Announcing the 'Creditanstalt' Heinrich Brüning and Andrew Mellon Memorial Prizes

The 'Creditanstalt', Vienna, Proudly Announces the Creation of 

The Heinrich Brüning Memorial Prize for Self-Defeating Macroeconomic Stabilization Policy (aka Austerity)

and

The Andrew Mellon “Liquidate labor, liquidate stocks, liquidate farmers, liquidate real estate” Prize for the Expeditious Resolution of Banks (aka Bank Runs)

Candidates for either or both of the prizes currently are

1. Wolfgang Schäuble, German Finance Minister
2. Jeroen Dijsselbloem, Dutch Finance Minister and Euro Group President
3. Angela Merkel, German Chancellor
4. Jens Weidmann, Bundesbank President
5. Helmut Kohl, former German Chancellor, and with Francois Mitterand (deceased), founding father of the Maastricht Treaty
6. Nicolas Sarkozy, former French President and co-initiator with Angela Merkel of the 'Deauville Agreement' for Private Sector Involvement in a Greek debt 'restructuring' (aka default)
7. Olli Rehn, Vice-President of the European Commission, for blaming the Keynesian messenger (see letter and Financial Times piece)

The award committee of the 'Creditanstalt' is happy to entertain additional nominations by April 1. Readers of this blog are encouraged to submit their votes by May 1 [extended to May 5!].

The recipient of the Brüning Memorial prize will be awarded the sum of One Million 'Euros' in Bundesbank TARGET2 Claims on the European Central Bank, while the recipient of the Mellon Prize will receive One Million 'Cypriot Euros' (subject to currency controls and 'bail-ins' of the ECB and Central Bank of Cyprus).

The prizes will be awarded in a gala ceremony in the prestigious offices of the 'Creditanstalt', Vienna, on May 11, a historically commemorative date for the bank (on May 11, 1931, the 'Creditanstalt', the then largest Austrian bank, filed for bankruptcy, initiating a worldwide cascade of bank failures).

Main Office of the former Creditanstalt, Vienna, ground zero of the 1931 worldwide bank run

[Disclaimer: Any identification with living persons or institutions of the same or similar names is hereby denied.]

Background

The leading prize in economic science ('The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel') has become discredited by being repeatedly awarded to out-and-out 'Keynesian' charlatans such as Hicks, Stiglitz, Meade, and Krugman (the grand-master Keynes fortunately died well before he could be so honored). The 'Creditansalt' has realized the need to restore economic policy in these troubled times to a sound foundation. This is the motivation for establishing these substantial prizes. With state budgets coming under increasing pressure and the financial system still teetering, it has become imperative to formulate economic policies that have the biggest 'bang' for their Euro. For this reason, the prizes are named for distinguished economic policymakers of the past who proved that judicious and well-reasoned decisions could have world-historical implications beyond their wildest dreams. They serve has an inspiration for the current generation of policy makers, who, after the lapse of so many years and the decline in the teaching of economic history, may have lost sight of their shining examples.

German Chancellor Heinrich Brüning

Heinrich Brüning was the last democratically elected Chancellor of the ill-fated German Weimar Republic and served at the height of the Great Depression 1930-1932. After losing a parliamentary majority he began to rule by emergency decree, thus serving as an inspiration for the recent caretaker governments of Greece and Italy. His restrictions on credit, cuts in government spending and reductions in wages led to mass unemployment and the growth of support for radical parties on the right and left. Political intrigues of reactionary cliques led to the fall of his government in 1932, "one hundred meters before the finish line", i.e., before reparations payments were suspended in the Hoover Moratorium and austerity measures could bear fruit (although in fairness to Brüning some historians argue that he was about to switch to an expansionary policy just before his cabinet collapsed). He also pushed for a customs union with Austria, which played a crucial role in the demise of the 'Creditanstalt' and the subsequent worldwide bank run.

U.S. Treasury Secretary Andrew Mellon

Andrew Mellon was a wealthy banker and industrialist who served as U.S. Secretary of the Treasury from 1921 until 1932. He is especially remembered for his courageous stance during the Great Depression against fiscal stimulus, monetary expansion and injecting liquidity into failing banks. According to President Herbert Hoover in his 1952 memoirs, "Mellon had only one formula: 'Liquidate labor, liquidate stocks, liquidate farmers, liquidate real estate'" (H. Hoover 1952, Memoirs: The great depression, 1929-1941, p. 30). [In fairness to Mellon, Hoover is the only source for this quote, and it may have been self-serving on Hoover's part to pass the buck to Mellon, who was by then long dead.]

