Rudi Dornbusch was born and grew up close to my birthplace in Krefeld, in today’s North-Rhine Westphalia, on 8 June 1942. Precisely 70 years ago, a reason to give this great and generous economist, who died ten years ago, a memory. There are other reasons for me, more personal. My late aunt knew his mother quite well and always praised her Mutterwitz, if you wonder where his formidable wit and speed of mind might have originated. When Eliana Cardoso visited the OECD Development Centre in Summer 1988, she was accompanied by her husband Rudi who wanted just to have a desk and to circulate freely in Paris, in intellectually more rewarding places. (The invitation of the couple, I am afraid, turned out to be less than the Centre President had hoped for, as they left the place with a deep feeling of disappointment.) Nonetheless, I had an opportunity to show them my Ph.D. which I had just finished at the tender age of 37, on the “Latin American Transfer Problem”, where I tried to shift the focus to the budgetary problem of public debt, away from the then common view that Latin America suffered mostly from a dollar exchange problem. Dornbusch suggested that I sent a shortened fraft to Peter Kenen, so my Ph.D turned into a Princeton Study in International Finance[1]. I guess they both liked how I used the interwar debate on Germany’s reparation problem to reinterpret the Latin American debt crisis of the 1980s.
Dornbusch’s focus on Latin American financial crises in the 1980s and 1990s provides valuable insights for today’s Europe, as highlighted by a smart blog entry by Ed Dolan, “How the Latin Triangle Swallowed the Euro”, based on Dornbusch’s article[2]. In the graph borrowed from Ed Dolan, the vertical axis denotes the real exchange rate, and real wages that is, as in a fixed-currency setting appreciation lowers import cost and raises the consumption wage; appreciation is upwards. That upward movement of real wages and exchange rates depicts the past period in Southern Europe and in countries with a hard peg to the euro, such as Estonia. The cycle begins at A, with a balanced current account and full employment (well, God bless& fulfill our assumptions!). The Eurozone brings interest convergence, rising real estate prices and rising wages; the economy shifts to B, which denotes an increasingly unsustainable deficit. And then, to quote Rudi Dornbusch, comes the crisis, eventually:
“The crisis takes a much longer time coming than you think, and then it happens much faster than you would have thought, and that’s sort of exactly the Mexican story. It took forever and then it took a night.”
With a sudden stop in external finance, and with the devaluation option off the table, the remaining alternative is a sharp turn toward fiscal austerity. In the short run, that will move the country toward point C, with falling GDP and rising unemployment. If the austerity is sufficiently stringent and kept in place long enough, nominal prices and wages may begin to fall. In principle, such an internal devaluation could move the country down along the line from C toward A. So in the “best” of worlds, with civil servants salaries cut by more than 20% and flexible labour markets, what can be achied is the recovery path of Estonia. Neither is that outlook too appealing, as Krugman has noted by pointing that only half of the slump has been recovered since the peak, nor is all the deflationary hardship to impose politically feasible in all countries. Bruening tried so, we got Hitler.
In recent weeks, when the Eurozone crisis intensified again in that cycle of extreme market stress and public intervention established by now, I have started to wonder what Dornbusch would have said and written. Dornbusch was a Eurosceptic. In “Euro Fantasies: Common Currency as Panacea” he doubted that a common currency could work in the absence of flexible labour markets. And as a Keynesian (which he had increasingly become as his Chicago years vanished in the haze) he feared the deep recessions that the budget cuts stipulated by the Maastricht criteria would cause. He shared the scepticism with many US economists, which he classified in a way that now looks increasingly clairvoyant: “The euro: It can’t happen. It’s a bad idea. It won’t last.”[3]
[1] Helmut Reisen (1989), Public Debt, External Competitiveness and Fiscal Discipline in Developing Countries, Princeton Studies in International Finance No. 66
[2] Dornbusch, Rudiger (2000), "The Latin Triangle," in Keys to Prosperity, MIT Press.
[3] See Lars Jonung and Eoin Drea (2009), “The euro: It can’t happen. It’s a bad idea. It won’t last. US economists on the EMU”, European Economy, Economic Papers # 395, December.