Update (9/30): Eurostat just released the September figures for inflation: Headline: 0.3%, Core, 0.7%
Hans Werner Sinn did it again. In the Financial Times he violently attacks Mario Draghi and the ECB. To summarize his argument (but read it, it is beyond imagination):
- The ECB gave too much liquidity to banks in peripheral EMU countries since 2008, thus fueling a spending boom.
- Then, with the SMP and the OMT programs it “lowered the interest rates at which overstretched eurozone members could obtain credit and reversed the losses of their foreign creditors, triggering another borrowing binge”
- Finally, “The ECB’s plan to purchase [private borrower's] debt could end up transferring dozens if not hundreds of billions of euros from eurozone taxpayers to the creditors of these hapless individuals and companies.”
- Last (but not least!!) he claims that deflation is necessary in EMU peripheral countries to restore competitiveness
I am shocked. Let me start from the last point. Even assuming that competitiveness only had a cost dimension, what would be required is that the differential with Germany and core countries were negative. Deflation in the periphery is therefore only necessary because Germany stubbornly refuses to accept higher inflation at home. And no, the two things are not equivalent, because deflation in a highly leveraged economy increases the burden of debt, and triggers a vicious circle deflation-high debt burden-consumption drop-deflation. I refuse to believe that a respected economist like Hans Werner Sinn does not see such a trivial point…
As for the rest, the spending binge in peripheral countries began much earlier than in 2008, and it is safe to assume that it was fueled by excess savings in the core much more than by expansionary monetary policies.
Further, does Sinn know what a lender of last resort is? Does he know what is “too big to fail”? Where was he when European authorities were designing institutions incapable of managing the business cycle, while forgetting to put in place a decent regulatory framework for banks and financial institutions?
And finally, does Mr Sinn remember what was the situation in the summer of 2012? Does he remember the complete paralysis of European governments that were paralyzed in front of speculative attacks to two large Eurozone economies? Does he realize that were it not for the OMT and the “whatever it takes”, today Spain and Italy would not be in the Euro anymore? Which means that probably the single currency today would not exist? Maybe he does, and he decided to join the AfD…
Spain is today the new model, together with Germany of course, for policy makers in Italy and France. A strange model indeed, but this is not my point here. The conventional wisdom, as usual, almost impossible to eradicate, states that Spain is growing because it implemented serious structural reforms that reduced labour costs and increased competitiveness. A few laggards (in particular Italy and France) stubbornly refuse to do the same, thus hampering recovery across the eurozone. The argument is usually supported by a figure like this
And in fact, it is evident from the figure that all peripheral countries diverged from the benchmark, Germany, and that since 2008-09 all of them but France and Italy have cut their labour costs significantly. Was it costly? Yes. Could convergence have made easier by higher inflation and wage growth in Germany, avoiding deflationary policies in the periphery? Once again, yes. It remains true, claims the conventional wisdom, that all countries in crisis have undergone a painful and necessary adjustment. Italy and France should therefore also be brave and join the herd.
Think again. What if we zoom out, and we add a few lines to the figure? From the same dataset (OECD. Productivity and ULC By Main Economic Activity) we obtain this:
It is unreadable, I know. And I did it on purpose. The PIIGS lines (and France) are now indistinguishable from other OECD countries, including the US. In fact the only line that is clearly visible is the dotted one, Germany, that stands as the exception. Actually no, it was beaten by deflation-struck Japan. As I am a nice guy, here is a more readable figure:
The figure shows the difference between change in labour costs in a given country, and the change in Germany (from 1999 to 2007). labour costs in OECD economies increased 14% more than in Germany. In the US, they increased 19% more, like in France, and slightly better than in virtuous Netherlands or Finland. Not only Japan (hardly a model) is the only country doing “better” than Germany. But second best performers (Israel, Austria and Estonia) had labour costs increase 7-8% more than in Germany.
Thus, the comparison with Germany is misleading. You should never compare yourself with an outlier! If we compare European peripheral countries with the OECD average, we obtain the following (for 2007 and 2012, the latest available year in OECD.Stat)
If we take the OECD average as a benchmark, Ireland and Spain were outliers in 2007, as much as Germany; And while since then they reverted to the mean, Germany walked even farther away. It is interesting to notice that unreformable France, the sick man of Europe, had its labour costs increase slightly less than OECD average.