The Creditanstalt

The Austrian Bank Creditanstalt was founded in 1855 with significant participation of the Rothschild family and imperial patronage. It became the largest Austrian bank but was induced by the Austrian National Bank to acquire the failing Bodenkreditanstalt in 1929. In some respects this parallels the acquisition of Bear Stearns by JP Morgan Chase under Federal Reserve auspices in March 2008, although the 2008 bank crisis was subsequently triggered by the failure of Lehman Brothers, not JP Morgan Chase. Creditanstalt's solvency became increasingly undermined, although this was disguised by accounting tricks and secret and probably illegal support via foreign accounts of the National Bank that weakened the latter's official gold and foreign currency reserve position. Bankruptcy was declared on May 11, 1931, which led to a run on the Austrian Schilling. While a bridge loan for 150 million Schilling was quickly forthcoming from the Bank of England to the Austrian National Bank, the Bank of France, the second largest holder of gold reserves in the world next to the USA at the time, prevaricated and even secretly encouraged withdrawal of Schilling accounts to put the Austrian government under pressure to renounce plans for a customs union with Germany (see Brüning section above). Does the willingness of the Eurozone to allow the Cypriot Banking Model to catastrophically fail reflect a similar political decision to thwart that country's controversial closeness to Russian business interests? While French and Bank for International Settlements loans were eventually provided, it was too late to prevent a collapse of the Austrian financial system, so that capital controls had to be imposed. The bank run then went internationally viral, spreading to Hungary, Germany, Britain (which managed to avoid bank failures by going off the gold standard in 1931), and the US (where 40% of banks failed before the US devalued and effectively left the gold standard while introducing deposit insurance under Roosevelt in  1933).

The 1931 Creditanstalt banking crisis stands as an incomparable monument to European monetary cooperation, and the troika (European Commission, European Central Bank and the International Monetary Fund) may have to redouble their efforts to live up to this historical precedent.

References:

Iago Gil Aguado, 2001, "The Creditanstalt Crisis of 1931 and the Failure of the Austro-German Customs Union", The Historical Journal, Vol. 44, No. 1, pp. 199-221. [According to Aguado, the archives of the Creditanstalt have still not been opened to historical research]

Barry Eichengreen, 1995, Golden Fetters. The Gold Standard and the Great Depression 1919-1939 (New York and Oxford: Oxford University Press) pp. 264-286.

Richhild Moessner and William A Allen, 2010, "Banking crises and the international monetary system in the Great Depression and now", BIS Working Papers No 333

[For report on May 11, 2013 awards ceremony, jump to this post. For breakdown of poll results, go here.]

Latest Illustrated News from the Euro Spa

(C) 2012 Silverberg/BW

The Euro in Her Death Throes

While Dr. JW (left) insists on more bloodletting (austerity and internal devaluation), Dr. MD (right) vigorously advises cupping (structural reforms). Meanwhile, a bank run is in progress in the lower left periphery. Euro's handmaiden AM (center) refuses further infusions (bailouts) until an ironclad chastity vow (fiscal pact under G auspices) has been made (after William Hogarth, A Harlot's Progress, Plate 5, picture source Wikimedia Commons Public Domain).

Krugman on Cluster's Last Stand

Paul Krugman has an interesting op-ed in the NY Times on industrial clusters, jobs, and economic policy (specifically the appropriateness of the US auto bailout, and it role in the US electoral debate). So I'll use the hiatus in the Euro crisis (a brief one, I expect) to talk about one of the other great applications of complexity theory to economics, the relationship between increasing returns, economic geography, and trade, and what it might mean for current issues like manufacturing job creation/destruction, the rise of China and the decline of the rest...

