Here’s a weekly post. I have a huge backlog of weekly topics to write that require more data. In the meantime, despite my vacation schedule, I want to revisit Richard Koo’s comments three weeks ago after his meeting with a number of German policymakers. I think they are illuminating in terms of why Euro crisis policy is as it is. And given the downturn in German economic prospects, this is significant.
Crisis opportunism
The full document is here. Here are the passages I want to focus on:
“Crisis necessary for structural reforms”
These politicians were not even satisfied with the state of structural reforms in their own country, arguing that Germany still had much work to do. But based on their experience of the difficulty of implementing these reforms, they believe firmly that this represents a once-in-a-lifetime opportunity to pursue similar initiatives in southern Europe.
When Germany implemented its reforms around 2005, there was no time to waste because German businesses were moving one factory after another to the low-wage countries of eastern Europe. Even so, they said there was tremendous political opposition. What they learned from this experience was that such reforms were possible only under crisis-like conditions. That experience contributed to their view that the current economic crisis represented an excellent opportunity for fundamental reforms in southern Europe.
Perfect opportunity?
In other words, Germany’s own trying experiences around 2005 had convinced them that the unfolding crisis in southern Europe represented a once-in-a-lifetime opportunity. Chancellor Angela Merkel’s tendency to talk about the need for structural reforms whenever she has a chance is based on her own experience of the difficulty of implementing those reforms in Germany. One member of parliament close to Ms. Merkel said the Chancellor is not opposed to fiscal stimulus itself but cannot accept fiscal stimulus without structural reform
Clearly this is just Koo’s interpretation of what his German hosts were saying to him rather than what the German policymakers actually said. However, if this is an accurate interpretation, it is significant in terms of how these policy makers view the Euro crisis. I first addressed this on 4 July writing that “German policymakers don’t understand debt deflation“. I am going to do my best here to contextualize why this matters in light of some recent comments by Yanis Varoufakis and Kantoos Economics.
The German Policymaker’s Experience
The passage sounds believable to me because of what I wrote in 2010 on the same topic, 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.
In my view, it is reasonable to believe that German policymakers credit the Schroeder push for structural reforms with their own economic resilience now in the face of a serious economic crisis. I don’t personally believe that labour reforms play that supportive a domestic macro role given that they effectively represent a redistribution of income from labour to employers and thus have further weakened German domestic demand. Where the labour reforms count is in allowing Germany to increase its exports. As I indicated a week ago, most people interpret this as helping Germany become the biggest winner from euro fixed exchange rates.
The problem with this view is that in trade theory, exports are a “cost”. Exporting means having to use domestic productive capacity for export abroad instead of for domestic consumption. That’s clearly a cost. The benefit of free trade is lower cost imports. That is to say, the benefit is more consumption or the same consumption at lower cost.
Germany’s program then is mercantilist. Mercantilism is a economic philosophy in which countries like Germany are willing to bear this cost in order to boost production and output.
Mercantilism’s Achilles’ Heel
The problem with the mercantilist view is that it makes one dependent on external demand. Here’s how I put it a year ago when asking “What is the secret to Germany’s economic success?“:
The consensus view is that Germany is firing on all cylinders, making its economic model something worthy of emulation for large economies. Sweden is often touted as a similar example for small open economies. The reality, however, is that for every exporter, there must be an importer; So, to the degree that German economic success is built on exports, it is also built on global imbalances.
[…]
The bottom line: the fundamentals of the German economy are relatively good and support continued long-term growth.
Nevertheless, I am sceptical of the pace of German recovery for two reasons. First, Germany is fully integrated with the rest of Europe where many economies are struggling with debt issues, weakening demand for German exports. Germany is increasingly exporting to the growing emerging markets. However, its prime export market is within the euro zone. So, when the global downturn hit, German GDP was savaged by its export dependency. GDP fell by 5% in 2009. So, Real GDP in Germany is still lower than when the downturn began, whereas in the U.S. it is higher than when the downturn began. Working from a lower base certainly makes it easier to report higher GDP growth. SeeEconomic recovery and the perverse math of GDP reporting for why.
Second, domestic demand remains weak in Germany. While German retail sales increased 1.2% in 2010, German retail sales were down for the fourth month in five in December, the latest month for which figures are available. That this weak 1.2% increase in 2010 is the highest reading since 2005 and cause for optimism tells you that domestic demand growth is a sticky wicket for the German economy. Demographic factors almost certainly come into play here. Claus says Germany is too old but this is because fertility rates in Germany are one of the lowest in Europe. And without immigration, retail sales growth will be slower. Is this a bad thing? If all we cared about was per capita income or per capita growth, the answer is no. However, Claus’ post on an aging Germany points to an increasing burden from Germany’s social programs for pensioners. And German national debt of over 77% of GDP reflects this burden.
These headwinds point to moderating growth. And if the European periphery spirals down, it will drag Germany down with it via trade and financial linkages. Germany needs to develop internal demand, especially if it is going to pay for its social programs. Nearly 5 million people in Spain are out of work. Unemployment is low in Germany, which could offer hope for the Spanish jobless. Germany has the lure of high wages and Spanish workers have the benefit of being highly education and skilled. Outmigration from Spain to Germany could be a win-win for both nations and a reinforcement of the advantages of European integration.
Overall, we should credit Germany for building a recovery based not just on exports, but on capital investment and saving. One reason that Germany is a manufacturing and export powerhouse is because it has invested in those businesses. Certainly, wage restraint over the past decade by German labour unions has kept German companies in the mix. But, at heart, the German export story is about investment in human and physical capital. And that is definitely worthy of emulation.
The recent data show that my scepticism regarding the pace of German recovery was well-founded. For a more complete prediction and analysis of this situation, see 2010’s Spain’s debt woes and Germany’s intransigence lead to double dip.
