German exports and the Eurozone

I have argued that the low level of German wage increases before the financial crisis were a significant destabilising influence on the Eurozone, which also indirectly contributed to Germany taking a hard line on austerity. The basic idea is that Germany gained a significant competitive advantage over its Eurozone neighbours, which it has since been unwilling to unwind (through above average German inflation). What this competitiveness gain did was lead to very healthy export growth and a large current account surplus, and that additional demand meant that Germany did not suffer as much as its neighbours from the second Eurozone recession that policy created. Peter Bofinger has made a similar argument.

This argument is often criticised on the grounds that Germany’s healthy export growth was not primarily due to any competitive advantage, but instead was the result of non-price factors like strong demand from China for the type of goods Germany produces. This and other criticisms were recently made in a paper by Servaas Storm. One of the points made by Storm has itself been criticised by Thorsten Hild, and Hild’s point is entirely correct (see also Storm’s reply here). But the issue about what was the primary cause of strong export growth remains.

Trying to disentangle how much of German export growth was due to the competitiveness advantage they gained would require some econometric analysis which unfortunately I do not have time to undertake. But the point I want to make here is that if there has been a permanent positive shift in Germany’s exports (i.e one unrelated to price or cost competitiveness), then this strengthens the argument that I have been making. Before we get there, it is worth going through the basic macroeconomics involved.

Every country will tend towards some long run level of competitiveness. There are many ways of describing why this is: the need to obtain a balance between the production and demand for domestically produced goods, or the need to achieve a sustainable current account deficit. There are many reasons why this long run level of competitiveness could change over time, but in the absence of a plausible story about why that has happened to Germany (or equivalently, why a 7% of GDP current account surplus might be sustainable) it seems reasonable to assume that it has remained unchanged.

So if an economy in a monetary union, like Germany, moderates wages so that it gains competitiveness in the short term (where the short term could last a decade), this gain has to be unwound at some point. Just as the decline in competitiveness in the periphery needs to be reversed by creating below Eurozone average inflation there, the opposite applies to Germany.

Now suppose there has in fact been a permanent upward shift in the overseas demand for German goods. In the long run if nothing changed we would have an imbalance: the demand for German goods would exceed the supply, or the current account surplus would be unsustainable. The way the economy reacts to get rid of that imbalance is through additional German inflation. Not only must past gains in competitiveness be reversed, but competitiveness must decline even further to reduce the demand for German goods.

For those brought up on a mantra of the need to constantly improve competitiveness, this may seem perverse: getting punished for making goods other countries want. But of course it is not punishment at all. A decline in competitiveness is the same thing as an appreciation in the real exchange rate, and this makes consumers better off, because overseas goods become cheaper (in the jargon, there is a terms of trade gain). It is time for Germany to export a bit less, and start enjoying the benefits.

Posting note

For various reasons over the next month the frequency of posts may diminish. Don’t go away - I will be back.  

Competitiveness: some basic macroeconomics of monetary unions

From comments on an earlier post, it is clear how many people do not understand how a monetary union works. Thinking about it, I also realise that while the macroeconomics involved is entirely straightforward and uncontentious, it may only be obvious to someone who is used to working with models. As I do not want to restrict my readership to those with such knowledge, I thought a brief primer might be useful.

We need to start with the idea that for a country with a flexible exchange rate, you will not increase your international competitiveness by cutting domestic wages and prices. The reason is that the exchange rate moves in a way that offsets this change. This is what economists might call a basic neutrality proposition, and there is plenty of evidence to support it. The Eurozone as a whole is like a flexible exchange rate economy. So if wages and prices fall by, say, 3%, then the Euro will appreciate by 3%.

So what happens if just one country within the Eurozone, like Germany, cuts wages and prices by 3%. If Germany makes up a third of the monetary union, then overall EZ prices and wages will fall by 1%. Given the logic in the previous paragraph, the Euro will appreciate by 1%. That means that Germany gains a competitive advantage with respect to all its union neighbours of 3%, plus an advantage of 2% against the rest of the world. Its neighbours will lose competitiveness both within the union and to a lesser extent against the rest of the world.

