Two weeks ago I received a request from Prof Sinn to make it known to my readers that he feels misrepresented by my post of September 29. Here is his very civilized mail, that I publish with his permission:
Dear Mr. Saraceno,
I have just become acquainted with your blog: https://fsaraceno.wordpress.com/2014/09/29/draghi-the-euro-breaker/. You misrepresent me here. In my book The Euro Trap. On Bursting Bubbles, Budgets and Beliefs, Oxford University Press 2014, and in many other writings, I advise against extreme deflation scenarios for southern Europe because of the grievous effects upon debtors. I explicitly draw the comparison with Germany in the 1929 – 1933 period. I advocate instead a mixed solution with moderate deflation in southern Europe and more inflation in northern Europe, Germany in particular. In addition, I advocate a debt conference for southern Europe and a “breathing currency union” which allows for temporary exits of those southern European countries for which the stress of an internal adjustment would be unbearable. You may also wish to consult my paper “Austerity, Growth and Inflation: Remarks on the Eurozone’s Unresolved Competitiveness Problem”, The World Economy 37, 2014, p. 1-1, http://onlinelibrary.wiley.com/doi/10.1111/twec.2014.37.issue-1/issuetoc, in which I also argue for more inflation in Germany to solve the Eurozone’s problem of distorted relative prices. I would be glad if you could make this response known to your readers.
Professor of Economics and Public Finance
President of CESifo Group
I was swamped with end of semester duties, and I only managed to read the paper (not the book) this morning. But in spite of Mr Sinn’s polite remarks, I stand by my statement (spoiler alert: the readers will find very little new content here). True, in the paper Mr Sinn advocates some inflation in the core (look at sections 9 an 10). In particular, he argues that
What the Eurozone needs for its internal realignment is a demand-driven boom in the core countries. Such a boom would also increase wages and prices, but it would do so because of demand rather that supply effects. Such demand-driven wage and price increases would come through real and nominal income increases in the core and increasing imports from other countries, and at the same time, they would undermine the competitiveness of exports. Both effects would undoubtedly work to reduce the current account surpluses in the core and the deficits in the south.
This is a diagnosis that we share But the agreement stops around here. Where we disagree is on how to trigger the demand-driven boom. Mr Sinn expects this to happen thanks to market mechanisms, just because of the reversal of capital flows that the crisis triggered. He argues that the capital which foolishly left Germany to be invested in peripheral countries, being repatriated would trigger an investment and property boom in Germany, that would reduce German’s current account surplus. This and this alone would be needed. Not a policy of wage increases, useless, nor a fiscal expansion even more useless.
Problem is, the data speak against Mr Sinn’s belief. Since the crisis hit, capital massively left peripheral countries, and yet this did not fuel domestic demand in Germany. Last August I showed the following figure:
It shows that after a drop (in the acute phase of the financial crisis) due to a sharp decline of GDP, since 2009 domestic demand as a percentage of GDP kept decreasing, in Germany as well as in the rest of the Eurozone. The reversal of capital flows depressed demand in the periphery, but did not boost it in Germany. Mr Sinn is too skilled an economist to fail to see this. The reason is, of course, that the magic investment boom did not happen:
What basically happened, I said it before, is that adjustment was not symmetric. Peripheral countries reduced their excess demand, while Germany and the core did not reduce their excess savings. The result is that, if we compare 2007 to 2014, external imbalances of the periphery were greatly reduced or reversed, while with the exception of Finland the core did not do its homework:
The conclusion in my opinion is one and only one: We cannot count on markets alone, in the current macroeconomic situation, if we want rebalancing to take place. In the article he suggested I read, Mr Sinn states that a 4 or 5 per cent inflation rate would be politically impossible to sell to the German public:
Moreover, it is unclear whether the German population would accept being deprived of their savings. Given the devastating experiences Germany made with hyperinflation from 1914 to 1923, which in the end undermined the stability of its society, the resistance against an extended period of inflation in Germany could be as strong or even stronger than the resistance against deflation in southern Europe. After all, a rate of 4.1 per cent for German inflation for 10 years, which would be necessary to allow the necessary realignment between France and Germany without France sliding into a deflation, would mean that the German price level would increase by 50 per cent and that, in terms of domestic goods, German savers would be deprived of 33 per cent of their wealth. If the German inflation rate were even 5.5 per cent, which would be necessary to accommodate the Spanish realignment without price cuts, its price level would increase by 71 per cent over a decade and German savers would be deprived of 42 per cent of their wealth.