I needn't mention that Paul got the Nobel Prize for his work on trade, economic geography and agglomeration economies (see his Nobel Prize speech  and 2010 New Economic Geography paper for very readable summaries). And very fine work it was, especially since it made the case in a way academic, neoclassical economists could finally take seriously, using general equilibrium and 'micro-founded' optimizing behavior, which says more about the state of American academic economics than how plausible the argument is. For it is actually a very old argument (and even more, implemented national policy), going back to Alexander Hamilton and Friedrich List (as well as Alfred Marshall), and known as the infant industry and the industrial district. Industrial activity is characterized by a variety of forms of increasing returns - learning by doing, innovation performance curves (e.g. Moore's Law), scale economies, network externalities, rich labor markets, informational spillovers, agglomeration economies due to the presence of clusters of suppliers... The list of possible sources is long and I won't go into details, but the results are similar. Under certain circumstances geographical concentrations of activity will emerge, patterns of specialization arise, a core-periphery structure becomes dominant. It's why cities exist, as well as Silicon Valleys, Wall Streets. It's an old phenomenon: in the 19th century a 50 square mile district of Lancashire, England, produced 80% of world cotton exports, although it was located halfway around the world from its raw cotton sources. It exists at many scales: from small market towns to globally dominant industrial districts or even nations. And whether it comes about is more or less a function of the strength of the increasing returns factors compared to the classical determinants of location: transport costs, factor prices, comparative advantage. And where it comes about can be almost accidental: early adventitious  advantages can grow into insuperable barriers to change.

Now we come to the jumping-off point of Paul's op-ed. An extensive feature in the NY Times on "How the U.S. Lost Out on iPhone Work" examines the question of why Apple moved its production of iPhones to China, and whether these jobs will ever come back to the US. The authors come to the conclusion that Apple's principal contractor there, the Taiwanese company Foxconn (the largest electronics contract manufacturer in the world) and its labor force are so proficient, flexible, and dedicated in what they do, that no American firm could ever hope to compete with them. (The article fails to mention the other reasons Foxconn's Chinese plants have been so much in the news: an epidemic of overworked employees jumping off their rooftops, and the casualties from aluminum dust explosions due to poor workplace ventilation in the iPhone plants - the unsung costs of globalization). It is not so much wages that drove this outsourcing, according to the Times authors, but the Chinese complex of skilled engineers, disciplined workers, and suppliers. In Paul's terminology, in other words, an industrial cluster!

I would not dispute the importance of industrial clusters in explaining much of economic geography. However, it does not seem to be the case that Apple outsources the final assembly of products like the iPhone to China because so much of its supply chain is already located there, as Paul claims.

Quite the contrary: Xing (2011) shows that only 3.7% of the iPhone's final cost of production is due to Chinese value added, based on 2009 data for the iPhone 3G S (original data from iSuppli teardown). The rest comes from imported high-valued electronic components from Korea (12.8%), Japan (33.8%), Germany (16.8%), and yes, the USA (6.2%), with 26.8% of unspecified (non-Chinese?) origin, including Corning's acclaimed Gorilla Glass for the screen, manufactured in Harrodsburg, Kentucky and Shizuoka, Japan . Thus the fact that the entire cost of the finished iPhone shows up as an export from China to the USA is highly misleading, since 96.3% of its manufacturing value added was produced elsewhere, including a substantial amount in the USA (not to mention Apple's 64% markup on unit costs!). And much of that huge Apple margin goes to software development, R&D, and marketing, the bulk of which I presume is still being done in the US.

While there are certainly agglomeration (and scale!) economies in final assembly of electronic goods (after all, Foxconn has huge assembly plants with campuses of highly disciplined and docile Chinese workers, when they are not jumping off rooftops or getting killed by exploding aluminum dust), one shouldn't underestimate how much wage and transport costs are still driving factors. Another recent Times article reports that GE is repatriating water heater assembly from China to the US because the fall of entry-level wages in the US by $10-15 due to the economic crisis now makes it profitable to do so. Thus wage and transport costs still play a substantial role in location decisions, and can even result in manufacturing jobs returning to the US (or migrating even further to lower-wage countries like Vietnam, Bangladesh and Indonesia).

Now come the caveats. The data are from 2009. The Chinese value added may have grown since then. Second, Xing assumes that none of the unidentified 26.8% of iSuppli's teardown represents Chinese production (and even some of the identified Korean, Japanese, Germany and US input may indirectly represent some Chinese production).

