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A curious claim by Alan Blinder

Alan Blinder in the Wall St. Journal today urges his readers to "remember the two fundamental determinants of exchange rates: (1) productivity in different countries—so, other things equal, faster productivity growth should lead to a rising exchange rate; and (2) prices and wages in different countries—so lower inflation should lead to a rising exchange rate. Thus, for a currency union to succeed, its member nations need to register approximately equal productivity growth and approximately equal wage and price inflation."

Really? There are at least two curiosities here, which I will label A and B.

(A) In standard usage, when an economist speaks of an exogenous shift that "should lead to a rising exchange rate," he is applying a theory of the market exchange rate in a regime of floating exchange rates. Here Blinder is talking about a currency union, within which there "should" be no changes in exchange rates because there is a common currency. If factor x would cause an appreciation of Germany's currency under floating rates but does not within the eurozone, that is not prima facie a failing of the currency union. Some other mechanism will provide the appropriate monetary adjustment, typically money flows into Germany from other countries.

(B) According to the standard Purchasing Power Parity theory of floating exchange rates, Blinder's (2) is the only fundamental determinant of exchange rates. If (1) matters, it matters only so far as it works though (2). There is in fact no need for currency union members to have approximately equal productivity growth. Example: Panama and the US have been in a successful currency union for 107 years. Likewise Maine and Florida.

Can any of my economist friends explain to me why on earth Blinder thinks that you can't have a currency union between countries with disparate productivity growth?

  • jmh530

    You might find this interesting:
    though I'm not sure how well it resolves your points.

    I think there's solid statistical evidence of cointegrating relationships between nominal exchange rates and the price levels of different countries (though it tends to work over a long horizon unless the inflation differential is large), but I haven't personally tested the relative productivity hypothesis.

    If the US and Panama are at roughly trend real GDP growth and inflation at expectations and Panama experiences an idiosyncratic shock to real GDP, then most mainstream economists would likely say that Panama should have looser monetary policy. However, if it can't because it is effectively in a currency union, then if I'm not mistaken the problem would get worse for Panama since monetary policy would not change (so this is basically the same as Germany vs. Greece). This could lead the people in Panama to want to adopt their own monetary policy that would be looser. However, this isn't the same thing as long-run productivity.

  • Bill Stepp

    Another thing to mention is his statement that Germany's greater productivity cannot be matched by other EU countries, not least because (so-called) "structural reforms" of labor markets "take years to bear fruit while financial markets count time in seconds." To use a Friedmanism, this is hogwash. German productivity ranked comparatively low vis-a-vis other European countries after the fall of the Berlin Wall, but rose in the 1990s thanks to labor and capital market reforms, as well as business tax cuts. Blinder neglects the latter two changes.
    Blaming the timing factor ignores that in a liberalized market capitalists and entrpreneurs would step up and create new businesses and expand existing businesses even as failing businesses went by the wayside in a sustained sort of creative destruction and economic rebirth.
    But this is not part of the Keynesian big government playbook lying on Blinder's desk.
    To use a sports analogy, blaming "Teutonic efficiency for what ails Europe" (as the WSJ's sidebar puts it) is like a runner donning leg irons and finishing last in a race, then blaming the winner for his ack of competitiveness.
    What European countries such as Greece, Italy, Spain et al. need to do to improve their sclerotic economies is to throw off their state-imposed barriers to entrpreneurship, business- and job creation. Such a solution would work a lot faster than Blinder and his Keynesian colleagues think.

  • soundmoney

    I agree with the other comments and would add: the direction of capital flows–and whether they are a function of 'push' and are usually referred to as "flight" or a function of 'pull' and reflect a more favorable tax/regulatory investment environment–tend to dominate. Blinder's analysis would have concluded that Puerto Rico should have left the "dollar zone" — until the new governor came to office. Aside from Panama, why do we never hear that the voluntary "dollarized" countries such as El Salvador and Ecuador 'should' leave the dollar and restore their own currencies and devalue in order to "become more competitive."

  • David Stinson

    The way that I have been thinking of the euro situation is that a single monetary policy for economies with, for example, significantly different productivity (along with labour market rigidities and immobility) would have to bring about monetary disequilibrium, and thus malinvestments, somewhere.

    In any case, it does appear that monetary disequilibrium is or has been present in the eurozone. Perhaps there are some elements of the currency union that are not perfectly analogous to a fixed exchange rate regime or that are sustaining disequilibrium? Is there some element in the euro that makes it more like a pegged regime (in the pegged vs fixed distinction that Hanke often refers to)? The fact that the euro appears to be unsustainable seems to imply that that is in fact the case (or something).

  • Blinder

    1) Confuses real wage growth with inflation.
    2) Confuses wages with consumption (or assumes that wages are always consumed).
    3) Reasons in a circle.

    He claims, "… other things equal, faster productivity growth should lead to a rising exchange rate [emphasis added] …" and then concludes "nations need to register approximately equal productivity growth and approximately equal wage and price inflation".