That may seem complicated, but to a first approximation it is in fact very simple. The Eurozone as a whole gains nothing: the gains to Germany are offset by the losses of its union neighbours. For the union as a whole, it is what economists call a zero sum game. Germany gains, but its EZ neighbours lose.

One of the comments on this earlier post said that there was nothing in the ‘rules’ to prevent this, the implication being that therefore it was somehow OK. But it must be obvious to anyone that this kind of behaviour is very disruptive, and hardly compatible with Eurozone solidarity. An idea sometimes expressed that it represents healthy competition is wide of the mark. The only incentive it provides is for other countries to try and emulate this behaviour. If they all achieved that, nothing would be gained. The Eurozone inflation rate would, other things being equal, be lower, but other things would not be equal: the ECB would cut rates to try and get inflation back to its target.

The reason there are no formal rules about all this is straightforward: you cannot legislate about national inflation rates. What you could do, to incentive governments, is establish fiscal rules based on inflation differentials of the kind described here. That would have meant that as relative German inflation rates fell, the government would have been obliged to take fiscal (and perhaps other) measures to counteract it. Once again, this is a symmetrical case to what should have happened in the periphery countries. But if rules of this kind had been on the table when the Euro was formed, I’ll give you one guess about which country would have objected the most.

The wheels on the bus

I have an image in my mind. Its a bus running downhill, and its brakes have failed. There are four men in the front cab. The two men in the middle are both trying to control the steering wheel to keep the bus on the road. The man to their right has control of the accelerator, and is pushing on the gas hoping this will crash the bus to the right. The fourth man to their left controls nothing, but as his pleas to stop pressing the accelerator fall on deaf ears, he begins to wonder whether it would be better for the passengers to grab the wheel and crash the bus to the left. The three other drivers do not agree on very much, except that it is all the fault of the guy on the left, and now appear to be thinking about throwing him off. As the bus hurtles downhill swerving from side to side, its passengers are battered, some injured, and a few are jumping off.

I do not need to explain the symbolism. I tried to change the image to explain why the man on the right refuses to stop pressing on the accelerator of growing primary surpluses, but gave up because the real reason is that he wants to crash the bus anyway. (The argument that the Eurozone’s rules do not allow debt write-offs is just nonsense.) Otherwise I think the image works well. The two men in the centre represent Tsipras and maybe Hollande. Hollande is saying that if only you would let me have the wheel (‘structural reform’) all would be well, but in truth the main reason the passengers are being injured (unemployment and welfare cuts) or are jumping (migration) is the speed of the bus.

The central question is whether the men in the middle are delusional. By keeping the Greek economy on the road that is the Eurozone are they only going to prolong the agony with the same inevitable crash which is Grexit?

There is only one reason for optimism that I can see, although it assumes yet further reductions in Greek living standards. The hill the bus is travelling along will begin to flatten out and the road might even start to rise as Greece becomes more competitive in terms of price. I outlined here why that has not yet boosted the Greek economy to the extent it has in Ireland, but if unemployment remains at or above 25% Greece should get even more competitive. Instability and unwise Troika interventions may delay the process, but eventually the tourists will come. The Eurozone does contain a natural correction mechanism: it is just slow and painful.

If this does eventually lead to sustained growth in Greece, it does not excuse what has gone before: recoveries do not justify recessions, and government profligacy does not have to imply a 25% fall in GDP! However this correction mechanism is not bound to succeed, if it is countered by another dynamic, which is one that has been and continues to be imposed by the Troika. That dynamic is austerity chasing primary surpluses when that austerity makes the economy shrink. Macromodels would probably tell us which dynamic will win out, but they will not factor in a deterioration in the financial position of banks (already not good as Frances Coppola points out) as the economy stagnates, and the deteriorating social and political situation that austerity brings.

So the eventual outcome still depends on the decisions of the Troika. It always has of course. The truth that their apologists find so uncomfortable is that the Troika has been in charge of the economy since 2010, and therefore is responsible for the mess we are now in. The idea that all would be well if only Greece had undertaken every item of structural reform they specified (and a lot was done) is just silly. Now it appears as if it is all the fault of the former Greek finance minister, because he dressed funny, or kept wanting to talk about economics, or did some contingency planning - it is so absurd you couldn’t make it up.