Nevertheless. the fact that "Designed in California by Apple, Assembled in China" is printed on iPhones, and that the direct bilateral trade gap between the US and China is so wide, create a misleading picture. Very little of the iPhone is made in China. From a technological and value-added standpoint, one would be more justified in saying "Made in Japan, Germany, Korea, and the USA", in that order, before adding "And then Assembled in China." And in many ways the Chinese contribution is still the least industrial cluster-like part, namely final, labor-intensive assembly. So, no, Apple doesn't assemble the iPhone in China because so much of its supply chain is already there. It really does seem to be just about low wages.

Where the Chinese electronics industrial cluster (not to mention the Chinese automobile cluster) will really be flexing its muscle in the near future is in the rise of domestic Chinese producers of smartphones like Huawei and ZTE . They have been growing very rapidly in the Chinese domestic market but increasing are targeting the export market, either as OEM suppliers or under their own brand names. I have no doubt that they are or will become focal points of true industrial clusters,  while Foxconn is still just the end node of the value-added chain, however proficient it is at what it does.

So what does this imply for a theory of economic geography and international trade?. In a world in which supply chains now twist and turn through a large number of countries, a network or international input-output approach is needed to understand what is happening and who is contributing what, both in monetary and technological terms. Johnson and Noguera (2011) have applied this value-added approach to recalculate the net international flows (of course, making a number of simplifying assumptions in order to do the calculations with the available data). The result is that, on a value-added basis, China's trade surplus with the US is 40% smaller and Japan's is 33% larger than when measured in bilateral terms (all those Japanese components in iPhones assembled in China again - see figure below).

US trade deficit with six Asian countries, measured bilaterally and using value-added concept (Johnson and Noguera, 2011).

And what do the seemingly contradictory stories in the Times about Apple and GE manufacturing in China tell us? To the extent that these companies subcontract work to China rather than invest in manufacturing capacity themselves. they are  completely footloose. Apple can decide, on the basis of shifting currency exchange rates, wage and transport costs, to pack up and move its production tomorrow to another country, conceivably even back to the US, as GE, for much more transport-intensive products like water heaters and refrigerators, already seems to be doing. A purported Chinese industrial cluster and existing supply chain is no constraint (unique high-technology components from Japan, Korea and Germany are more critical, but these can easily be shipped anywhere). It's Foxconn that has made the sunk investments in plant and trained workers in China. Of course, Apple might have a hard time at first finding the massive assembly capacity somewhere else that Foxconn already provides. But remember, an industrial district north of Bangkok manufactures 40% of the world's hard drives (it was badly hit by the recent flooding), so this kind of electronics capacity could and has been recreated in another low-wage country when costs warranted it.

That said, Paul's main point, that the Obama administration acted correctly in bailing out the auto industry and preserving American industrial capacity in the whole value-added chain of auto manufacturing, is well taken. But the iPhone is not really a comparable case, and Apple and Corning have actually done a fine job of at least keeping the highest paid and most innovative work at home (it could have gone entirely to Samsung and Schott).

While industrial clusters are a fact of economic history, the long-term process of creative destruction means that eventually even the most successful clusters decline. Would it have made sense for England to pour money open-endedly into preserving her textile industries through the 20th century against Japanese and other low-wage competition (the same applied even to Japan 50 years later)? Time and the product cycle march on, and wait for no man. The real problem in high-wage countries is to find other employment opportunities in time to maintain international competitiveness (much as Germany has done) before existing clusters collapse. And the growth of domestic and financial services have not done the job in the US.

This tale has one epilogue I will come back to in a later post: China's refusal to let the RMB appreciate to balance out real exchange rates has unleashed a race to the bottom (not even exempting Germany), forcing the rest of the world to lower their real and even nominal wages to stay in the game. This deflationary spiral will prevent the industrialized countries from returning to vigorous growth (more on that later).

Central Banking Works!

Some readers of this blog have been wondering why I haven't posted anything since returning to Europe from Goa on New Year's Eve.

The reason is Mario Draghi, who proved in late December that central banking works, at least for the time being. While he didn't deploy the 'big bazooka' of a credible backstop for Italian and Spanish bonds (or massively buy them up on the secondary market), as many people had expected, he did do the next best thing. And a very unconventional thing it was, squaring the circle of not explicitly monetarizing sovereign debt (the great German taboo) while bringing down intra-EZ spreads. He provided massive three-year liquidity to EZ banks, accepting national bonds as collateral. This has induced creditors to return to these bond markets, reducing spreads of Italian and Spanish bonds over German Bunds, substantially on maturities below three years, but even on longer term ones. Yes, Victoria, central banking works!