This shows all the logic of Ordoliberalism: It is impossible to sell inflation to the the German public, because this would deprive them of their savings. This argument only makes sense if one subscribes to the Berlin View that the bad guys in the south partied with hard earned money of northern (hard) workers. Otherwise the argument makes no sense at all, as high inflation in the core for next few years simply compensates low inflation in the past. Should I remind Mr Sinn that the outlier in terms of labour costs is not the EMU periphery, but Germany?
Also, I find it disturbing that, while acknowledging that inflation in Germany would be needed, Mr Sinn rejects it on the ground that it would be a hard sell. The role of intellectuals and academics is mostly to discuss, find solutions (or at least try), and then argue for them. All the more so if this is unpopular, because it is then that their pedagogical role is most needed. All too often public intellectuals abdicate to their role, and simply follow the trend. Should we all argue in favour of a euro breakup only because public opinion is less and less favorable to the single currency?
Finally, a short comment on another bit of Mr Sinn’s article:
And although the core countries would suffer [from high inflation], the solution would not be comfortable for the devaluating countries either. They will unavoidably face a long-lasting stagnation with rising mass unemployment and increasing hardship for the population at large. People will turn away from the European idea, and voices opting for exiting the euro will gain strength. Thus, it might be politically impossible to induce the necessary differential inflation in the Eurozone.
I don’t really see his point here. But let’s take it for good, just for the sake of argument. I think it is too late to worry about support for the euro in the periphery. It is hard to see how “excessive” inflation in the core would impose more hardness than seven years of adjustment, ill-conceived structural reforms, and self-defeating austerity.
So Mr Sinn, thank you for your mail and for the reference to your paper that I have read with interest. But no, I don’t think I misrepresented you. The core of your argument remains that the burden of adjustment should rest on the periphery’s shoulders. And you failed to convince me that this is right.
I just read, a few days late, a very instructive Op-Ed by Otmar Issing for the Financial Times. The zest of the argument is in the first few lines, that are worth quoting:
Imagine you are asked to give advice to a country on its economic policy. The country enjoys near-full employment; its growth is above, or at least at full potential. There is no under-usage of resources – what economists call an output gap – and the government’s budget is balanced, but the debt level is far above target. To top it all monetary policy is extremely loose.
This is exactly the situation in Germany. Recently forecasts for growth have been revised downwards, but so far the overall assessment is unchanged. At present there is no indication of the country heading towards recession. Inflation is low but there is no risk of deflation. From a purely national point of view Germany needs a much less expansionary monetary policy than it is getting from the European Central Bank. This is a strong argument why fiscal policy should not be expansionary, too.
Where is the economic textbook that argues that such a country should run a deficit to stimulate the economy? There is hardly a convincing argument for such advice.
The quote is a perfect example of what is wrong with mainstream thinking in German academic and policy circles. First, the incapacity to fully appreciate to what extent the German national interest is linked to the wider fate of the eurozone. From a purely national point of view, Germany needs stronger growth in the eurozone, its main trading partner. And it needs higher inflation at home and abroad. Which means that no, monetary policy is not too expansionary for Germany, as Issing claims.
But there is a more important issue: Issing seems not to grasp that the problem with the German economy is that it is unbalanced. True, it is near full employment (even if much could be said about the quality of that employment), but it relies too much on exports and too little on domestic demand, with the result that it runs, since 2001, increasing current account deficits. To say it bluntly, Germany has been sitting on the shoulders of the rest of the world economy, and since 2010 it has been followed by the rest of the eurozone that is globally running trade surpluses. I have already said many times that this is a bad (and dangerous) strategy.
I do not know what textbooks Issing reads. Germany’s intellectual tradition must include OrdoTextBooks. The ones I know say that expansionary fiscal policy, at full employment, crowds out private expenditure and exports. And guess what? This is exactly what Germany should do, for its own and its neighbours’ welfare. And if at the same time private expenditure was also boosted, with wage increases (hey, don’t listen to me; listen to the Bundesbank!) and incentives for investment, crowding out could be limited to foreign demand.
