On Germany’s response to Euroland’s problems

Earlier today I wrote a post on the free blog site about blaming Germany for the problems in the euro zone. I ended up defending the German political response and blaming the euro. Let me just add a bit of colour to that here.

The canard is that the Germans are inflation-phobes because ninety years ago the country went through a great hyperinflationary trauma that now dictates the German views on monetary policy even today. The thinking here is that if the Germans would just let go of the past and allow a little inflation, everything would be alright.

Bollocks I say, total and utter bollocks.

As I wrote in the post earlier today, it’s not just about inflation and wage and price levels. At heart, the euro crisis is a private debt crisis centred in the banking system. We see that again and again. In Ireland, it was the government’s assumption of the private debt of banks that led to its sovereign bailout.  In Spain, it was the spectre of contingent liabilities from a collapsed financial system which led to the Spanish bank bailout and OMT. In Cyprus, it was the collapse of the two largest banks that resulted in a bailout and depositor haircuts. Everywhere and in every European country from Germany to Greece and Iceland to Ireland, very large and systemically relevant banks have been rescued, propped up, bailed out or resolved because of a loss of capital from the credit writedowns of their private debts. In no way does a little inflation change this.

Moreover, where is this inflation going to come from? Even in the US, where the Fed has conducted quantitative easing on a massive scale, inflation remains subdued. I believe this is largely because consumption demand growth has stalled in the wake of a jobs crisis, one that is significantly larger in the eurozone periphery than in the US. And this suggests to me that even though the Germans might acquiesce to higher inflation, achieving it would be difficult. Deleveraging is the order of the day, still. And this owes in large part to the jobs crisis, which has created an acute level of debt distress.

The debt distress is also an outgrowth of the euro zone’s strictures which do not permit countercyclical reflation that balloons the fiscal deficit. In the US, we saw deficits of 8 or 9% of GDP without fiscal cuts. This year, the US will reach deficits of 4%, probably without a severe austerity-led crisis. In the eurozone, the fiscal and monetary stance that the US took is simply not allowed.

Should the Germans (or the Fins or the Austrians) take the lead in permitting everyone to ignore the rules? Is that how large systems work or are supposed to work? I don’t believe so. I believe that it should be expected that the eurozone would try to adhere to the rules in place while working to make changes to the rules that are most problematic. But I don’t believe for one second that we are on the cusp of seeing wholesale change.

I would argue that the problem is the euro and its faulty design flaws, not the Germans. The euro and the eurozone do not have sufficiently robust institutional structures to prevent crisis or to even attenuate the severity of crisis. And we cannot expect these tools to develop except as a result of a harsh and painful economic and social climate. I wish it could be otherwise. But it isn’t and it won’t be. More pain is to come, unfortunately.

Italy’s industrial output falls back to 1970s – Telegraph

“Mr Napolitano said the hardships faced by the people have become excruciating, and demanded a spate of measures to boost growth and halt the relentless rise in unemployment.
The plea came after fresh data showed industrial production in March fell 7.6pc from a year earlier, dropping for the 15th consecutive month. New orders fell 10pc.
The Istat data agency reported earlier that exports continued to fall in the first three months of the year and are down 6pc since last year, dashing hopes for a trade boost to offset the collapse in internal demand. This is in stark contrast to Spain, where exports have held up well.
Ten of thousands marched in Rome over the weekend to protest austerity measures with placards saying “we can take no more”. They were led by increasingly militant trade unions, left-wing politicians and the Five Star movement of comedian Beppe Grillo, the biggest party in parliament.”

The European Central Bank: The ECB can’t substitute for periphery financial reform | The Economist

“European banks in the periphery have many fundamental problems. With the euro area in recession and asset quality deteriorating, they remain significantly under-capitalised. In some cases, their governance is problematic. Many remain dependent on ECB facilities for funding, and thereby lack sustainable business models. Regulatory uncertainty abounds.
Viewed from the macroeconomic perspective, the banking sector is still too big and the private sector excessively indebted.
Treating these fundamental problems requires a “root-and-branch” reform of the European banking system, in the periphery and beyond. But the ECB does not have the instruments to implement such a comprehensive reform.”

France must reform or face punitive measures: EU’s Oettinger | Reuters

“France should only be granted more time from the European Commission to cut its deficit if it also introduces reform measures, EU Energy Commissioner Guenther Oettinger was quoted saying on Monday.”

Schäuble ready to tolerate German inflation – FT.com

“Wolfgang Schäuble, German finance minister, has given vital political cover to the Bundesbank, speaking out in support of the idea that Germany could tolerate a rate of inflation above the eurozone average.
Making a rare exception to the rule that Berlin does not comment on central bank policy, Mr Schäuble declared that price rises “in a corridor between 2 and 3 per cent” would be “tolerable” in Germany – slightly above the European Central Bank’s target of keeping average inflation across the eurozone at close to but below 2 per cent.”

Karl Smith on the liquidity leak

“this mechanism solves (at best) only one of the core problems of the eurozone, namely incorrect relative prices between Portugal and Germany.  It helps less with the “Portuguese nominal wages are too high” problem, the “Portuguese banks are not sound” problem, and the “Portugal badly needs structural reform” problem, among other difficulties.  The inflation would be an easier sell to the German public if it really would set the rest of the eurozone right, but that is a difficult case to make.”

Bundesbank Signals Germany Would Accept Higher Inflation – SPIEGEL ONLINE

“Germany’s central bank has indicated it may tolerate higher inflation in Germany as the price of rebalancing economies within the euro zone. The move marks a major shift away from the Bundesbank’s hardline approach on price stability. Economists have hailed the decision as a “breakthrough.””

The euro crisis: Der Elefant im Raum | The Economist

I’m sorry this is bollocks. The Germans have said specifically thy would tolerate more inflation.
“Mr Cowen’s posts, and many others like them by other authors, sometimes look like elaborate efforts to avoid concluding that German inflation-phobia, while totally understandable and rational, looks like a grave moral error in the current economic environment.”

Does the eurozone have a monetary policy transmission mechanism? Or rather a liquidity leak?

“Ryan Avent suggests allowing banks to swap their risky commercial loans for safer assets.  Other ideas propose running QE on packages of small to mid-sized loans or accepting those loans as collateral at the ECB.  Of course these assets are difficult to price and also moral hazard problems would loom.  If the ECB is not “overpaying” for the small loans, they won’t be encouraged.  If the ECB is overpaying, there are plenty of Sicilian businessmen who have friends at the local bank.  The mere lending isn’t enough, the projects also need to be good ones, because in these cases we are talking about tackling issues in the real economy.  Can a long-distance ECB collateral support operation spur good, growth-inducing projects?  It is easy to see why the Germans might be skeptical.”