But does this put an end to the Eurozone crisis, as even Reuters BreakingViews has argued? Was the Euro crisis a figment of our imaginations (as a self-fulfilling prophecy, of course there is always something to that)?

Unfortunately, I think the ECB has only bought us an admittedly much needed respite by bringing us back from the brink. The fundamental issues I and many others have discussed still remain: the real exchange rate imbalances in the EZ, austerity as a self-defeating deflationary policy prescription, and the lack of a governance structure that would turn the Eurozone into a viable currency zone instead of a fixed exchange rate regime with a central bank with one hand tied behind its back. I'm currently working on a fundamental treatment of the latter - what does it really mean to be a currency, and why the Euro never was one - which will appear either has an extended post or a working paper, hopefully sometime soon.

In the meantime the threat of a disorderly Greek default looms, as does Italy and Spain's (not to mention Ireland and Portugal) increasingly desperate search for a growth alternative to the Greek austerity death spiral.

Wishing Everyone a Happy Meltdown in the New Year!

We'll be flying back from warm and sunny Goa on the 31st and arriving in Vienna in time for last minute shopping for the New Year. Then we'll celebrate and cocoon for a few days to acclimatize to the dreary Viennese winter before resuming this blog (unless something really untoward happens in the meantime).

So here's wishing everyone a happy and uneventful New Year!

Standing on the Toes of Giants

Many economists have been analyzing the world economic crisis in public arenas these last few years, and particularly the Eurozone crisis since Greece began its slide off the slippery slope. Many of these analyses have been on the mark. A few have been wildly off the mark, and a few, even by outstanding economists, have just missed the bull's eye. The reasons why are illuminating in showing just how easily one can misdiagnose a problem even when coming to it with the best credentials.

Alan S. Blinder (Princeton) and Martin Feldstein (Harvard) are honorable men, but also outstanding economists. And they have both recently published extensive op-eds on the Eurozone crisis in leading newspapers. Yet, informed and astute as they are (Blinder for example published one of the best road maps of the US subprime mortgage crisis in the New York Times in 2009: Six Errors on the Path to the Financial Crisis), their analyses are both flawed, interestingly enough in complementary ways. Putting them together, however, gets us a little bit further on the road to solving the problem.

Let me start with Blinder's The Euro Zone's German Crisis in Dec. 13's Wall Street Journal (unfortunately, WSJ articles are inaccessible to anyone without a subscription). Blinder is on the mark in claiming that the Eurozone crisis is primarily due to Germany. Unfortunately, he makes this claim for entirely the wrong reasons. By examining the statistics on unit labor costs (ULC), he correctly identifies the competitiveness problem between Germany and the EZ periphery (it has been widely known that German unit labor costs are a lower outlier on the index ranking EZ ULC evolution). But by neglecting that unit labor costs are defined as a quotient of nominal wages and productivity, he jumps to the mistaken conclusion that this must be due to some "German productivity miracle." In fact, quite the opposite is the case: German productivity growth in the period 2001-2011 was at best mediocre. The low value of German ULC is almost entirely due to something I (among many others) had long ago identified as what one can variously call "wage restraint" or "wage dumping": German nominal wages have risen much slower than her productivity, and very much slower than her EZ trading partners. Essentially none of Germany's  ULC advantage is due to exceptional productivity growth.

Here are the facts, as I presented them in an (as yet unpublished) letter to the editor of the WSJ on Dec. 18, and in an email on Dec. 20 to Professor Blinder:

I was a not a little taken aback by the premise of your Dec. 13 WSJ op-ed "The Euro Zone's German Crisis," since it is completely unsupported by economic statistics. I sent the following letter to the editor to the WSJ on Dec. 18, which to date has not been published:

