German policymakers don’t understand debt deflation

Editor’s note: this post was originally for Credit Writedowns Pro subscribers when written. But it has been made freely available due to an important reference later on the free site here.

Debt deflation is taking hold in Europe. We have seen the crash in Greece’s economy unfold over the last two years. And now we are witnessing similar things in Spain. As Marshall Auerback puts it, Spain is the New Greece. But now come signs that Italy too is beginning its debt deflationary spiral. According to the Italian statistical office, Italy’s budget deficit rose to 8 percent of gross domestic product (GDP) in the first quarter. As it was 7 percent for the same period a year earlier, it is clear that Italy’s fiscal situation is worsening. These were the worst results since 2009.

But German policy makers don’t understand what is happening. A recent encounter with Richard Koo makes that clear.

Koo explained Japan’s slide back into recession in 1997 caused by fiscal retrenchment. It was this episode which sowed the seeds of the deflationary trap Japan now finds itself in. He also explained how the US fiscal cliff risks the same sort of outcome. But the Germans didn’t get it:

While the Germans politely listened to my explanation of this new (for them) concept, they continued to insist the competitiveness issue could not be resolved without structural reforms.

As I indicated two years ago when recounting the soft depression in Germany:

During the end of the days under Helmut Kohl, Germany was completely unable to undertake any kind of structural labour reform. But the neo-liberal German Chancellor Gerhard Schroeder followed the Clinton model very effectively and moved his party to the centre. Schroeder instituted widespread reforms in four stages called the Hartz Concept after Peter Hartz, a German manager and member of the board of directors of Volkswagen. The result has been stagnating wage growth in Germany which has facilitated an export boom.

So, the Germans want the periphery to do the same. They look at this crisis in an almost Shock Doctrine fashion as an ‘opportunity’ to get the southern Europeans into the same kind of reforms. And without the pressure of a crisis, it won’t happen. If it doesn’t happen, in the German view, the European crisis will continue.

This is wrong. The crisis will continue only because European sovereign debt is not backstopped by the ECB and debt deflation has set in due to a simultaneous public and private sector deleveraging. In an economy with high private debt, this leads to debt liquidation, and a credit and economic contraction.

Yes, the European crisis has to do with the euro and the vendor financing dynamic that resulted from German structural reforms occurring in isolation in a fixed exchange rate system.  But now that these imbalances have built up, it is the German deflationary crisis response which has created the problem. So, the Germans are causing the problem in order to get structural reforms. They seem to get that. What they don’t seem to get is how close to destruction they are bringing the global economy.

Reading this Koo account was depressing for me [pun intended]. It is clear now that German policymakers are pushing us into a deflationary spiral on purpose, playing a grand game of chicken with the global economy in order to force their European partners into structural reform. And they will continue to do so. What the Germans don’t seem to realise is that they have unleashed debt deflationary forces that could create a second Great Depression.