What Would Rudi Dornbusch Do?

Greece appears no closer to agreeing a cash-for-reforms deal with creditors, despite claims from Greek Finance Minister Yanis Varoufakis a deal is close. Investors would be more encouraged by those claims -- had we not had such mixed messages.

What’s the only consistent message from negotiations? Both sides remain far apart on certain issues, particular labor market and pension reforms. No specific suggestions hint that significant progress has been made on either.

One thing appears clear: Greece will not be able to repay €300 million to the IMF on June 5th.

Special Section on Greece, the Euro, and Europe

Stanley Fischer, Vice-Chair of the U.S. Fed, was a co-author and best friend of my thesis advisor Rudiger Dornbusch. Stan has frequently been in global headlines, particularly the FT, these days. Thankfully, he is providing great assistance to the public, worldwide, debates on how to handle the macro adjustments going on.

Rudi, as he was known collegially, was far, far more the colorful one of the pair. Rudi had an incredible, deft sense of humor, and equally, was a big “pain-in-the-a...” I both laugh out loud and shudder at the same time when I think back. Rudi died of a brain tumor in 2002.

Stan was clearly of a more consistent temperament to be the Central Banker, which he duly became. But Rudi had a compelling set of attributes I think about a lot these days. He qualified as both a world-class currency expert and a native German. He personally advised on both Mexican peso and Brazilian real contagion issues. Sincerely, I have been wondering a lot what Rudi would do about Greece, the euro, and Europe in general these days.

What would his advice be if he were still alive?

Listen to Stan. That is a place to start.  But honestly, Rudi himself would be more compelling. I went to the archives and Google-d up a thought piece Rudi published in Foreign Affairs in September of 1996.  That moment in time was just one year after I worked with him.  

I can’t put the whole piece in play. This is a great excerpt.

“EURO FANTASIES: COMMON CURRENCY AS PANACEA,” Foreign Affairs, Sept/Oct. 1996, Rudiger Dornbusch

Achievement of a common currency is being touted as Europe's event of the century even as its real impact is in doubt.

EMU (European Monetary Union) could create a powerful and vigorous Europe, politically and economically cohesive and financially strong enough to dwarf the United States and the dollar. Or it might turn out to be a nonevent. Then again, financial markets might blow it away before it even starts, or bureaucratic bean counters might strangle it by rigid application of the Maastricht tests, thus ruling the partners unfit to consummate the union.

The most likely scenario is that EMU will occur but will neither end Europe's currency troubles nor solve its prosperity problem. Euro-fantasies envision EMU as a panacea, or at least a pivotal step toward making Europe wonderful -- politically, culturally, economically, socially, financially.

Do not hold your breath.

The United States has substantial flexibility in both wages and labor market institutions. With such arrangements it could conceivably enter a regime of fixed exchange rates. Europe has neither flexible wages nor functioning labor markets, but already has mass unemployment. EMU will add to it, both on the way there and once the system is trapped in fixed rates across vastly divergent countries. If there was ever a bad idea, EMU is it.


Whatever persuaded European leaders in 1991 to single out money as the key vehicle of political integration, it is a poor choice.

Money at best is apolitical, and the European central bank will accomplish that. Leaving aside the political benefits, if any, from integrating currencies, can economic gains be reaped?

EMU is unlike the all-important customs union and the brilliant scheme of completing the internal market. Those dramatic initiatives carried incentives to make the European market, desperately uncompetitive and segmented as it was, into one large unit. The imagination was captured by the vast and highly competitive U.S. market, and the initiative was both bold and worthy.

EMU has little of that.

Currency integration will bring two benefits in two ways. First, the elimination of cumbersome money-changing will make transactions more convenient and reduce the costs of making payments. Second, exchange-rate volatility will be reduced, to zero in fact, and businesses will be better able to trade and invest across intra-European borders.

But by itself a single market does not mean integration of the means of payment. The value of a euro in Barcelona will not necessarily be computed the same in Berlin until and unless a transfer system, akin to the U.S. Federal Reserve's inter-bank wires, is accompanied by a requirement to clear all checks at par. Such a requirement, which would protect against stiff and varying charges by oligopolistic banks, is vitally important to business.