So, I read textbooks and I conclude that Otmar Issing is dead wrong. Germany should boldly expand domestic demand (public and private), thus overheating its economy, crowing out exports, and increasing inflation. The effect would be rebalancing of the German economy, growth in the rest of the eurozone, and relief in the rest of the world, for which we would stop being a drag.
Unfortunately this is not bound to happen anytime soon.
Just a quick note on something that went surprisingly unnoticed so far. After Draghi’s speech in Jackson Hole, a new consensus seems to have developed among European policy makers, based on three propositions:
- Europe suffers from deficient aggregate demand
- Monetary policy has lost traction
- Investment is key, both as a countercyclical support for growth, and to sustain potential growth in the medium run
My first reaction is, well, welcome to the club! Some of us have been saying this for a while (here is the link to a chat, in French, I had with Le Monde readers in June 2009). But hey, better late than never! It is nice that we all share the diagnosis on the Eurocrisis. I don’t feel lonely anymore.
What is interesting, nevertheless, is that while the diagnosis has changed, the policy prescriptions have not (this is why I failed to share the widespread excitement that followed Jackson Hole). Think about it. Once upon a time we had the Berlin View, arguing that the crisis was due to fiscal profligacy and insufficient flexibility of the economy. From the diagnosis followed the medicine: austerity and structural reforms, to restore confidence, competitiveness, and private spending.
Today we have a different diagnosis: the economy is in a liquidity trap, and spending stagnates because of insufficient expected demand. And the recipe is… austerity and structural reforms, to restore confidence, competitiveness, and private spending (in case you wonder, yes, I have copied-pasted from above).
Just as an example among many, here is a short passage from Mario Draghi’s latest audition at the European Parliament, a couple of weeks back:
Let me add however that the success of our measures critically depends on a number of factors outside of the realm of monetary policy. Courageous structural reforms and improvements in the competitiveness of the corporate sector are key to improving business environment. This would foster the urgently needed investment and create greater demand for credit. Structural reforms thus crucially complement the ECB’s accommodative monetary policy stance and further empower the effective transmission of monetary policy. As I have indicated now at several occasions, no monetary – and also no fiscal – stimulus can ever have a meaningful effect without such structural reforms. The crisis will only be over when full confidence returns in the real economy and in particular in the capacity and willingness of firms to take risks, to invest, and to create jobs. This depends on a variety of factors, including our monetary policy but also, and even most importantly, the implementation of structural reforms, upholding the credibility of the fiscal framework, and the strengthening of euro area governance.
This is terrible for European policy makers. They completely lost control over their discourse, whose inconsistency is constantly exposed whenever they speak publicly. I just had a first hand example yesterday, listening at the speech of French Finance Minister Michel Sapin at the Columbia Center for Global Governance conference on the role of the State (more on that in the near future): he was able to argue, in the time span of 4-5 minutes, that (a) the problem is aggregate demand, and that (b) France is doing the right thing as witnessed by the halving of structural deficits since 2012. How (a) can go with (b), was left for the startled audience to figure out.
Terrible for European policy makers, I said. But maybe not for the European economy. Who knows, this blatant contradiction may sometimes lead to adapting the discourse, and to advocate solutions to the deflationary threat that are consistent with the post Jackson Hole consensus. Maybe. Or maybe not.
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’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.
Today we learn from Daniel Gros, on Project Syndicate that the emphasis on German surplus is misplaced:
The discussion of the German surplus thus confuses the issues in two ways. First, though the German economy and its surplus loom large in the context of Europe, an adjustment by Germany alone would benefit the eurozone periphery rather little. Second, in the global context, adjustment by Germany alone would benefit many countries only a little, while other surplus countries would benefit disproportionally. Adjustment by all northern European countries would have double the impact of any expansion of demand by Germany alone, owing to the high degree of integration among the “Teutonic” countries.
Fascinating. The bulk of the argument is that Germany is a small player in the global economy, and therefore that its actions have no impact. I have two objections to Gros’ argument. Read More