"While Alan Blinder's recent piece "The Euro Zone's German Crisis" (WSJ Dec. 13) has the great merit of refocusing attention on the competitiveness imbalances at the heart of the Euro crisis (something that Paul Krugman, Martin Wolf, Paul de Grauwe and numerous others, including my humble self almost a year ago in the New York Times, had also identified), I must take issue with his characterization of the problem as stemming from a "German productivity miracle." OECD figures on labor productivity for 2001-2007 show Germany's annual rate of growth to be only 1.4%, exactly equal to France's and Portugal's, but lower than Austria's (1.9%), Belgium's (1.5%), the UK's (2%), Greece's (2.3%!), Hungary's (3.7%), Ireland's (2.9%), or Sweden's (2.9%), not to speak of non-EU competitors like Japan (2.1%) and the USA (2%). Of the major EU economies, only Italy and Spain had lower rates of productivity growth. Thus Germany's exceptional ability to undercut competitors on unit labor costs can only be due to the evolution of the numerator of that index, i.e., the rate of growth of nominal wages, which has variously been referred to (even by such diplomatic personalities as Mme. Lagarde) as "wage dumping" ("Lohndumping" in German). And indeed independent studies have shown that German wages have significantly trailed German productivity growth and inflation, leading to an absolute fall in median German real wages over the last ten years.

Since these productivity measures do not take qualitative components of competitiveness - the traditional strength of German industry rather than price - fully into account, a stickler could argue that they underestimate German productivity growth. Still, it is highly misleading to speak of a German productivity miracle instead of a German wage scandal."

German productivity growth rates after the onset of the crisis 2008 are even more dismal because of Germany's high export dependency (world trade collapsed faster than domestic demand), the high procyclicity of productivity, and the specific 'labor hoarding' resulting from Germany's extensive use of short-work programs. Thus the German unit labor cost outlier in the 2000 decade is almost entirely due to 'wage restraint' or 'wage dumping.'

The OECD spreadsheet on which I based this analysis is available here.

To his great credit, Professor Blinder readily admitted to this mistake in his analysis in an email reply (I was apparently not the first one to point it out to him). It makes a world of a difference whether German competitiveness advantage is due to superior productivity growth or, if you'll pardon a Marxist terminological indulgence, superior exploitation of her workers. But before wallowing in Marxist self-righteousness I would qualify this observation in two ways. First, a mature open economy in which wage growth systematically lags productivity creates a conundrum for its trading partners, since it is out of long-run macroeconomic equilibrium and can only maintain employment levels by, e.g., generating export surpluses (i.e., it is underconsuming). This characteristic of the contemporary German economy - an excessively low consumption share - has been repeatedly highlighted by Professor Peter Bofinger (the "token" Keynesian on the German Council of Economic Advisers). Thus German employment is dependent on finding someone "willing" to be the consumer of last resort and overconsume, i.e., run a current account deficit (financed by German and other banks), and until 2008 that was to a large extent the EU periphery. This is exactly analogous to the relationship between China and the USA over the last 20 years. German workers may have been content with this "exploitative" relationship since it guaranteed them relatively higher employment rates (by EU standards).

Second, German competitiveness also really does derive from the fact that Germany continues to enjoy an advantageous specialization pattern: it still produces the things high-growth countries demand, both in the rest of the EU during the housing boom, and even now in emerging markets, and that they cannot (yet) produce themselves - specialized capital goods and producer intermediates like chemicals, and high-end automobiles. So hats off to Germany for defending her industrial comparative advantage, but there is no justification in calling this a "productivity miracle." Rather, you can take your pick of "obsessive wage restraint," "wage dumping,", or "super exploitation."

We now come to Martin Feldstein's A weak euro is the way forward in the Dec. 19 Financial Times. Feldstein again identifies the Euro crisis as a balance of payments problem resulting from divergent competitiveness, and like Blinder, attributes this in part to superior German productivity growth ("Productivity in Germany rose much faster than it did in Italy, Spain and France" - while we have already seen that this is true to an extent for the first two, it was definitely not true for France or even Portugal). He then goes on the propose a devaluation of the Euro as an essential part of the immediate corrective for the current account deficit EZ countries.

While it is clear that a Euro devaluation with respect to the rest of the world would boost exports and restrain imports for the block as a whole (but impact individual countries differently, probably benefiting Germany most of all, and Portugal and Spain least), it is less clear that this would provide the internal rebalancing of current accounts within the EZ that the crisis mandates. Feldstein points out that over 50% of peripheral EZ trade is with partners outside the EZ. But to gauge to what extent a devaluation would correct the current account deficits, we need to know where these deficits come from.