One ray of hope offered by Anatole Kaletsky is that now “ritual humiliation” has been achieved, the Troika will be more forgiving. I wish he was right, but this argument fails to account for the German finance minister who clearly believes that exit is the best option. He wants the bus to crash for the sake of the other cars on the road. An optimistic view would be that the shock [1] of what was done to Greece a few weeks ago will bring others to their senses, and Schäuble’s influence on the Eurogroup (and strangely the IMF) will decrease. I fear the larger truth is that the non-German bloc in the Eurozone does not have an alternative economic vision to offer (although it clearly exists), and will never face Germany down.

[1] Link added 31/07

Germany and pre-recession cost cutting

In a recent post I argued that many of the Eurozone’s current problems stem from low nominal wage inflation in Germany before 2008. In that post I also noted that this could be justified if Germany had entered the Eurozone at an uncompetitive real exchange rate, but that I thought there was little evidence for this. I want here to expand on that point.

One area that I have worked on extensively in the past is what might be called the empirical analysis of equilibrium exchange rates. The term equilibrium is short for where the real exchange rate is heading over a five year or so time horizon. While predicting exchange rate movements from day to day is impossible, this is not the case over the longer term. It was for this reason that the UK Treasury asked me to analyse what an appropriate entry rate for Sterling might be if we had joined the Euro in 2003.

There are two ways of describing the approach I take in this analysis. The first is to calculate the exchange rate that will achieve ‘external balance’. As John Williamson repeatedly points out, external balance does not mean current account balance, but the current account that is consistent with medium term trends in domestic supply and demand. This is why the approach is equivalent to a second way of describing it, which is to apply the ideas of the ‘new open economy’ literature that now dominates open economy macro.

In a 1998 study with Rebecca Driver for the (now called) Peterson Institute (which contained a key contribution from John Williamson and Molly Mahar) we calculated equilibrium rates for 2000 for France in the range of 3.06-3.74 Fr/DM, and Italy 927-1133 Lire/DM. The actual entry cross rates were 3.35 Fr/DM and 990 Lire/DM, which is pretty close to the middle of those ranges. In other words, according to our analysis Germany did not enter at a significantly uncompetitive rate compared to these two major economies.

A crude way of doing exactly the same analysis is simply to look at the current account balance. Here it is for Germany, as a percentage of their GDP. The problem with this simple approach is that the current account is a noisy signal, and it is exactly this problem that the analysis described above tries to deal with. But for the sake of argument let’s say that, because of well known lags, the current account in 2001 reflected the competitive position of Germany when the Euro was created.

Germany’s current account in 2001 was in balance, and according to the OECD its output gap that year was a positive 0.7%. So Germany could only be uncompetitive on entry to the Eurozone if that current account balance was unduly influenced by one off factors, or that it really should have been running a structural surplus because of relative demographics or some other reason. But such structural surpluses are normally of the order of 1% or 2% of GDP. Looking at the current surplus of over 7% of GDP, you just have to conclude that Germany currently has a hugely undervalued real exchange rate, which is just another way of saying that it is too competitive compared to its Euro partners. It achieved that competitive advantage from 2000 to 2007.

So where did this idea that Germany entered at an overvalued (uncompetitive) exchange rate come from? I suspect it derives its force from what happened to German GDP growth after the Eurozone was created. As the chart below shows, Germany entered a recession in 2003. In addition, in 2003 foreign trade subtracted from growth. However in terms of the contribution of trade to growth this was a blip: both before and after export volumes grew faster than import volumes, reflecting the growing competitive advantage it was gaining through low nominal wage growth. (A ‘sustainable’ pattern would have domestic demand growing at the same rate as GDP, with a foreign contribution averaging zero.) So if we consider the period 2002 to 2004, for example, the recession was despite a positive contribution from trade, so trade can hardly have been a cause of it. The real reason for the depressed German economy was a decline in domestic demand, coming from both consumption and investment.

Whatever the reason for depressed domestic demand growth, it was not permanent, with healthy growth in 2006 and 2007. By that time, however, Germany had through low nominal wage growth gained a large competitive advantage compared to its Eurozone partners, which was the subject of my earlier post.