Of course, most of the countries I considered when zooming out have floating exchange rates, so that they can compensate the change in relative labour costs through exchange rate variation. This is not an option for EMU countries. But this means that it is even more important that the one country creating the imbalances, the outlier, puts its house in order. If only Germany had followed the European average, it would have labour costs 20% higher than their current level. There is no need to say how much easier would adjustment have been, for crisis countries. Instead, Germany managed to impose its model to the rest of the continent, dragging the eurozone on the brink of deflation.
What is enraging is that it needed not be that way.
Yesterday I quickly commented the disappointing growth data for Germany and for the EMU as a whole, whose GDP Eurostat splendidly defines “stable”. This is bad, because the recovery is not one, and because we are increasingly dependent on the rest of the world for that growth that we should be able to generate domestically.
Having said that, the real bad news did not come from Eurostat, but from the August 2014 issue of the ECB monthly bulletin, published on Wednesday. Thanks to Ambrose Evans-Pritchard I noticed the following chart ( page 53):
The interesting part of the chart is the blue dotted line, showing that the forecasters’ consensus on longer term inflation sees more than a ten points drop of the probability that inflation will stay at 2% or above. Ten points in just a year. And yet, just a few pages above we can read:
According to Eurostat’s flash estimate, euro area annual HICP inflation was 0.4% in July 2014, after 0.5% in June. This reflects primarily lower energy price inflation, while the annual rates of change of the other main components of the HICP remained broadly unchanged. On the basis of current information, annual HICP inflation is expected to remain at low levels over the coming months, before increasing gradually during 2015 and 2016. Meanwhile, inflation expectations for the euro area over the medium to long term continue to be firmly anchored in line with the aim of maintaining inflation rates below, but close to, 2% (p. 42, emphasis added)
The ECB is hiding its head in the sand, but expectations, the last bastion against deflation, are obviously not firmly anchored. This can only mean that private expenditure will keep tumbling down in the next quarters. It would be foolish to hope otherwise.
So we are left with good old macroeconomic policy. I did not change my mind since my latest piece on the ECB. Even if the ECB inertia is appalling, even if their stubbornness in claiming that everything is fine (see above) is more than annoying, even if announcing mild QE measures in 2015 at the earliest is borderline criminal, it remains that I have no big faith in the capacity of monetary policy to trigger decent growth. The latest issue of the ECB bulletin also reports the results of the latest Eurozone Bank Lending Survey. They show a slow easing of credit conditions, that proceed in parallel with a pickup of credit demand from firms and households. While for some countries credit constraints may play a role in keeping private expenditure down (for example, in Italy), the overall picture for the EMU is of demand and supply proceeding in parallel. Lifting constraints to lending, in this situation, does not seem likely to boost credit and spending. It’s the liquidity trap, stupid!
The solution seems to be one, and only one: expansionary fiscal policy, meaning strong increase in government expenditure (above all for investment) in countries that can afford it (Germany, to begin with); and delayed consolidation for countries with struggling public finances. Monetary policy should accompany this fiscal boost with the commitment to maintain an expansionary stance until inflation has overshot the 2% target.
For the moment this remains a mid-summer dream…
Yesterday’s headlines were all for Germany’s poor performance in the second quarter of 2014 (GDP shrank of 0.2%, worse than expected). That was certainly bad news, even if in my opinion the real bad news are hidden in the latest ECB bulletin, also released yesterday (but this will be the subject of another post).
Not surprisingly, the German slowdown stirred heated discussion. In particular Sigmar Gabriel, Germany’s vice-chancellor, blamed the slowdown on geopolitical risks in eastern Europe and the Near East. Maybe he meant to be reassuring, but in fact his statement should make us all worry even more. Let me quote myself (ach!), from last November:
Even abstracting from the harmful effects of austerity (more here), the German model cannot work for two reasons: The first is the many times recalled fallacy of composition): Not everybody can export at the same time. The second, more political, is that by betting on an export-led growth model Germany and Europe will be forced to rely on somebody else’s growth to ensure their prosperity. It is now U.S. imports; it may be China’s tomorrow, and who know who the day after tomorrow. This is of course a source of economic fragility, but also of irrelevance on the political arena, where influence goes hand in hand with economic power. Choosing the German economic model Europe would condemn itself to a secondary role.
