that a fixed exchange rate introduces but I cannot see as clearly as they do that the Euro is largely to blame for the European crisis.

Antonio Fatás

on October 25, 2011 |   Edit