Germany’s undervalued real exchange rate - its competitive advantage compared to the rest of the Eurozone - cannot persist. It will be eroded by faster inflation in Germany relative to other Eurozone countries. The only question is whether this happens through a boom in Germany, or continued depression in the rest of the Eurozone. Yet failure to see the source of the problem as coming from Germany continues to mire the debate. There is endless discussion of the need for structural reform outside Germany that ‘must be part’ of any solution to the Eurozone’s current problem. Structural reform may or may not be desirable in many countries, and perhaps even Germany, but it has nothing to do with the need to raise the level of aggregate demand in the Eurozone as a whole. As far as competitiveness imbalances within the Eurozone are concerned, the problem is a result of a negative inflation shock in Germany. The natural place to look for a solution is not structural reform outside Germany, but a period of above target inflation within Germany, and it is in the interests of pretty well every Eurozone country other than Germany that this should happen.

The untold story of the Eurozone crisis

Everyone knows that the Eurozone suffered a crisis from 2010 to 2012, as periphery countries could no longer sell their debt. A superficial analysis puts this down to profligate governments, but look more closely and it becomes clear that the formation of the Euro itself led to an excessive monetary stimulus in these periphery countries. This is widely understood.

But this is not the whole story. It leaves out one key element that is vital if we are to understand the situation today. Here is a chart of nominal wage growth (compensation per employee) in the Eurozone and selected countries within it before the Great Recession.

Percentage change in compensation per employee (annual): source OECD Economic Outlook

Between 2000 and 2007 German wages increased by less than 10% compared to over 20% in the Eurozone as a whole (which of course includes Germany). This difference was not primarily caused by excessive growth in the periphery countries: wages in France, Belgium, the Netherlands, Italy and Spain all increased by between 20% and 30%. The outlier was Germany.

Of course growth in nominal wages of less than 2%, and sometimes less than 1%, is not consistent with a consumer price inflation target of close to 2%. It was for this reason that the ECB lowered short term interest rates from 4.4% in 2000 to 2.1% in 2004. They were not worried by excessive inflation in the periphery - they had to lower rates to counteract the effect of low nominal wage growth in Germany. [1] 

So the reason why Germany seems to have largely escaped the second Eurozone recession of 2012/3 is that it pursued (perhaps unintentionally) a beggar my neighbour policy within the Eurozone. Low nominal wage growth in Germany led to lower production costs and prices, which allowed German goods to displace goods produced in other Eurozone countries both in the Eurozone and in third markets. This might make sense if Germany had entered the Eurozone at an uncompetitive exchange rate, but my own analysis suggests it did not, and Germany’s current relative cyclical position and its current account surplus confirm this.

As I argued in an earlier post, I do not think this divergence in cyclical position is the main reason why Germany resists expansionary measures in the Eurozone. But it is a lot easier to take up these obstructive positions when you are benefiting from this beggar my neighbour policy, and other countries that have suffered as a result appear not to understand what you have done.

[1] One of the comments on my earlier post tried to justify this beggar my neighbour policy using the following argument. Although the ECB's inflation target was close to 2%, they suggested that inflation below this was clearly desirable. What the Eurozone provided was an incentive system to try and achieve below target inflation by becoming more competitive. Germany had successfully risen to this challenge, and now it was up to other countries to try and do the same. Now if this competitiveness had been achieved by improvements in productivity, then this idea - although still mistaken - would be worth discussing. When it is achieved by cutting nominal wages (such that real wage increases are below productivity growth), it is not clear what efficiency gains are being achieved.

Postscript: Simon Tilford of the Centre for European Reform makes much the same argument here (HT Zoe Keller). 

Eurozone Asymmetries

Suppose a large Eurozone country – let’s call it France - decided that it needs to substantially increase its minimum wage in order to reduce poverty. The increase is sufficiently large that it leads to a sustained increase in average French wage inflation, which in turn decreases the competitiveness of France relative to the rest of the Eurozone. France cannot be permanently uncompetitive, so the obvious consequence would be that France has to endure a subsequent period in which its relative inflation was below the Eurozone average.

