In 2000, Milton Friedman gave a keynote address to the Bank of Canada. In it, he shares some of his thoughts about the newly formed Eurozone. He said that he had very low expectations for it and that differences were going to accumulate among the countries as a result of non-sychronous shocks affecting countries differently. Furthermore, he said that countries would ultimately need different monetary policies from one another. It is clear at this point that Friedman’s foresight was correct, however I would like to share some thoughts and examples that back up his claim.
After the formation of the common-currency area, there was very little inflation in Germany (roughly 1-2% per year) in the 2000s. However, some of the peripheral countries such as Greece did experience consumer and producer inflation (typically 3-5% annually). I will admit that I am slightly confused on how this could happen, so if someone could shed some light on it I would appreciate it. Nonetheless, this backs up Friedman’s claim that non-sychronous shocks would impact the countries differently.
Because of this inflation in the peripheral Eurozone countries, the real exchange rate in these countries increased, making their exports more expensive and imports from the core Eurozone countries cheaper on a relative basis. In simple economics terms, these peripheral countries experienced falling net exports. To make up for falling net exports dragging on the economy, these peripheral countries relied on borrowed money to increase government spending. As this continued to go on for several years these countries’ debt to GDP ratios continued to rise. It was not until the recession in 2008 that falling GDPs in eurozone countries exposed the severity of the problems and increased such countries debt/GDP ratios by means of the denominator falling.
As Friedman suggested countries like Germany and Greece would need different monetary policy options and they do right now. Greece would like a policy to devalue their currency and increase net exports while Germany has historically been against inflation since their period of post-war hyperinflation.
Here is my take on the dilemma that countries such as Greece face using the simple macroeconomic model for aggregate demand, Y=C+I+G+NX:
The government cannot increase C or I on its own. G is already too high and no one will lend to them further to increase it and they cannot change NX because the exchange rate is fixed. Austerity measures and wage restraints to limit G and prevent more inflation could work on paper, but in the long-run they are going to be a very difficult sell. Do you believe leaving the Euro-zone is the only option in the long-run for a country like Greece or is there another way out of their dilemma? I wonder what Friedman would suggest Greece do today…