I have emphasized the point I want to stress, once again, here: adopting an export-led model structurally weakens a country, that becomes unable to find, domestically, the resources for sustainable and robust growth. And here we are, the rest of the world sneezes, and Germany catches a cold. The problem is that we are catching it together with Germany:
The ratio of German GDP over domestic demand has been growing steadily since 1999 (only in 19 quarters out of 72, barely a third, domestic demand grew faster than GDP). And what is more bothersome is that since 2010 the same model has been
adopted by imposed to the rest of the eurozone. The red line shows the same ratio for the remaining 11 original members of the EMU, that was at around one for most of the period, and turned frankly positive with the crisis and implementation of austerity.It is the Berlin View at work, brilliantly and scaringly exposed by Bundesbank President Jens Weidmann just a couple of days ago. We are therefore increasingly dependent on the rest of the world for our (scarce) growth (the difference between the ratio and 1 is the current account balance).
It is easy today to blame Putin, or China, or tapering, or alien invasions, for our woes. Easy but wrong. Our pain is self-inflicted. Time to change.
I am puzzled by Wolfgang Münchau’s latest piece in the Financial Times. Let me start by quoting the end:
[...] The ECB should have started large-scale asset purchase a year ago. It certainly should do so now. The EU should allow governments to overshoot their deficit targets this year, and suspend the fiscal compact, which will result in further fiscal pain from 2016.
Even a casual reader of this blog will quickly realize that it would be hard for me to agree more with these statements. The macroeconomic stance at the EMU level has been seriously inappropriate since 2010, with fiscal policy globally restrictive (thank you austerity), and monetary policy way too timid.
So, what is the problem? The problem is the first part of Münchau’s editorial, in which he attacks the Bundesbank for its plea in favour of faster wage growth in Germany (the Buba asked for an average wage increase of 3%).
This is frankly hard to understand. The eurozone problems, and it’s flirting with deflation, stem from the victory of the Berlin View, that laid the burden of adjustment on the shoulders of peripheral countries alone.
The call for wage increases in Germany signals, and it was about time, that even conservative German institutions are beginning to realize the obvious: there will be no rebalancing, and therefore no robust recovery, unless German domestic demand recovers. This means a fiscal expansion, as well as private expenditure recovery. Unsurprisingly, the Buba rules out the former, but it is nice to see that at least the latter has become an objective. Faster wage growth may not make a huge difference in quantitative terms, but it still marks an important change of attitude. This is a huge step away from the low-wage-high-productivity-export-led model that the Bundesbank and the German government have been preaching (and imposing to their partners).
Münchau is right in calling for a different policy mix in the EMU. But this is complementary, not alternative, to a change in the German growth model. I would have expected him to applaud a small but potentially important change in attitude. Instead I have read a virulent attack. Puzzled, puzzled…
Spoiler alert: we conclude that anything could go, and that claiming otherwise is not very serious.
What do we know about the end of monetary unions?
The European elections were marked by low turnouts and increasing support for Eurosceptic parties. These two elements reflect a wave of mistrust vis-à-vis European institutions, which can also be seen in confidence surveys and in the increasingly loud debate about a return to national currencies. The controversy over a country leaving the euro zone or even the breakup of the monetary union itself started with the Greek crisis in 2010. It then grew more strident as the euro zone sank into crisis. The issue of leaving the euro is no longer taboo. If the creation of the euro was unprecedented in monetary history, its collapse would be none the less so. Indeed, an analysis of historical precedents in this field shows that they cannot serve as a point of comparison for the euro zone.