However this would require a period where French unemployment was above its natural rate. French politicians declare that this would be politically unacceptable to French voters. Instead they suggest French inflation should remain at 2%, and the remainder of the Eurozone should increase their inflation rate to 4% for a time (giving an average Eurozone inflation rate of over 3%) to ensure France regains competitiveness. Now this would not normally be possible, because the ECB’s inflation target is 2%. However the influence of France on the ECB is such that the ECB fails to raise interest rates in time to prevent 3% average inflation, and subsequently keeps interest rates low because they repeatedly forecast inflation falling back down to 2% in due course.

The rest of the Eurozone would understandably be upset at having to endure 4% inflation. Some countries might suggest that perhaps, in the absence of ECB action, they could tighten fiscal policy to get their inflation below 4%. However France refuses to countenance changes to agreed fiscal targets, and instead suggests that what is really required is for other countries to adopt a similar increase in the minimum wage to the one originally undertaken in France. The French head of the ECB gives a speech where he intimates that the ECB might be prepared to raise interest rates a little bit in exchange for other countries introducing this ‘structural reform’ to their minimum wage levels. The French government also hints that it might be prepared to allow very limited fiscal contraction outside of France, but only if this took the form of tax increases rather than public expenditure cuts.

Your reaction to this little imaginary story is that it couldn’t possibly happen because other Eurozone countries would not permit it to happen. My suggestion is that Germany rather than France is doing exactly this at the moment, except that in their case it started with a period where German wage inflation was below the Eurozone average (for reasons discussed by Dustmann et al here). [1] German control of the ECB might not be as complete and simple as I imagined French influence in the story above, but it has the advantage that interest rates have hit the zero lower bound, and the threat that anything unconventional could be declared illegal. And in this real world story I too wonder why other Eurozone countries allow Germany to get away with it.

[1] In fact what Germany is doing is worse, because inflation asymmetries and debt deflation mean that the output costs of achieving zero inflation outside Germany to regain non-German competitiveness are far greater than the costs associated with 4% inflation in my story. 

Lessons of the Great Depression for the Eurozone

It is easier to consider the problems of the Eurozone by first thinking about the Eurozone as a whole, and then thinking about distribution between countries. In both cases, the Eurozone is making exactly the same mistakes that were made in the Great Depression of the 1920s/30s.

The Eurozone is currently suffering from a chronic lack of aggregate demand. The OECD estimates an output gap of nearly -3.5% in 2013. Monetary policy is either unable or unwilling to do much about this, so fiscal stimulus is required. This is the first lesson from the Great Depression that is being ignored. Instead of stimulus we have austerity imposed by the Stability and Growth Pact (SGP).

Within the Eurozone, we have a problem created by Germany undercutting pretty well every other economy in the 2000-2007 period. I am not suggesting this was a deliberate policy, but the consequences were not appreciated by any Eurozone government at the time. Some correction has occurred since 2007, but it is incomplete. The second lesson of the Great Depression and the Gold Standard is that achieving correction through deflation and trying to cut wages is both hard and unnecessarily painful.

The solution eventually arrived at in the 1920s/30s was a series of devaluations (leaving the Gold Standard). That is not possible within the Eurozone. However adjustment is much less costly if it is achieved by raising prices in the country that is too competitive, rather than reducing prices in those that are uncompetitive. In practical terms we are not talking about very much here: a period with inflation in Germany at 3%, and at a little above 1% elsewhere, should be sufficient. Instead we now have inflation in Germany of 1% and in the rest of the Eurozone only a little above zero.

Relative unit labour costs (2000=100): source, OECD Economic Outlook May 2014

At this point a sort of moral indignation overcomes economic logic in the debate. Many Germans say why should we suffer 3% inflation to help put right irresponsible policy elsewhere? This is illogical, because it sees inflation below the Eurozone average as a virtue rather than a sin. A country within a monetary union obtaining inflation below the average (as Germany did in the early 2000s) is not a sign of virtue but a sign of a problem, just as it is for other union members to exceed the average.

A country cannot undercut its competitors forever. Any country experiencing below average Eurozone inflation should expect that this will be followed at some point by above average inflation. If the Eurozone could achieve average 2% inflation over the next few years that would mean 3% inflation in Germany - that is part of the Euro contract. To the extent that German policymakers attempt to renege on this contract by either preventing the ECB using unconventional means to achieve its target, or insisting on maintaining the deflationary SGP, then they become directly responsible for the misery that the Eurozone is currently going through.