The German people’s experience
In contrast to German policymakers, German people don’t view the Hartz reforms as unmitigated successes. The reforms have eroded the German social safety net and increased economic insecurity, even while the unemployment rate has dropped.
If you are an average (West) German worker, you have witnessed the following in quick succession over a twenty-year period:
- A solidarity tax, payoff to Russia, and promise to join single currency as the price for re-unification
- A loss of the Deutsche Mark, the symbol of Germany’s post-war economic discipline and success
- A loss of the German economic miracle of the 1950-1980s and a soft depression due to a confluence of events including reunification, a property bubble, aging society, and poor demographics
- A breach of the Maastricht debt and deficit hurdles due to the soft depression
- A stagnation of wages and a loss of economic security and some of social safety net benefits with Hartz reforms because of soft depression
- A bailout of reckless German lenders pushing government debt to GDP well over 75% and now 81%
- Successive bailouts of other euro area members who have not gone through the same trauma and reform
The average German worker feels like a cash cow being sucked dry by a quick succession of reforms and bailouts that take money out of her pocket. First it was for reunification, then for European integration, then to right the economy, then to bail out German banks, and finally to bail out the European periphery. Fatigue has set in. As I argued yesterday, this bailout fatigue will take on increasing political importance in Europe as the economy slides further into recession:
The question is what are the political ramifications of a downturn when bailouts are being discussed. I believe the downturn makes bailouts more toxic politically in core countries, even in exchange for austerity. The Reuters article below about German resentment over euro bailouts gets at the feeling. Let’s remember as well that Germany still feels the emotionally-charged sting of post German-reunification solidarity taxes. So, to some in Germany, this feels like a constant siphoning off of money even while the structural reforms in Germany have lowered worker protections and wage gains. For the average German voter now is the time to start saying no.
The debate on German public sentiment
Yanis Varoufakis started the debate off by posing a question, a Mental Experiment for establishing the relative mood for solving the Crisis in Europe, in Britain & in the USA he called it:
I have a hunch: that the Eurozone’s profound difference to both the United States and Britain is that, unlike these anglosaxon ‘currency unions’, the Eurozone’s real elite does not want the Crisis to disappear quickly and painlessly. In this post I offer a mental experiment that will help each and every reader rule on the merits of my hunch via introspection (or, perhaps, projected introspection).
[…]
“Red Button: You press it Chancellor and the Euro Crisis ends immediately, with a general rise in growth throughout Europe, a sudden collapse of debt for each member-state to below the Maastricht level, no pain for Greek citizens (or for Italians, Portuguese, etc.), no guarantees for the Periphery’s debts (states or banks) to be provided by German and Dutch taxpayers, with interest rate spreads below 3% throughout the Eurozone, a diminution in the Eurozone’s internal imbalances, and a wholesale rise in aggregate investment.
Yellow Button: You press it Chancellor and the situation in the Eurozone remains more or less as is for a decade. The Euro Crisis continues to bubble along albeit in a controlled fashion. While the probability of a breakup, which will be a calamity for Germany, will remain non-trivial, the chances are that, if you push the yellow button, the Eurozone will not break up (with a little help from the ECB), German interest rates shall remain extremely low, the euro will be nicely depressed (‘nicely’ from the perspective of German exporters), the Periphery’s spreads will be sky-high (but not explosive), Italy and Spain will enter deeper into a debt-deflationary spiral that sees to a reduction of their GDP by 15% over the next three years, France shall slip into quasi-insolvency, GDP per capita will rise slowly in the surplus countries and fall precipitously in the Periphery. As for the first ‘fallen’ nations (Greece, Ireland and Portugal), they shall become little Latvias on the Mediterranean: devastated lands with a total GDP at around 50% to 60% of pre-Crisis levels, a massive exodus of all their skilled labour, and a destination for cheaper holidays as well as real estate bargain hunting . In aggregate, if you choose the yellow button Chancellor, the Eurozone will remain recessionary, Eurozone unemployment will stay well above UK and US levels, investment will be anaemic, and poverty on the up and up.”
Which button do you think Mrs Merkel would want to push? And, quite a separate question, which of the two buttons would the median German voter want her to push?
German economic blogger Kantoos took issue with this and Yanis’ overall line of argument as did German economist Henning Meyer. German blogger Stephan Ewald agrees with Yanis generally.
I think my post here gives you a better sense of what is really happening beyond the caricatures though. According to the Koo commentary at the outset of this post, German policy makers are indeed playing exactly the game that Yanis describes. Their crisis response is designed to force structural reforms in the eurozone periphery in exchange for German aid. This is dangerous and irresponsible brinkmanship that has made the crisis considerably worse.
The man on the street in Germany on the other hand, is much more concerned about limiting the costs of all these bailouts, especially in a situation of stagnant worker income, increased economic insecurity and renewed recession. There is no “punish-the-periphery” overtone to any of this. Sure, the Greeks (and Spanish and Italians) are often cast in a negative light in the German media and this reduces empathy for their plight. but, it’s still a far stretch to saying public sentiment in Germany favours hurting the Greeks economically.
Your takeaway here should be twofold:
- German elites are playing a dangerous “shock doctrine” kind of game to extract reforms from the periphery. And this has resulted in deadweight economic loss in the euro area, increased the cost to Germany of the crisis, and induced a sense of bailout fatigue in the electorate.
- The likelihood of a disorderly breakup increases in a general euro area recession because nationalism will take over as people circle the wagons. Economic downturns reduce empathy and increase self-defensive behavior. In my view, this means defaults and eventually disorderly breakup is now the base case in Europe.
As such, I would continue to avoid peripheral debt. I also expect knock-on effects in equity markets, particularly in the US where earnings multiples are 30-40% higher than they are in Europe.