To do so, I have looked at the bilateral trade flows between key peripheral and core EZ countries, in this case Italy and Spain on the one hand, and Germany on the other, using the OECD STAN Bilateral Trade database. The disadvantage of this method is that it excludes bilateral trade in services, tourism, transfers etc., that enter into the current account but not the balance of trade. The difference is small for Spain but significant for Italy:

Measure	Percentage of GDP
Year	2000	2001	2002	2003	2004	2005	2006	2007	2008	2009
Country
Italy Current Account	-0.48	-0.05	-0.87	-1.37	-0.88	-1.60	-2.50	-2.42	-3.15	-1.93
Italy Balance of Trade	0.13	0.52	0.49	0.13	-0.11	-0.72	-1.42	-0.61	-0.68	-0.41
Spain Current Account	-3.97	-3.96	-3.27	-3.53	-5.26	-7.35	-8.95	-10.00	-9.61	-5.19
Spain Balance of Trade	-4.61	-4.22	-4.03	-5.13	-6.91	-8.15	-8.66	-9.50	-9.23	-4.34

Italy is actually in trade surplus until 2004, but the current account is always negative and consistently lower than the balance of trade. Where this is coming from deserves further analysis (interest payment transfers to foreigners on national debt?). In any event the trade deficit is a surprisingly insignificant part of Italy's problems.

I now calculate the bilateral balance of trade (BOT) deficit with respect to Germany as a percentage of the country's balance of trade with the entire world:

Measure	Percentage of GDP
Year	2000	2001	2002	2003	2004	2005	2006	2007	2008	2009
Country
Italy BOT World	0.1	0.5	0.5	0.1	-0.1	-0.7	-1.4	-0.6	-0.7	-0.4
Italy BOT Germany	-0.4	-0.4	-0.6	-0.7	-0.9	-1.0	-1.0	-1.1	-0.9	-0.9
Italy-Ger  % Share in BOT	-298.2	-78.9	-117.1	-542.3	873.1	142.4	70.8	186.7	136.5	222.6
Spain BOT World	-4.6	-4.2	-4.0	-5.1	-6.9	-8.1	-8.7	-9.5	-9.2	-4.3
Spain BOT Germany	-1.0	-1.1	-1.2	-1.5	-1.8	-1.8	-1.8	-2.3	-1.9	-0.9
Spain-Ger  % Share in BOT	22.0	26.6	30.7	29.2	26.5	21.5	20.3	23.7	20.8	21.6

Thus we see that the Spanish bilateral trade deficit with Germany is a consistently large part of Spain's very large BOT deficit with the world: between 20% and 30%. This will be unaffected by a Euro devaluation, as presumably will be revenues from tourism transfers, etc. from Germany and the rest of the EZ core. (I have to qualify this by pointing out that a Euro devaluation would make holidays in Turkey relatively more expensive for German tourists than one in Spain, thus indirectly benefiting the latter without directly effecting Spanish prices for Germans.) For Italy, the BOT deficit with Germany is as much as 222% of its world BOT deficit, meaning that it is already running a trade surplus with much of the world outside of the EZ core. Its EZ-core trade relations are the overwhelming cause of its trade deficit (what is causing its even larger current account deficit is impossible to say at this point). Thus, while this is only a first-order analysis of the effects that a Euro devaluation would have on the balance of trade/current accounts of Italy and Spain, it should be clear that any change in their "terms of trade" that only impinges on the non-EZ world but not with the EZ-core will not go very far in solving their problems.

We can conclude that any solution to the Eurozone crisis that does not trigger deflation, leaves Germany's competitiveness with respect to the rest of the world unchanged (i.e., avoids a beggar-thy-neighbor devaluation policy) but realigns the internal EZ imbalances, must do the following:

1. raise German wages with respect to EZ-peripheral wages;
2. devalue the Euro by a corresponding amount.

This "squaring of the circle" was precisely what  I recommended in my Jan. 19 New York Times op-ed. Either one alone will not do the trick, nor will invoking nonexistent and unrealizable productivity miracles take us far. By stepping on the toes of two economic giants, we can see this more clearly again.

The paradox of why Germany has shunned this mutually advantageous solution while tenaciously clinging to the Euro still remains, however, and is the subject of my last blog, What does Germany want (and why she can't have it)?