The Hydraulic Theory of the Euro

Jean-Baptiste Queru recently posted what I call the "Hydraulic Theory" of currency union.  Other than an overall theme of "Blame Germany", it's somewhat discombobulated, but I think the basic point is:

The core mechanism that allows multiple states to share the same currency is pretty simple: since the weaker states can't devalue their currency to compensate for their trade deficit with the stronger ones, money has to flow from the stronger economies to the weaker ones in order to maintain the balance.

Which is pointing out that balance of payments in an identity: your surplus + my deficit = 0

This identity doesn't cause the balance of payments, rather it merely identifies that if someone owes money, someone else must be OWED that money.  Consider if I told you that last year I racked up $20k in debt (credit card).  You could correctly infer that I spent $20K more than I made last year.  It would be ABSURD to say that the debt caused the spending! Rather, the debt simply MEASURES the spending.  The spending resulted from choices I made!

JBQ seems to think that the deficit numbers are simply handed out or something, and that Greece was simply handed a number (-100 Billion) and then forced to spend and borrow that much.  Hopefully you will recognize that this is an absurd way to think of this.  Rather, the deficit number is simply the sum of all the spending decisions Greece made over the course of the year.

Jean-Baptiste is further confused on the facts in the EU.  There are plenty of "weaker states" both inside the EU and outside which run trade surpluses.  Ireland, which is emerging from a mini-depression, and has much lower per capita GDP than Germany, runs a trade surplus.  This is because the Irish government and Irish individuals have made decisions to consume less and save more.  [Update 7/9/15:  It's been pointed out that Ireland in fact has higher GDP per capita than Germany!  I was not aware, and in fact I'd generally thought of Ireland as one of the poorer Western EU nations.  In any case, the hydraulic theory is so wrong there are plenty of counterexamples.  For instance Slovakia has a per capita GDP ~ 40% lower than Germany, but seems to run a trade surplus.] In fact, the general pattern is that poorer (but well-run) nations tend to run trade surpluses which fund further internal investment.  China has run a massive trade surplus for ~20 years.

JBQ is also confused about the US system.  It is true that the Federal government tends to redistribute money from richer states to poorer states, but this has nothing to do with "currency union".  Rather it reflects that fact that the US tax code is highly progressive (more so than EU average) and Federal spending is also progressive (though less so than EU).   JBQ wants to argue that this redistribution is REQUIRED for a currency union.  To argue the contrary, I'd simply point out that c.1900, when differences between the states were even larger, total Fed spending was like 3% of GDP, and most of that was spent on non-redistributive costs like defense.  JBQ's theory predicts that the US system c. 1900 would blow up, but nothing of the sort happened.

Another sort of contrary example is Puerto Rico.  PR gets enormous net transfers from the Feds- about $4k for every man, woman & child in PR per YEAR- 13% of GDP, yet PR has a huge debt, which it just announced it is defaulting on.  Perhaps the problems of debtor states are due to the choices they make, rather than a balance of payment number which "forces" them to assume debt?