The Logic Behind The German Euro Gamble

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Includes: DAX, DBGR, DRR, DXGE, ERO, EUFX, EUO, EWG, FGM, FXE, HEWG, QDEU, ULE, URR
by: Antonio Fatas

In the current economic policy debate in Europe there seems to be an increasing polarization between the German view and the view of the other countries. How did we end up with such polarized views of the world? What is the basis for the apparent German stubbornness to change their mind about what are the right economic policies for the Euro area? Here is my best attempt to explain the economic logic behind that side of the debate, including a critical view of the arguments whenever is needed.

1. Europe needs structural reforms. Correct, this has always been true and it will be true in the coming years or decades.

2. Some countries/governments will find any excuses they can to avoid reforms. Correct. Without external pressure or a crisis, change will not happen. This was also true for Germany in the post-2000 reforms.

3. Imbalances of spending and debt (and asset price bubbles) were a fundamental cause of the crisis. Correct.

4. The pre-crisis imbalances requires post-crisis sacrifices. Correct but only up to a point. We understand that deleveraging can slow down growth but this does not justify the extent of the Euro crisis. For example, the fact that pre-crisis growth was not balanced and required an adjustment does not justify the post-crisis downward revisions that we have seen of potential output in many Euro members.

5. Competitiveness and low wages are the key to growth. Wrong. Prices need to reflect the balance of supply and demand and while it is possible that in some cases some prices or wages are above their optimal levels the idea that reduction in nominal wages leads to growth is wrong. It just leads to deflation. And the idea that reduction in real wages is always good makes no sense. If this was true, let's all work for free to be more competitive. In addition, reduction in wages look a lot like competitive devaluations that we know are not possible everywhere.

6. Good behavior, high saving and a surplus in the current account are a sign of strength. Wrong. Not every country can run a current account surplus. The world cannot save (net of investment).

7. Inflation is always bad. Wrong. Even the Bundesbank always understood that 0% inflation was not optimal. All central banks around the world set inflation targets above 0% for a reason. Questioning 2% as a target and arguing for 3% or 4% (permanently or temporarily) is consistent with the framework central banks use to think about inflation.

8. Germany can live without the euro, it has only been a source of costs for the economy. Germany will certainly be a successful economy without the euro but so far Germany is one of the countries that has benefitted the most from the creation of the euro.

9. Demand does not matter, the only thing that matters is supply and structural reforms. Wrong. Recessions are a reality and some of them are driven by a deficiency in demand. While it will still be true that reforms are needed (see point #1), in the short-term policy should be focused on demand. And what matters for the short run (spending) might be different than what matters for the long run (saving and investment).

So that's how we ended up with a policy that is based on the idea that pre-crisis excesses justify any post-crisis suffering. That assumes that whatever output drops we see are the consequence of the imbalances that led to the crisis and the absence of reforms. That refuses to debate inflation despite the agreement among central banks that 0% inflation is never optimal. That is willing to gamble with the political consequences of discontent in some Euro countries even if they lead to yet another crisis and possibly a break up of the Euro zone.