And suppose the Canadian government tightened fiscal policy a lot, just like it did in the 1990's. And suppose this caused the exchange rate to depreciate a lot, just like it did in the 1990's. Would everyone say: "Oh look! Canadian austerity caused a big drop in Canadian GDP, which proves that fiscal policy has big effects!" ? Or would they say "That drop in Canadian GDP is fake, and Canadian GDP, measured properly, did not fall. Because the Bank of Canada loosened monetary policy to fully offset the tighter fiscal policy, so the exchange rate depreciated, and Canadian inflation stayed on target."?

Suppose Statistics Canada only reported Canadian GDP measured in US dollars. So every time the exchange rate appreciated or depreciated by 1%, Canadian GDP would jump up or down by the same 1%, even if Canada was producing exactly the same quantities of goods and services as before. But everyone would agree that those fluctuations in Canadian GDP, measured in US dollars, were "fake".

The title is more inflammatory than I want it to be, but I can't think of a simple way to ask the question properly. And it is a genuine question, because I don't know how they construct GDP data for Eurozone countries. And I know there's no chance I will be able to figure out the answer by myself from reading the Eurostat methodology footnotes. And I don't know what data macroeconomists are using. And I never was that good at national income accounting anyway. I'm trying to get my head straight on this. That's why I'm asking. Because I'm muddled, again.

Now, there really is a real difference between a pair of countries like Canada and the US and a pair of countries like Greece and Germany. The first pair of countries has a flexible exchange rate between them, and the second pair of countries doesn't. And that difference matters, in the short run, because prices and wages are sticky, but the nominal exchange rate isn't, so the real exchange rate can adjust much more quickly if the nominal exchange rate can adjust than if we have to wait for prices and wages to adjust. But in the longer run, it shouldn't matter much. Fiscal policy should have roughly the same long run effect on the real exchange rate whether the nominal exchange rate is fixed or flexible.

You can see where I'm going with this. Greece had a loose fiscal policy in the 2000's, then tightened fiscal policy a lot in the 2010's. Even if Greece had perfectly flexible prices and wages, so fiscal policy had no effect on output and employment, and changed only the mix of output and employment between the tradeable and non-tradeable sectors, we would expect to see a big drop in Greek GDP relative to German GDP, if both are measured in the same common currency. But that drop in GDP would be "fake", in exactly the same way that the drop in Canadian GDP, measured in US dollars, in the 1990's, is "fake". Canadian GDP wasn't "really" that high when we had loose fiscal policy, and wasn't "really" that low when we had tight fiscal policy.

Now I'm not daft. I know that when you have that big an increase in unemployment (and emigration) there's no way that Greek output hasn't dropped, by a lot, any way you measure it.

But thinking longer term, if we compare Greek and German GDP per capita, both measured in Euros, it would be utterly unsurprising to see Greece doing relatively worse in future, compared to the days when it ran large budget deficits, even if Greek employment and productivity recover fully. The relatively high Greek per capita GDP, compared to other Eurozone countries, when both are measured in the common currency, back when Greece ran unsustainably large budget deficits, was at least partly "fake", being due to an unsustainably high real exchange rate.

How big is this effect? I don't know. It would depend on the real exchange rate elasticity of net exports. If that elasticity is low (as I suspect it might be, for Greece), the effect would be big, because a given trade deficit caused by a budget deficit would require a big appreciation of the real exchange rate.

This post is what came into my mind after reading the Mean Squared Error post (HT Mark Thoma), arguing that Greece wasn't doing too badly, relative to Germany, in terms of per capita GDP, before 2010. Now JEC does say:

"One indicator we might want to look at is Greece's per capita output compared with that of the EU as a whole, on a price-harmonized (i.e. purchasing power parity) basis. Conveniently, Eurostat publishes exactly that, expressed as an index for each country with the annual EU average pegged at 100."

If Greece produces olives, and imports German cars, an unsustainably high real exchange rate, caused by an unsustainably large fiscal deficit, means an unsustainably high price of olives relative to cars, so Greeks would have unsustainably high purchasing power over cars and olives compared to Germans. Each Greek olive would buy more German cars; and each German car would buy fewer Greek Olives.

