Krugman Versus ZeroHedge

Includes: DBGR, DXGE, EWG, FGM
by: Shareholders Unite

We've been recently kicking the tires of Austrian economics (here, here, and here), which seems to be rather popular in the financial world (much more so than in the economics world were we come from). We think that it is wanting on many levels, as we tried to show in these previous (and upcoming) articles.

Probably the biggest Austrian inspired financial website is ZeroHedge. It has (like people as Jim Rogers, Peter Schiff, and Marc Faber) predicted financial mayhem for years, has daily rants against policy makers (the 'central planner' Bernanke, etc.) and Keynesianism in particular.

While it makes for entertaining reading, the economics behind it is deeply wanting. Take for instance what they are arguing about Germany in reaction to the EU Commission starting an inquiry into Germany's trade surplus:

Because how dare Germany produce stuff that the world needs and buys,
instead of flooding its economy with record debt to fund
consumption-driven "groath.

Yes, Germany produces products that are successful in world markets, but this has next to nothing to do with the huge surplus on the German trade balance, and the cheering from ZeroHedge shows a rather basic misunderstanding of this. Krugman, in several blog posts (here, here, here and here), has pointed this out.

  1. Not every country can run a trade surplus, world trade balances (despite some accounting problems)
  2. A trade surplus simply means that a country spends less than it produces
  3. Germany act as a net drag to the euro area, both through running large trade surpluses and producing low inflation

The first two points are rather uncontroversial, the third warrants some explanation. The basic problem in the euro area is that countries have misaligned prices. These were actually the result of the creation of the euro, which led to a huge boost in confidence in the peripheral countries, as they could no longer devalue.

The result of this confidence boost is visible in the collapse of the bond yield differentials vis-a-vis Germany:

As a result, capital flew from the center (banks) to the periphery, creating large surpluses on the capital balance. Of course, the mirror image of a surplus on the capital balance is a deficit in the trade balance, the periphery increasingly became uncompetitive as the capital inflows created booms (of various characters) resulting in an accumulation of inflation differentials with the core countries.

And in the years before the financial crisis this process was actually helped by the ECB setting interest rates too low, and one might want to keep in mind that the main reason it did that was because Germany wasn't doing so well in the early euro years..

Now, when the music stopped because of the financial crisis, the capital inflows stopped, but the accumulated inflation differentials remained and the point is, these are extremely hard to reverse as the peripheral countries do not have currencies that can be devalued.

The problem is, Germany's policy stance is shifting the burden of adjustment entirely onto these peripheral countries, by:

  • Running a large trade surplus, that is, Germany spending less than it produces and earns
  • Producing very low inflation
  • One could add to this that Germany is the main driver behind the eurozone machinery that obliges the periphery to stringent austerity measures.

How does this work out?
Not very well. The huge spending cuts and tax hikes in most of the periphery have indeed cut their trade deficits, but this is simply mostly a cyclical, not a structural adjustment as the reduced spending also cuts import demand. If and when these countries emerge from their deep slump, import demand will simply increase again and the trade deficits will re-emerge.

We might also notice that the deep slump is a terribly expensive way to (temporarily) cut trade deficits, unemployment has shot up way into double digit territory almost everywhere in the periphery.

Whilst sky high unemployment and deeply depressed demand have indeed had a moderating influence on wages and prices, the efforts have not been nearly enough. Only in Greece prices are falling (moderately) and that only in the last year. And remember, for this to happen, a six year slump in which output fell by more than a quarter and unemployment shot up to nearly 30% was necessary.

And this is not even all the cost of this 'internal devaluation.' Falling prices and output wreak havoc on public finances. Lower prices increase the real burden of debt, and lower output reduces tax receipts and increases the debt/GDP ratio. Note two things:

  1. In order to create a sub 1% deflation, it took six years of output losses, more than a quarter of real GDP loss, and employment reaching nearly 30%. This is how difficult it is to create deflation. Portugal, Spain, Ireland, Italy are close, but not there yet.
  2. The eurozone periphery is faced with a terrible catch-22 situation: creating deflation improves competitiveness but wrecks the economy and public finances.

But not creating the deflation

There has to be a better way
This is were Germany comes in, it can help in two ways:

  1. Spend more and save less as a country, remember, Germany's huge trade surplus is simply the expression that the Germans spend less than they earn and produce. This would increase the demand for the periphery's exports, helping with the adjustment process
  2. Produce somewhat higher inflation. Germany's inflation of 1.5% sets the bar very low for the periphery to get under. Remember, to win back lost competitiveness, the peripheral countries have to produce lower inflation than Germany's. With such low inflation in Germany, they actually have to lower prices, that is produce deflation. We've just demonstrated that you have to wreck your economy (and public finances) to achieve that.

The cost of German intransigence here is tremendous, and this could very well come back and bite them in the tail. Their exports to the eurozone periphery is suffering due to the unprecedented slump there. But much more importantly, German tax payers are on the hook for hundreds of billions of euros through various eurozone rescue operations should these countries slump further.

Remember, the damage done by negative growth and zero or negative inflation to the public finances and public debt/GDP ratio is immense, and by shifting all the burden of adjustment on the periphery, this is only made worse.

So clearly, we side with the Krugman part of the story here. While we understand the admiration of ZeroHedge and others for the German economy (did they notice even German public debt/GDP stands over 80%?), their huge trade surplus can't be repeated everywhere, and, together with the low inflation, makes the adjustment for the eurozone periphery to win back lost competitiveness that much harder.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.