I have not mentioned at any point levels of debt or structural reforms. Both are distractions for the current problem of inadequate demand and below target inflation. They are relevant only in that they allow policymakers to distract attention from the basic issues. Two of the major lessons of the Great Depression are to use fiscal stimulus to get out of a liquidity trap, and that it is far too painful to insist that uncompetitive countries should bear all the costs of readjustment. The Eurozone has failed to learn either lesson.

  

The view from Germany

As an exemplar, take this article that appeared in Spiegel (HT MT). It defends Germany against criticism of its current account surplus, but its main worry is not harsh words from the US government, or Paul Krugman, or Martin Wolf, but from Marco Buti of the European Commission. But before saying something about that, or the article itself, we need to be clear about the basic facts. (I have talked about the myths elsewhere.)

From 2000 to 2007, the periphery of the Eurozone (EZ) enjoyed a boom, while Germany did not. As a result, inflation in the periphery (and much else) of the EZ exceeded inflation in Germany by a significant and persistent amount. By 2007, this meant that Germany had become too competitive in relation to the rest of the EZ. This situation is not sustainable. The large German surplus is a symptom of that situation.

Under flexible exchange rates, the German currency would have been able to appreciate against the other EZ countries, eliminating the competitive advantage. In a currency union, the only feasible outcome is for German inflation to run ahead of the rest of the EZ by a significant and persistent amount for a number of years. If the ECB was willing and able to target 2% inflation, then that would mean future German inflation significantly and persistently above 2%. That would require excess demand in Germany, to balance deficient demand in the rest of the EZ. There is really no way around this consequence of a 2% inflation target - it is just arithmetic.

The problem arises because the ECB is unwilling or unable to target 2% inflation. That in theory allows Germany to attempt to force the EZ as a whole to make the required internal adjustment without inflation in Germany exceeding 2%. It can do this by a restrictive fiscal policy. This is exactly what it has done. The figure below shows the underlying primary financial balance in Germany and the whole EZ (including Germany). (Source: Oct 2013 OECD Economic Outlook.) The projected German surpluses are expected to bring down the debt to GDP ratio from 51% of GDP in 2012 to 48.5% of GDP in 2014.

Other EZ countries are defenseless against this deflation, because of imposed austerity or the EZ Fiscal Compact. As a result, the path we seem to be on involves German inflation at around 2% and average EZ inflation well below 2%. This may be in Germany’s narrow national interest, but for the EZ as a whole it is much more costly, partly because of the difficulties of reducing inflation when it is close to zero. Deflation in the EZ as a whole is also costly for those outside the EZ when everyone’s interest rates are near zero (see Francesco Saraceno here).

Much of the Spiegel article is about the pointlessness of blaming Germany for its success in exporting. This of course completely misses the point, but if outside criticism focuses on Germany’s current account rather than its inflation rate it is perhaps not a surprising reaction. The German current account surplus is a symptom of the underlying problem, which is a tight fiscal and monetary policy in the EZ. Whether the tight monetary policy (bringing EZ inflation below 1%) is an unforced or forced error (because interest rates are near zero) is not crucial here, except to the extent that German pressure is behind any reluctance until recently to cut interest rates. 

At one point, however, the article does note that criticism of Germany “holds that the Germans live and consume below their means, which is detrimental to foreign companies because there is less demand for their products in Germany.” But its response is to say that this is the fault of “countries like Greece, Italy and Spain, [who] have only themselves to blame for their troubles because they spent years living beyond their means and at the expense of their own competitiveness.” In other words, why should Germany suffer above 2% inflation because the rest of the EZ allowed themselves to become uncompetitive.

Mapping macroeconomics into a morality play is almost always a mistake. So let’s just stick to the rules of how the EZ is supposed to work. The ECB is supposed to have a (‘just below’) 2% inflation target. If it was able to meet that target, Germany would have to suffer 3%+ inflation for a number of years. Now you might respond that the ECB is within its mandate if it targets 1% inflation to allow Germany to only have 2% inflation, because below 2% inflation is allowed. I think that would be stretching the mandate rather a lot (see Andrew Watt here), but even so, if that were true, why didn’t the ECB target 1% inflation from 2000 to 2007 to avoid inflation outside Germany exceeding 2%?