    He assumes that productivity growth leads to a rising exchange rate if wage/consumption growth in the two economies remains equal. Only one economy produces more, but consumption in the two economies remains equal, so the more productivity economy must be accepting less for its produce.

    In reality, the exchange rate need not change if the more productive economy also consumes more while consumption in the less productive economy is unchanged. Demand for the output of the first economy from the second economy does not increase, so the exchange rate does not change.

    Blinder's analysis seems like wishful thinking. He wants to believe that his level of consumption is immutable, so he projects this assumption onto the world.

  • Paul Marks

    Alan Binder's article is astonishingly ignorant – he misses out the most important factor in exchange rates, the INCREASE IN THE MONEY SUPPLY.

    Now once "inflation" meant an increase in the money supply – but that is clearly NOT how Alan Binder is using the word, he means "prices in the shops" or some such.

    He is just missing the obvious.

    If the number of (for example) Dollars are doubled and the number (the amount) of Pounds are not doubled will this not effect the exchange rate between Dollars and Pounds? Is this not the BASIC FACTOR determining the long term exchange rate? According to Binder clearly "no", he does not list the increase in the money supply at all.

    This is rather like the post World War One world – during the war the supply of Pounds had been increased far more than the supply of Dollars (partly because Britain had been at war from 1914 and the United States had been at war since 1917) yet after the war (actually in 1924 – but cut me some slack) it was "back to the old exchange rate we go".

    This overvalued the Pound (in terms of the Dollar) and hit British export industries on the head – but instead of allowing the Pound to fall (in terms of the Dollar) the American Federal Reserve (led by Ben Strong at the New York Fed – trying to help his friend Governor Norman of the Bank of England) expanded the Dollar money supply – with terrible results (the boom/bust event of the late 1920s).

    Sorry for the history lesson – but it is important.

    It is the amount of (for example) Dollars in comparison to the amount of (for example) Pounds that determine the "exchange rate" between them (NOT exactly – the real world is not neat and tidy, but in general terms, and OVER TIME). Increase the amount of one currency (but not the other) and, OVER TIME, the exchange rate will change.

    This is really basic stuff – utterly basic.

    Yet Alan Binder goes waffleing on about "productivity growth", "wages" (and on and on) – all very important (in terms of general economic affairs), but all MISSING THE BASIC POINT when it comes to exchange rates.

    It is as bad as (for example) saying "gold is worth 35 Dollars an ounce" without even checking how much gold the governmnet has in relation to how many Dollars there are.

    This is the world of "the Pound is worth five Dollars" without checking how many Pounds there are and how many Dollars there are.

    The numbers "35" and "5" are just waffle – they are numbers plucked from someone's backside, they have no relation to reality.

    And talking about "productivity growth" or "wages" does not alter this – it is (again) just MISSING THE POINT.

    As for the Euro.

    As Jim Rogers (and others) have pointed out…..

    Just let governments (such as Greece) go bankrupt.

    If these means that various banks go bankrupt as well – well then they go bankrupt as well.

    The Euro would remain.

    It is the very action of trying to "save the Euro" (by creating FROM NOTHING vast amount of new Euros – to throw at banks and national governments) that destroys the currency.

    The ECB (European Central Bank) has already bought both bank and national government debt (with money it creates from NOTHING).

    Should the ECB do this on an "unlimited" scale (and the word "unlimited" is a direct quote from the establishment's favourate comic – the Ecomonomist magazine) THAT is what would destroy the Euro.

    For example, Rogers would put his money where his mouth is and sell all the Euros he owns – at once.

    And so would many others.

    The inflation (in the proper sense of the word – i.e. the increase in the money supply) would lead directly to the collapse of the Euro, indeed it would BE the collapse of the Euro.

  • David Stinson
  • Paul Marks

    My own belief is that the Euro is basically a POLITICAL project – i.e. the German support for it is based on the old dream of a "United Europe" (a dream that goes back to the Middle Ages – a sort of Roman Empire, accept it would be German, remember the Germanic "Holy Roman Empire" was not always a joke, once it was a real power).

    However, it would not surprice me of the Budesbank had got itself into a terrible position – and not just because the German governement has indicated that it will bailout (rather than allow to close) any major German commercial bank that it is bankrupted by defaults in government debt by Greece and the others. And, yes, if the Euro collapses the Bundesbank may find itself liable for all sorts of sillyness.

    The original Euro agreement was strange – after all if there was to be a single currency with an Central Bank in Frankfurt, what was the Bundesbank (and the Bank of France and …..) for?

    Why were they not abolished?

    Were they kept in order to subsidize commercial banks and government borrowing?

    If so – they were an "accident waiting to happen".

    The whole idea of "Central Banking" is demented – that is the reason I read this site (inspite of differences with people here – I share their opposition to Central Banking).

    Even the Swiss Central Bank is no good.

    Want to see losses?

    Wait till their accounts are published (or leaked).