Although there seem to be a number of cases where monetary unions split apart, few are comparable to the European Monetary Union. Between 1865 and 1927, the Latin Monetary Union laid the foundations for closer monetary cooperation among its member states. This monetary arrangement involved a gold standard regime that established a principle of monetary uniformity with a guarantee that the currencies set up by each member state could move freely within the area. Given the absence of a single currency created ex nihilo as is the case today with the euro, the dissolution of the Union that occurred in 1927 holds little interest for the current debate. In fact, experts in monetary unions instead characterise this type of experience as “areas of common standards”. A study in 2007 by Andrew Rose (see here) assesses 69 cases of exits from a currency union since the Second World War, which would indicate that there is nothing unique about the break-up of the euro zone. However, this sample of countries that have left a currency union cannot really be used to draw meaningful lessons. A large number of these cases involve countries that gained their political independence in the process of decolonization. These were also small developing economies whose macroeconomic and financial situations are very different from those of France or Greece in 2014. The most recent experience was the break-up of the rouble zone, following the collapse of the USSR, and of Yugoslavia, both of which involved economies that were not very open commercially or financially to the rest of the world. In these circumstances, the impact on a country’s competitiveness or financial stability of a return to the national currency and any subsequent exchange rate adjustments are not commensurate with what would happen in the case of a return to the franc, the peseta or the lira. The relatively untroubled separation of the Czech Republic and Slovakia in 1993 also involved economies that were not very open. Finally, the experience most like that of the EMU undoubtedly involves the Austro-Hungarian Union, which lasted from 1867 to 1918. It had a common central bank in charge of monetary control but no fiscal union , with each State enjoying full budgetary prerogatives except with regard to expenditure on defence and foreign policy. It should be added that this Union as such could not go into debt, as the common budget had to be balanced. While the Union established trade and financial relations with many other countries, it is important to note that its break-up occurred in the very specific context of the First World War. It was thus on the ruins of the Austro-Hungarian Empire that new nations and new currencies were formed.
It must therefore be concluded that monetary history does not tell us much about what happens at the end of a monetary union. Given this, attempts to evaluate a scenario involving an exit from the euro are subject to a level of uncertainty that we would call “radical”. While it might be possible to identify certain positive or negative results of exiting the euro, going beyond this to give specific calculations of the costs and benefits of a break-up comes closer to writing fiction than to robust scientific analysis. As for the positive side, it can always be argued that the effects on competitiveness of a devaluation can be quantified. Eric Heyer and Bruno Ducoudré have performed such an exercise for a possible fall in the euro. But who can say how much the franc would depreciate in the case of an exit from the euro zone? How would other countries react if France left the euro zone? Would Spain leave too? In which case, how much would the peseta fall in value? The number of these variables and their potential interactions lead to such a multiplicity of scenarios that no good faith economist can foresee, let alone calculate. The exchange rates between the new European currencies would once again be determined by the markets. This could result in a panic comparable to the currency crisis experienced by the countries in the European Monetary System (EMS) in 1992.
And what about the debt of the private and public agents of the country (or countries) pulling out? The legal experts are divided about what share would be converted by force of law into the new currency (or currencies) and what would remain denominated in euros, which would add to agents’ debt burden. So it is likely that an exit would be followed by a proliferation of litigation, with unpredictable outcomes. After the Mexican crisis in 1994, and again during the Asian crisis in 1998, both of which were followed by devaluations, there was an increase in agents’ debt, including government debt. Devaluation could therefore increase the problems facing the public finances while also creating difficulties for the banking system, as a significant share of the debt of private agents is held abroad (see Anne-Laure Delatte). The risk of numerous private defaults could therefore be added to the risk of default on the public debt. How would one measure the magnitude of such impacts? Or the increase in the default rate? What about the risk that all or part of the banking system might collapse? How would depositors respond to a bank panic? What if they seek to prop up the value of their assets by keeping deposits in euros and opening accounts in countries that they consider safer? A wave of runs on deposits would follow, threatening the very stability of the banking system. It might be argued that, upon regaining autonomy for our monetary policy, the central bank would implement an ultra-expansionary policy, the State would gain some financial leeway, put an end to austerity and protect the banking system and French industry, and capital controls would be re-established in order to avoid a bank run … But once again, predicting how such a complex process would unfold amounts to astrology … And if the example of Argentina  in late 2001 is cited to argue that it is possible to recover from a currency crisis, the context in which the end of the “currency board” took place there should not be forgotten: a deep financial, social and political crisis that does not really have a point of comparison, except perhaps Greece.
In these circumstances, we believe that attempting to assess the cost and benefits of leaving the euro leads to a sterile debate. The only question worth asking concerns the political and economic European project. The creation of the euro was a political choice – as would be its end. We must break with a sclerotic vision of a European debate that opposes proponents of leaving the euro to those who endlessly tout the success of European integration. There are many avenues open for reform, as has been demonstrated by some recent initiatives (Manifesto for a euro political union) as well as by the contributions collected in issue 134 of the Revue de l’OFCE entitled “Réformer l’Europe”. It is urgent that all European institutions (the new European Commission, the European Council, the European Parliament, but also the Eurogroup) take up these questions and rekindle the debate about the European project.