A more reasonable interpretation would be that Germany is either putting pressure on the ECB so that its policies are favourable to the German national interest, or that it is taking advantage of the inability of the ECB to target inflation in a liquidity trap to force inflation below target through a restrictive fiscal policy. It is either trying to circumvent the rules, or take advantage while the referee's whistle is broken. [1]

Which brings us to one referee, which is the European Commission. I have been quite critical of the Commission in the past, and particularly of European Commissioner Olli Rehn (e.g. here). In March I also wrote a post criticising a paper co-written by Marco Buti, Director-General for Economic and Financial Affairs at the European Commission. That paper included the following quote: “In Germany, the fiscal stance is now broadly neutral, hence consistent with the call for a differentiated fiscal stance according to the budgetary space.” I was therefore slightly surprised to see Buti cast as chief German tormenter in the Spiegel article. To quote (my italics): “The chief economist of the European Commission, a native of Italy, has a tendency to blame many euro-zone ills on the nature and effects of German economic policy.” I find it tricky to reconcile Marco Buti’s March paper with this Spiegel description, but perhaps events in the intervening months (and the Commission’s own analysis) have strengthened views which could not have been expressed openly in public. (There are other constraints on the Commission, as John McHale notes here.) Whatever, I hope the Spiegel article is right, and those working for the Commission are applying all the pressure they can to change the view from Germany.

[1] It would be interesting to compare this deflationary bias in the EZ, reflecting a combination of the Fiscal Compact and the Zero Lower Bound, with Keynes’s worries about the Bretton Woods system, which helped create the IMF. Barry Eichengreen draws an analogy between current policies and the 1930s here.

The Other Eurozone Crisis

                What follows is not a new story: many people have argued that the problems of the Eurozone are as much about private sector expansion, current account imbalances and misalignment, as they are about excessive debt. What follows is an attempt to present this argument in as clear and convincing a way as possible, and say why this matters.

One of the central pieces of macro I teach undergraduates is an adaptation of the Swan diagram. For non-economists this simply plots a demand curve and a supply curve in national competitiveness and output space. As competitiveness improves, exports increase and imports fall, because the demand for domestic output rises. More technically, it describes an economy made up of producers of differentiated traded goods sold in imperfectly competitive markets, so the aggregate demand curve has an obvious interpretation. I draw the supply curve downward sloping following the textbook I use, but it could equally well be vertical.

Here is the diagram applied to the periphery and some quite central Eurozone economies.

The formation of the Eurozone led to substantial monetary easing in these economies, partly because financial markets wrongly thought that they were subject to risk levels not much different from Germany. The following table looks at two measures of real interest rates (long and short). I’ve missed off 1998-9 because entry was anticipated, so it is not clear where to put these years. I’ve taken current (CPI) inflation away from nominal rates, but hopefully with averages like these using actual rather than expected inflation is not too great a sin. Data is taken from OECD Economic Outlook.

Average Real Interest rates in the Eurozone

	Short (%)			Long (%)
	1990-97	2000-07	2008-11	1990-97	2000-07	2008-11
Germany	3.6	-0.7	-0.5	4.4	2.6	1.5
France	5.1	-0.8	-0.2	5.4	2.4	1.8
Italy	5.7	-1.1	0.4	6.6	2.2	2.4
Greece	18.4	-2.0	3.8
Ireland	4.7	-2.4	4.0	4.4	0.9	6.1
Portugal	5.4	-1.8	2.4	7.4	1.5	4.4
Spain	5.7	-2.1	0.3	6.0	1.2	2.3
Euro	4.3	-1.1	0.0

Real interest rates fell everywhere in the 2000-7 period (global savings glut?), but the fall was more modest in Germany than anywhere else. Lower real interest rates shift the AD curve to the right. With sticky prices we initially move horizontally from the 2000 point to the new demand curve (competitiveness changes slowly). However, as we are to the right of the supply curve, we get inflation and a loss of competitiveness until we reach 2007. From this date onwards country specific risk begins to return, and the aggregate demand curve shifts back. We need to go back to something like the 2000 position, which requires a recession and an internal devaluation to restore competitiveness. Different countries are at different stages in this process. The country which is furthest on the road back to a sustainable position is probably Ireland (although there are some statistical problems), but in others the process is only just beginning. Given low inflation in Germany, and the difficulty of cutting nominal wages, this road may be particularly painful and long.