Minor gains in the stability of the deutschemark-franc rates could be more than offset by the increased volatility of rates to outside markets and investors. Were that so, trade integration would be captured by the "ins" at the expense of Europe's "outs" and the rest of the world, from Eastern Europe to the United States. However, there is little evidence that currency volatility, low as it has been, is an impediment to trade. As a result, reduced volatility between the "ins" will not change the landscape of trade and investment in Europe much. In the meantime, it can be used to pressure countries like Britain to be in or really out.

Will Europe, governed by one money, do fundamentally better? The French view is emphatically positive: if Italy cannot devalue anymore, it cannot steal French jobs. Thus for France, one money is great.

But its enthusiasm is based on a fallacy, because what is at issue is the real rate of exchange adjusted for costs. If the nominal exchange rate cannot change, for equilibrium the real rate must change. Expect wages and prices to do the work. The French may be right to believe that it is far more difficult to make adjustments by deflation than by devaluation. But that is small comfort.

In countries with highly flexible wages, the exchange-rate regime makes little difference. In countries with rigid labor markets, like most of those in Europe, flexible exchange rates are all-important.
The most serious criticism of EMU is that by abandoning exchange rate adjustments it transfers to the labor market the task of adjusting for competitiveness and relative prices.

Without wage flexibility, the adjustment process is frustrated; losses in output and employment (and pressure on the European central bank to inflate) will predominate. The overriding cost of an integrated monetary area is that nominal exchange rates disappear as an adjustment mechanism. If a region goes into decline, say, because its exports become obsolete, deflation has to take the place of devaluation. If a region experiences a boom, say, because it has superior research, education, and trade performance, inflation takes the place of appreciation.

Exchange rates as an adjustment tool have a good history, Mexico and Latin America notwithstanding.

Forcing adjustment into the labor market, the European market with the poorest performance, is bound to fail. In backward regions unemployment will rise, as will social problems and complaints about integration. If exchange rates are abandoned as an economic tool, something else must take their place.

Maastricht promoters have carefully avoided spelling out just what that might be. Competitive labor markets is the answer, but that is a dirty word in social-welfare Europe.

What would Rudi do?

I take the liberty to answer that rhetorical question.

Number one: Rudi would tell Greece to leave the euro. Greece is clearly way too weak in per capita income terms, relative to the rest of the European Union, to stay in the fixed euro currency. With 26% unemployment at this moment in time, Greeks can’t bear more downward wage and job adjustments.  

Number two: Rudi would keep Greece in the customs union and the single internal market, though. He would urge flexible labor market adjustment reform on them (that could mean smaller unions, shorter contracts, variable compensation, etc.) Outside the euro, the private Greek labor market and all other Greek goods and services factor costs can now adjust swiftly, via a flexible currency move and more flexible labor markets, to restore competiveness for this poorest of European countries.

Number three: Rudi would get Greece to agree to keep a reform package with loans from both the EU and the IMF. The ECB helps with a new central bank system for Greece, to limit finance transaction costs.  He would see the current Greek weakness and see that a total lack of external sovereign debt finance would collapse the new Greek currency, cause a deep contraction of the Greek banking system, and leave the Greek government isolated politically from Europe and its desirable customs unions and internal market institutions.

Number four: Rudi would at least vocalize about getting Greek government spending down to comparable levels in GDP per capita terms. Less spending would lower sovereign debt demand. That lowers pressure on the new currency.  It also helps keep direct investment, of at least a public sort, on the way into Greece. That builds confidence.  Less government spending should create space for private market expansion, but only over years of time. Cuts wouldn’t help GDP growth matters in the moment, and would hurt.

Number five: Rudi would push flexible labor market reforms onto France, Italy, Spain, and Portugal.  He might see divergence in per capita income conditions between these countries and Germany is not as far apart, or at least not as far apart as Greece is. Pulling the euro would offer less underlying real adjustment.

Number six: Rudi would be pessimistic that the effective labor and wage reforms in these social welfare countries would be sufficient enough to do any good.  

Number seven: Rudi doesn’t like the euro much, regardless. He wouldn’t rule out scrapping the euro currency system. But he could see old internal competiveness issues --like those between France and Italy—re-emerge over time.  He sees the euro as more a political vehicle, in terms of benefits, than an economic one.  

In the end, Greece becomes the case for how to exit the euro currency.

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