How Germany Can Save The Euro

Includes: EU, EWG, FXE
by: Kevin Flynn, CFA

Does anyone out there feel like they're not getting enough worry about Greece? The question of a Hellenic exit from the euro, European Union or both has been a Damoclean sword overhanging markets for much of the last two years.

We're all familiar with the principal ingredients of the Faustian stew that nobody wants to eat: those lazy Greeks and their corrupt politicians lived above their means, and now they don't know how to live frugally and sensibly and get out of the hole. There is no provision for an exit; we cannot break the unbreakable vow. The political situation has irreparably declined.

Or maybe the vow isn't unbreakable; we've built a massive firewall. Yes, but it can't be wasted on wastrels. We don't want them to leave, but if they won't behave sensibly, what else can we do but let them go? It won't be so bad. We're prepared now. Markets are ready (thus spake Hank Paulson). What about Portugal and Ireland? We cannot allow contagion.

Not very pleasant, is it. The irony of it all is that the real solution to the Gordian knot isn't for Greece to leave the Eurozone. It's Germany that should leave.

No, seriously. My inspiration for this insight was triggered by Wharton economist Jeremy Siegel telling a conference on alternative investments that the only way for the Union to solve its debt problems and avoid contagion is for the European Central Bank (ECB) to devalue the euro. Quite sensible, I thought, but fat chance that the Germans would ever agree to devaluation. Sensible yes, because devaluing the euro would make debts easier to repay and the euro countries more competitive on the world markets. Fat chance as well, because the German conviction for having a strong, solid currency like their beloved Deutschemark would be immovable. They agreed to give it up only on the condition that the euro would be a virtual mark.

But as I reflected on the impossibility of German agreement, it came to me: Well then, let them have the mark back. It would solve everything.

Consider the chart below, which shows unit labor costs in the European Union the last 11 years. Impressive, isn't it? There is Greece, raising its costs faster than anyone, while Germany is well below the rest.

European Unit Labor Costs 2000-2011

Source: Eurostat

This problem is at the crux of the EU tension. Germany, its representatives will not fail to tell you, underwent a long period of wage repression and restructuring to make themselves more competitive. In other words, they wore the hair shirt and succeeded, so let the Greeks (Portuguese, Irish, whoever) do the same.

The argument omits key components of German success. The first is that an underlying motivation for Germany to accomplish its goals was national unity (the absorption and restoration of the former East Germany), and the second being that Germany had a significant tailwind during the recovery years of 2003-2008. The Greeks are being asked to extend an already grinding recession.

But there's a third, more important factor: just as the Greeks used the euro for access to cheaper borrowing and artificially raised their standard of living, the Germans used the euro for access to a cheaper currency. Exports rose from 29% of German GDP in 1999 to 47% in 2008. If Germany was still using the mark, what do you think its exchange rate would be? It wouldn't be anywhere near the current dollar rate of $1.30, I can promise you that. I would guess that in these troubled times, it would be something beyond $2.00, the rate in 2001 when the mark was last used. How about $3.00, circa 1985?

If Greece were to give up the euro, the hope is that it would benefit from a much cheaper drachma, at least so far as its debts and competitiveness were concerned. Another partial write-down of debts, even a full one (i.e., default) would also be a possibility. However, the up-front costs would be steep: switching costs, inflation that could possibly be severe for a time, a drop in the standard of living before it improved (the J-curve effect), the blow to national prestige.

Germany would experience the switching costs, but none of the rest. The mark would immediately be the strongest currency in Europe, and if anything the country would experience deflation rather than inflation. They might even be joined by the Netherlands, which would certainly be one of the odder turns of events of this century.

The euro would undoubtedly weaken without its anchor member. So much the better for all of the remaining members, including Spain, France and Italy, who would all benefit substantially from a euro that was at parity to the dollar. With one stroke, the imbalance (imprudence, if you like) in unit labor costs would be rectified. The Germany-less EU would surely see some increase in inflation, but nothing on the scale that would happen to a gutted Greece. More likely it would rise to mid-single digit rates before subsiding. With devaluation, there would be little need to print excess amounts of money, and there is too much slack in the labor force (EU-wide unemployment is around 10%) to worry about classic demand inflation suddenly raging unchecked.

The usual prescription for rectifying the German imbalances with the rest of the Union is for the Germans to consume more and save less. Such an approach has the advantage of working over time, but the disadvantage of trying to convert a thrift culture to a spending one. That takes years, if it works at all, because such changes are by no means a switch that can be simply turned on and off. It has never really taken hold in Japan, for example. There is also the inconvenient truth that the Union does not have years of waiting at its disposal to save itself from chaos.

There is no need for Germany to leave the European Union. The U.K. and Sweden are doing fine as euro-less members. Just give Berlin back the mark, and if a couple others want to join them (Finland, Austria), no worries. Let Frankfurt fight the eighty-year old inflation bogeyman all it wants. Throw in the ECB building there as a parting gift and put the new offices in Strasbourg, where the EU parliament is.

There is no need to ask Germany for another nickel, and no need to impoverish the periphery so the Germans can have a discount exchange rate. No need to listen to any more Calvinist, Hayekian moralizing from Finance Minister Wolfgang Schaeuble and his acolytes. The rest of Europe gets on with it, and for those who feel bereft, podcasts on the virtue of thrift and zero inflation will be available for download from the Bundesbank website.

The latest cover of Der Spiegel bears the headline, "Akropolis Adieu!" I say it's time for, "Auf Wiedersehen, Angela!" Take your ball and go home, guys. No reason for you to subsidize the weaker countries, and no reason for them to subsidize your exports. Keep your sound money, keep the Bundesbank, EU contributions, Austrian economics and by the way, have fun with that new $2.75 exchange rate. You'll adapt, I am sure, because you already know the magic formula of austerity and recession. You invented it.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.