What the Swan diagram can teach us about the Euro crisis and how to resolve it
The Swan diagram is an elegantly simple diagram in international economics that describes how a country can achieve the two objectives of internal and external balance. Designed by an Australian economist in the 1950s, it has been recently applied to China by both Paul Krugman and Gavyn Davies (http://blogs.ft.com/gavyndavies/2012/05/27/chinas-policy-mix-changes-for-the-better/#axzz21Ea00JbQ).
On the y axis we have the real exchange rate (although it can also be used with the nominal exchange rate with the additional assumption of fixed prices). On the x axis we have domestic demand.
We also have two curves. The upward sloping curve shows the relationship between domestic demand and real exchange rate that maintains internal balance. Internal balance is best thought of as the maintenance of full employment, with the area to the left of this curve representing underemployment, while the area to the right shows overemployment and inflation. It is upward sloping because an increase in domestic demand puts pressure on employment and inflation, which needs to be offset with a higher real exchange rate that discourages exports.
The downward sloping curve represents external balance in the economy. External balance can be thought of as a current account of zero, or more abstractly, as the target set by government for the current account. As domestic demand increases, it pulls in more imports, which needs to be offset by a falling real exchange rate to maintain external balance. Hence, to the left of this curve we have a surplus, as domestic demand is not strong enough to offset exports. To the right of this curve there is a deficit, as domestic demand is too strong with more imports than exports.
Why Spain is in that quadrant
At present, Spain is situated in the quadrant that signals a deficit on the current account and unemployment. It has had a deficit since 2008, while the unemployment crisis has been getting steadily worse since the global financial crisis.
What this reveals about a necessary part of a successful crisis resolution
It is not just the financial market solutions and monetary union solutions that need do be put in place for the Eurozone to survive. There is also the balance of payments crisis and the ‘real’ side of the economy. What Spain needs more than anything is a much lower real exchange rate, which would move the economy closer to both internal and external balance. The problem is, however, that they are in the currency union, meaning that they cannot get the needed exchange rate adjustment through nominal exchange rates. They must achieve this adjustment through a decline in relative prices, which is a much slower process than a currency devaluation.
This is the reason why the macroeconomic policies of Germany and the core are so important. If these countries encourage domestic spending, this will not only pull in exports from other European countries, but it will push up prices in these countries. This will accelerate the relative price adjustment that a country like Spain needs to regain competitiveness.
Assuming this acute phase of the Euro crisis comes to an end, this Swan diagram also points to possible issues of the monetary union in the coming years. If a country such as Spain suffers an asymmetric shock that moves it back to a position on the Swan diagram that we see now, there is yet no recognition of how a country will get out of this situation. With a one-size-fits-all monetary policy, it may be that the ECB cannot provide stimulus if inflation is already at the limit in other countries. Similarly, if Spain is fiscally constrained through European rules set out in the fiscal compact, the government cannot provide stimulus either, resulting in an economy that is stuck a long way from internal and external balance.
The negotiations of the Eurozone summits will have to watched closely for these macro economic complexities. Will there be some recognition that a monetary union may involve transfers to some countries in need? Is there a better way to conduct monetary policy and measure Eurozone inflation in a way that encourages balance in all countries?
The simplicity of the Swan diagram belies it’s understanding of economic adjustment. Countries cannot be in such a position of imbalance for too long. If citizens in a European country remain stuck in high unemployment for too long, they will look to political parties that promise something better. This will run the risk that these new parties will see an exit to the currency union as the best solution, and so the cycle of fear and uncertainty starts all over again.