Are the falls in real interest rates shown above enough to explain the loss in competitiveness seen in most Eurozone countries relative to Germany? It could be that in many periphery countries, particularly those that experienced housing booms, the key factor was a shift in risk perceptions. This shift could have been triggered by lower interest rates themselves (as some have argued for other countries like the US), or other financial supply side factors (see here, but also here).  Which is true may be important because it is related to how sustainable the original shift in the AD curve was. In theory a persistent reduction in real interest rates could lead to a prolonged shift in the demand curve, and reduced competitiveness, with no reversal of the sort shown in this chart. This is equivalent to asking how sustainable are the pattern of current account deficits and surpluses that emerged in the Eurozone in 2007. As I argued here, the balance of evidence suggests that these imbalances were unsustainable. Here are current accounts over this period.

Eurozone Current Accounts (as % GDP)

The Eurozone position as a whole (not shown) has hardly changed. The swing to surplus in Germany after 2000 is dramatic. Although the current account positions in France and Italy have deteriorated, this is not nearly as large as the deterioration in the smaller countries. This may also be an indication that in the smaller countries the demand stimulus generated by lower interest rates may have been much greater (the rightward shift in the AD curve larger), perhaps caused by excessive risk taking (housing bubbles etc).

This story is all about monetary conditions. Monetary easing was greater in the periphery countries when the Euro was created, partly because policy had been tighter there before Eurozone entry, and partly because risk premiums disappeared. If you look at fiscal policy, on the other hand, you find no comparable pattern. Overall fiscal policy, as measured by underlying deficits calculated by the OECD, became a little tighter in the Eurozone as a whole over the 2000-7 period. As the Chart below shows, Spain actually tightened quicker than this average, and fiscal policy was broadly unchanged in Ireland and Portugal. Even in Greece, the story is more a gradual reversion to previous bad old ways, after a pre-entry tightening. So the shift in the AD curve was not, with the exception of Greece, a result of a fiscal expansion.

Eurozone Fiscal Positions (Underlying deficit as % GDP, OECD Economic Outlook)

This does not imply that fiscal policy was appropriate in those countries over this period. I argued in an earlier post that fiscal policy should have been much tighter, to offset the monetary stimulus. But it is important to distinguish between what actually happened (a monetary stimulus) and what might have been (countercyclical fiscal policy).

                This is a story about monetary conditions and aggregate demand. Of course it is possible in theory that reduced competitiveness relative to Germany could represent some sort of wage push. However, the strong growth experienced in these countries on Euro entry is consistent with the diagram above, and is less consistent with a cost-push shock. In addition, the labour share has not shown any marked increase in most Eurozone economies over this period (see here). The fact that wages rose ahead of productivity outside Germany reflects relative demand conditions (see here). None of this takes away from the need to deal with underlying structural problems in many of these countries – it just says demand shocks can occur, and in a monetary union their impact can be substantial and persistent. This is a very familiar story in terms of both the historical experience of fixed exchange rate regimes and the academic literature.

                This analysis tells us why many Eurozone countries would be in recession today, even if there had been no debt crisis. Why is this important? After all, the debt crisis is real enough, and the implications – recession in many Eurozone countries – are the same. It is important because it pinpoints the nature of the fundamental policy error that was made in the Eurozone. It was not that the Stability and Growth Pact (SGP) was ineffective – it was, but this did not lead to excessive fiscal expansion (Greece excepted) as the table above shows. The problem with the SGP was that it ignored countercyclical fiscal policy. (I argue here that the SGP’s focus on deficits actually encouraged governments not to do the right thing.) If countries had responded to their deteriorating competitiveness position relative to Germany by tightening fiscal policy, the unsustainable shift in the AD curve shown above would have been at least reduced in size. In addition, the market’s fear about fiscal sustainability would have been greatly reduced. On both counts we might have avoided recession today.

                The really sad thing is that the Eurozone is continuing to make the same mistake. Such a collective failure by policy makers is really difficult to comprehend, although I will discuss in a later post how this may be related to economic orthodoxy in Germany.