A quick note before the rest of the day bears down on me. Kantoos Economics offers another take on the appropriate European policy response. He rejects the standard line of thinking:
One proposed solution is for Germany to employ fiscal stimulus at home, to increase domestic inflation and increase investment and spending. Simon Wren-Lewis goes as far as to argue that this is what a truly but hypothetical European government would do. I disagree: a European government would employ stimulus in the periphery, not Germany.
Broadly, I agree with this, although I think we view it through a different lens. If Europe had a true fiscal authority, it would automatically redistribute resources via transfer payments and taxes from wealthy regions to less wealthy regions - thus creating demand in the periphery as it adjusts. And also, such a system would allow for a mechanism to boost overall growth as well via deficit spending.
Absent a direct transfer, the next option is an indirect transfer - stimulating Germany in the hopes that greater domestic demand will stimulate exports from the periphery. Assuming that Germany has no interest in pursuing either strategy, Kantoos puts the ball in the ECB's court:
We live in a Keynesian world here in Europe, where downward wage adjustments are very hard. Add to this high debt levels, and it is clear that the internal devaluation process, in the midst of a deleveraging process by households, banks and firms, together with austerity will doom these countries to deflationary recessions....What the ECB should do is to toughen lending standards in Germany, raise collateral requirements, down payments etc., and do the reverse in Spain. This should limit investment and consumption in Germany, and encourage it in Spain. It should mimic a differentiated monetary policy, and try to come as close as possible to the respective natural interest rates.
I think this approach suffers from a number of challenges. First, if capital is relatively mobile, it would be difficult to prevent a loan in Spain from making its way to Germany, so I am not sure the ECB can produce a differential monetary policy. Second, it is not clear that easing lending conditions in the periphery would encourage additional spending. I don't think it will be all that easy to reverse the process of private sector deleveraging in the periphery simply by easing lending conditions.
More to the point, policy to date has been to match private sector deleveraging with public sector deleveraging - the austerity program. What the ECB could do in this situation is to alleviate the need for public sector deleveraging by acting to bring down interest rates on government debt in the periphery. And not with haphazard, start and stop programs the ECB activates only when their back is up against the wall. But instead, to make it clear they are a lender of last resort for Eurozone nations.
Also, I can't imagine that slowing the German economy, and by extension, the overall Eurozone economy, by enacting tighter credit conditions is in anybody's economic interest. I am skeptical that this demand will suddenly appear in Spain. And this, I think, is fundamentally the error in Kantoos' argument - he seems to see this as a zero sum gain. If we reduce demand in Germany, we can make it appear in Spain, thereby reducing the risk of overheating and bubbles in Germany. There are too many internal frictions to prevent such a smooth transfer of demand. Instead, acting to slow growth in Germany will only aggravate the drag in the periphery, thus generating more of the hysteresis effects described by Kantoos.
Finally, Kantoos directed his post at Paul Krugman, not me. But I think that Krugman would see his concerns about high inflation in Germany might refer Kantoos back to this post.