Solving the Euro problem and traders

One of the key problems with the Euro is that the countries in the EU are still not fully integrated. The economy of Germany does not move with the those of Italy, Greece or France. There is still a high level of independence which means that some macro fixes would be best be served through a tailored approach. Spain needs macro help that is not necessary for Germany. If each had the their own exchange rate, the weak countries would see an devaluation while the strong growth countries would see appreciation. This would be predicated on growth and independent monetary policy. That cannot happen in the EU today. The internal economic adjustment from an exchange rate change cannot happen if there is a single currency that moves with overall regional behavior. 

Gita Gopinath, a rising Harvard professor in international finance, suggest a novel solution to this problem that could be handled through using the tools of fiscal policy. If you increase VAT taxes on goods and services and also offer decreases in payroll taxes, you will get the same impact as a devaluation of the currency. This approach can be used by each country in the EU to adjust domestic costs. Goods would cost more from the VAT tax but the payroll tax change for domestic goods would make domestic good more profitable and or cheaper. Imported goods prices would increase relative to domestic goods which receive the payroll tax benefit. There would be a switch to cheaper internal goods which would be the same result as a devaluation. The impact of a currency move without a currency move. There are devils in the details but it is an interesting non-market price solution.

Why should a trader care about this idea? One, it does offer a solution to some of the Euro problems, but more importantly, it provides insight on a major theme on what is happening in international finance. There is more focus on trying to adjust economies without seeing the exchange rate change. We are seeing more effort to impose capital controls to stop currency fluctuations. There are more efforts to provide government assistance, but not outright tariffs, to offset the problem of adverse exchange rates. There is a growing focus on using government policy to solve international problems instead of allowing currency prices to adjust. This is a growing issue that is relevant for traders.Governments want to avoid market solutions.