 For a more detailed analysis of comparisons that can be drawn between the European Monetary Union and Austro-Hungary, see Christophe Blot and Fabien Labondance (2013): “Réformer la zone euro: un retour d’expériences”, Revue du Marché Commun et de l’Union européenne, no. 566.
 See Jérôme Sgard (2002): “L’Argentine un an après: de la crise monétaire à la crise financière”, Lettre du Cepii, no. 218.
After the latest disappointing data on growth and
indeflation in the Eurozone, all eyes are on today’s ECB meeting. Politicians and commentators speculate about the shape that QE, Eurozone edition, will take. A bold move to contrast lowflation would be welcome news, but a close look at the data suggests that the messianic expectation of the next “whatever it takes” may be misplaced.
Faced with mounting deflationary pressures, policy makers rely on the probable loosening of the monetary stance. While necessary and welcome, such loosening may not allow embarking the Eurozone on a robust growth path. The April 2014 ECB survey on bank lending confirms that, since 2011, demand for credit has been stagnant at least as much as credit conditions have been tight. Easing monetary policy may increase the supply for credit, but as long as demand remains anemic, the transmission of monetary policy to the real economy will remain limited. Since the beginning of the crisis, central banks (including the ECB) have been very effective in preventing the meltdown of the financial sector. The ECB was also pivotal, with the OMT, in providing an insurance mechanism for troubled sovereigns in 2012. But the impact of monetary policy on growth, on both sides of the Atlantic, is more controversial. This should not be a surprise, as balance sheet recessions increase the propensity to hoard of households, firms and financial institutions. We know since Keynes that in a liquidity trap monetary policy loses traction. Today, a depressed economy, stagnant income, high unemployment, uncertainty about the future, all contribute to compress private spending and demand for credit across the Eurozone, while they increase the appetite for liquidity. At the end of 2013, private spending in consumption and investment was 7% lower than in 2008 (a figure that reaches a staggering 18% for peripheral countries). Granted, radical ECB moves, like announcing a higher inflation target, could have an impact on expectations, and trigger increased spending; but these are politically unfeasible. It is not improbable, therefore, that a “simple” quantitative easing program may amount to pushing on a string. The ECB had already accomplished half a miracle, stretching its mandate to become de facto a Lender of Last Resort, and defusing speculation. It can’t be asked to do much more than this.
While monetary policy is given almost obsessive attention, there is virtually no discussion about the instrument that in a liquidity trap should be given priority: fiscal policy. The main task of countercyclical fiscal policy should be to step in to sustain economic activity when, for whatever reason, private spending falters. This is what happened in 2009, before the hasty and disastrous fiscal stance reversal that followed the Greek crisis. The result of austerity is that while in every single year since 2009 the output gap was negative, discretionary policy (defined as change in government deficit net of cyclical factors and interest payment) was restrictive. In truth, a similar pattern can be observed in the US, where nevertheless private spending recovered and hence sustained fiscal expansion was less needed. Only in Japan, fiscal policy was frankly countercyclical in the past five years.
As Larry Summers recently argued, with interest rates at all times low, the expected return of investment in infrastructures for the United States is particularly high. This is even truer for the Eurozone where, with debt at 92%, sustainability is a non-issue. Ideally the EMU should launch a vast public investment plan, for example in energetic transition projects, jointly financed by some sort of Eurobond. This is not going to happen for the opposition of Germany and a handful of other countries. A second best solution would then be for a group of countries to jointly announce that the next national budget laws will contain important (and coordinated) investment provisions , and therefore temporarily break the 3% deficit limit. France and Italy, which lately have been vocal in asking for a change in European policies, should open the way and federate as many other governments as possible. Public investment seems the only way to reverse the fiscal stance and move the Eurozone economy away from the lowflation trap. It is safe to bet that even financial markets, faced with bold action by a large number of countries, would be ready to accept a temporary deterioration of public finances in exchange for the prospects of that robust recovery that eluded the Eurozone economy since 2008. A change in fiscal policy, more than further action by the ECB, would be the real game changer for the EMU. But unfortunately, fiscal policy has become a ghost. A ghost that is haunting Europe…