Economics 9: international trade and the eurozone crisis

by George Hatjoullis

The international element has been alluded to in the previous lessons without explanation. It has been noted as a source of extra GDP and a place to sell extra GDP. Comparative advantage illustrates why international trade takes place even though each nation state is quite capable of producing all goods available. It is not simply to acquire things not available within national boundaries (though this too encourages trade). The theory of comparative advantage is used to argue that trade benefits all. As we saw in Economics 7 , it can benefit all. Whether it does is another matter.

International trade exists because economic activity is defined and regulated within national boundaries, at least in principle (this is less and less true). A country with more GDP than it can sell domestically can sell it abroad, at a price. The price is the issue. Different nation states typically use different forms of money and so a monetary exchange is necessary before trade can be consummated. The rate of monetary exchange, or the exchange rate, is thus the central focus of international trade. The exchange rate is simply the price of one form of money in terms of another form of money. In a freely floating exchange rate environment, the exchange rate is determined in a market through the operation of supply and demand.

Economists like the concept of one price. The idea is that the exchange rate makes the price of a unit of GDP in country A the same as the price of a unit of GDP in country B (minus any transport costs, tariffs etc). If the law of one price does not hold then it will pay someone to buy GDP in the cheaper country and sell it in the dearer country. This GDP arbitrage will bring the GDP price in line. The export of cheap goods will put upward pressure on the price of GDP in the cheaper GDP country and downward pressure on price in the importing more expensive GDP country, until the prices are the same (exchange rate adjusted).

This price adjustment can occur in three not mutually exclusive ways. Price in the cheaper country can rise, price in the expensive country can fall or the exchange rate can change to eliminate the arbitrage opportunity. In a freely floating exchange rate environment, the exchange rate does most of the work. So if a unit of US GDP costs $100 and a unit of UK GDP costs £60 (and ignoring trade costs, tariffs etc), the exchange rate needs to be $1.67 per pound to make the price of GDP the same in both nations. Don’t believe me? What if the exchange rate was $1.50? US exporters would do better buying in the UK and re-selling in the US. A unit of GDP in the UK costs £60. However, at an exchange rate of $1.50 this only costs the US importer $90. A nice $10 profit. This profit will be eliminated only if the exchange rate moves to $1.67 (or the GDP prices move).

Of course, the above is a criminal oversimplification. Apart from tariffs, transport costs etc, it assumes US and UK GDP is perfectly fungible. Moreover, it ignores the fact that monetary transactions occur not just for GDP but also ownership of the means of production (recall the distinction between GNP and GDP). Finally, there may be intergovernmental financial transactions. All these might also influence the exchange rate. Nevertheless, the simple arbitrage mechanism illustrated here will, in a market based system, be operating at some level.

What happens if the exchange rate is fixed? The price adjustment must take place in the price of GDP itself. It takes place through inflation and/or deflation. Let us go back to the above example and also assume both countries are initially operating at potential. In the above example, the UK needs some inflation and the US some deflation. Assume the exchange rate is fixed at $1.50. Assume also that the UK has a strict no inflation monetary policy. The only way to eliminate this arbitrage opportunity is for the US to experience deflation until the price of one unit of US GDP equals $90. Only then does it cease to pay US importers to buy in the UK and sell in the US.

How does the US deflation come about? If US citizens cannot move to the UK, and even businesses are restricted, then the deflation comes about by forcing US GDP below potential. People are laid off because instead of making GDP, the US imports from the UK. The deflation is achieved but only at the expense of the US remaining at below potential GDP and with unemployment. It would ease the burden on the US if the UK would also inflate but the UK resists this through price stabilising monetary policy. It can do this because it is the country with the trade surplus (selling more abroad than it imports). It can accumulate US dollar money in exchange for goods and act to contract the money supply by an equivalent amount. In effect, the UK simply increases savings but in terms of US dollars. The US has no choice but to cut spending and run down sterling savings. The burden of adjustment falls entirely on the US because the UK refuses to allow any inflation of the price of its GDP and the US cannot avoid adjustment.

What if the exchange rate is not only fixed but the US and UK have no restrictions on the movement of people or businesses across the two nations. The unemployed people and underutilized businesses of the US might move to the UK and produce GDP in the UK. The potential GDP shrinks in the US and expands in the UK. It is likely that some deflation will have taken place to bring about the unemployment and underutilization of businesses. However, there is no automatic reason why the deflation would have reduced the US GDP price to the level necessary to eliminate the arbitrage. Indeed with potential GDP expansion in the UK, the price of GDP could fall. The process could thus continue for a long time, with the UK potential GDP growing and US potential GDP contracting. Does any of this sound familiar?

It should sound familiar. The eurozone has fixed exchange rates and free movement of capital and labour. Resources are moving from the inefficient (high cost periphery) to the efficient (low-cost) northern core. The resource movement is enhancing the efficiency differences so the movement may continue for a long time. The adjustment could be eased if the northern core allowed more inflation in their sovereign regions (and in the eurozone overall). However, German pathological fear of inflation is circumventing this process despite the ECB’s best efforts. The process of labour and capital movements has physical and social limits. It is unclear what will happen when these are reached. The only way the periphery could avoid this cumulative collapse of potential GDP is move to flexible exchange rates (leave the euro) or suddenly become more efficient (reform). This is the eurozone crisis.

To recap:

1. Comparative advantage and unequal resource distribution explains trade.

2. Different countries have different monies and the exchange rate is the price of these monies in term of each other.

3. The law of one price equates the price of a unit of GDP across nation states.

4. In a floating exchange rate environment the exchange rate moves to equate the price of a unit of GDP across nation states.

5. If exchange rates are fixed price levels must adjust. The adjustment need not be symmetric. The trade surplus producing country can avoid adjustment.

6. If labour and capital are not mobile, the deficit country may experience below potential GDP if it becomes a high cost producer and cannot change its exchange rate.

7. If labour and capital are mobile then the deficit country may experience a cumulative destruction of potential GDP. This describes the present situation within the eurozone.