Paul Krugman: Italy and the UK

Italy and the UK, by Paul Krugman, in NY Times: FT Alphaville quotes an economist at an Italian bank, Erik Nielsen, wondering why Britain can borrow so much more cheaply than Italy. It’s a useful piece, largely because it illustrates how hard it apparently is to grasp the advantages of having your own currency.

The writer dismisses the notion that the ability to depreciate the pound gives Britain extra flexibility:

Repeatedly, I am told by investors that the UK is more creditworthy than Italy because the UK can depreciate the sterling, which is supposed to boost UK growth and taxable income. Only problem is that that’s theory while it hasn’t really worked that well in practice. Since the end of 2007, UK GDP has contracted cumulatively by 3.4% in spite of the great sterling depreciation as exports failed to recover, while Italian GDP has contracted by a bit more at 4.4%. Since late 2007, UK unit labour costs have increased by 9.5%; Italy’s by a more modest 7.6%. Most importantly, the weaker sterling has lowered imports as the UK got poorer through higher inflation. In 2007, the average Brit was 30% richer than the average Italian. This year (on Eurostat estimates), the average Brit will be just 5% richer than the average Italian.

It’s true that Britain has suffered a nasty recession — but it had a housing bubble and was highly dependent on earnings from the financial sector, neither of which were true for Italy. As for the rest, Nielsen is apparently using unit labor costs measured in domestic currency — which misses the whole point, which is that depreciation reduces your costs in other peoples’ currency. Here’s the real effective exchange rates of Britain and Italy on a ULC basis — that’s a weighted average of the exchange rate against trading partners, adjusted for changes in unit labor costs:


Britain has achieved a 15 percent relative deflation via depreciation; it would take incredibly painful deflation for Italy to achieve the same. Oh, and Nielsen is looking at GDP per capita at market exchange rates; of course that has fallen. On a purchasing power basis, no way has British income fallen 25 percent relative to Italy’s.

And a final point: using the Bank of England to buy British debt in a liquidity crunch would not be inflationary. I guess that three years into the liquidity trap, people still can’t grasp the point that the size of the monetary base really, really doesn’t matter.

So there are in fact very good reasons why Britain is in better shape than Italy, although the difference wouldn’t be as great if the ECB were able and willing to do its part.

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