This post is nothing new. It is just a reminder for non European readers (or for distracted European readers), about the way things work in the EMU. The German Bundesbank President Weidmann violently attacked the European Commission for failing to enforce fiscal discipline within the Stability Pact.
What is wrong with this? Is this not just another confirmation of the old cliché that Germans are obsessed with respecting the rules?
Well, think again. Everybody knows that EU countries need to curb their public deficit to be below 3% of GDP, and need to aim to structural balance. But it is less known, especially outside Europe, that since 2011, as a part of the so-called “six-pack”, the EU introduced the Macroeconomic Imbalances Procedure (MIP), “which aims to identify, prevent and address the emergence of potentially harmful macroeconomic imbalances that could adversely affect economic stability in a particular Member State, the euro area, or the EU as a whole”.
This procedure builds on a scoreboard of 14 indicators, among which we can read the following:
- 3-year backward moving average of the current account balance as percent of GDP, with thresholds of +6% and -4%;
Yeah, that is right, at the very first place. And guess what, Germany’s current account surplus, since the MIP came into force has been above 6% every single year. (it is expected to be 9% in 2016).
And yet, no corrective action has been imposed, and of course no sanctions. I understand that Germany has no problems with not being sanctioned. But maybe it would be wise to keep a low profile regarding others’ violations..
So, for once, I agree with Jens Weidmann: the Commission should be harsher on those who do not respect the rules. And of course, it will, but just with some. Among the many problems European governance has, this is not the least: all animals are equal, but some animals are more equal than others.
I was puzzled by Daniel Gros’ recent Project Syndicate piece, in which he claims that Germany’s dominance of the EMU may be coming to an end. Gros’ argument is based on two facts. The first is the slowing growth rate of Germany, that seems to be heading towards the pre-crisis “normal” of slow growth (Germany grew less than EMU average for most of the period 1999-2007). The second, more geo-political, is the lack of willingness (or of capacity) to manage, the crises that face the EU (in particular the refugees crisis).
Gros concludes that this loss of influence is dangerous, because Germany will not be able to resist the changes in policies that are pushed by peripheral countries and by the ECB. Of course, implicit in this statement, is Gros’ belief that these policies were necessary and useful.
I welcome the recognition that Germany has steered the EMU since the beginning of the crisis. Those of us talking about the Germanification of Europe have been decried until very recently. Yet, I do not share, not at all, Gros view.
True, Germany’s growth is slowing down. These are the risks of an export-led growth model: countries are not masters of their own fate. Germany stayed clear from the peripheral countries’ crisis (that it contributed to create) by turning to the US and to emerging economies as markets for its exports. But now that these countries are also having problems, the limits of jumping on other countries’ shoulders to grow, become evident. I am surprised by Gros’ surprise, as this was evident from the very beginning.
But here I do not want to reiterate my criticisms of the export-led model, starting from the fallacy of composition. Instead, I would like to challenge Gros’ argument that Germany influence is waning. I would say on the contrary that the Germanification of the eurozone is almost complete.
I took a few macroeconomic variables, and contrasted Germany with the remaining 11 EMU members. Let’s start with (missing) domestic demand, a defining characteristic of the export-led growth model:
Since 2007, the yellow line (EMU11) and the red line (Germany) converged, mostly because domestic demand in the rest of the EMU was reduced. This led of course to an increased reliance of the EMU as a whole on exports. The EMU as a whole had an overall balanced external position in 2007, while it has a substantial current account surplus today (the EMU12 went from 0.5% to 3.4 projected for 2016. Germany went from 7% to 7.7%). In other words, the EMU11 joined Germany on the shoulders of the rest of the world.
Austerity has of course much to be blamed for this compression of domestic demand: Just look at government balances (net of interest payments):
True, the difference between Germany and the rest of EMU is today larger than in 2007. But since Germany and the Troika took the driving seat in 2010, government balances of the EMU11 have been steadily converging to surplus, and they are not going to stop in the foreseeable horizon (the Commission forecasts go until 2016).
Finally, if we look at one of the main drivers of growth, investment, the picture is the same.
Be it private or public, the EMU11 Gross Fixed Capital Formation has been converging towards the (excessively low) German level (I did not draw the differences, not to clutter the figure).
And of course, there are labour costs, for which convergence to Germany was brutal, even if the latter, rather than EMU peripheral countries, were the outlier. To summarize, during the crisis the difference between Germany and the rest of the EMU was substantially reduced, and will continue to be in the next years:
The difference was reduced for all variables, except for government deficit. Self-defeating austerity slowed down the convergence. But private expenditure, in particular investment, more than compensated.
So, if I were Gros, I would not worry too much. The Germanification of Europe is well on its way. If Germany does not go to the EMU11 (it definitely does not!), the EMU11 keeps going to Germany.
But as I am not Gros, I worry a lot.
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.
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.
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
The Financial Times highlights one of the most striking conclusions of the latest ECB Financial Stability Report (full document here). The ECB, using FT’s words, “issued a stark warning over the threat posed by the scaling back of US monetary stimulus, calling on eurozone policy makers to do more to prepare for the market shocks from Federal Reserve tapering.”
There are of course many reasons why a change of policy of the largest world economy is closely monitored because of its potential impact. The ECB statements nevertheless are striking to me, because they are further confirmation of the small country syndrome that I pointed out in the past.
Quantitative Easing has been pivotal in ensuring that the hasty reversal of the fiscal stance in the United States did not dip their economy into a new recession. One may argue that today’s US economy is not sufficiently robust for exiting monetary stimulus. But it is sooner or later going to happen. The rest of the world has been free riding on Fed’s policies. In particular, the eurozone has benefited from QE in a context of sharp and pro-cyclical austerity, and very timid monetary policy.
Here is the statement I would have expected from the ECB: “The eurozone, the second largest economy of the world, has benefited from exceptional measures implemented by the Fed. This helped our economies and our financial markets in the context of a difficult consolidation process. Domestic factors in the United States will most likely cause a reversal of these policies. It is time European policy makers stand on their legs. As our economies persist in a state of chronic weakness, the ECB will consider its own quantitative easing program, to compensate for tapering in the United States, and provide to the European economy the environment it needs to rebound”
Such a statement, that I would find reasonable and balanced (maybe even too prudent), is nevertheless revolutionary nonsense in European policy circles. Instead we had the same old “copy-and-paste” demand to EMU countries of structural reforms and stable macroeconomic policies (read austerity). Not a single hint of even remotely possible non orthodox policies here at home. The sad truth is that we are structurally incapable of finding within our economy and our institutions the instruments to ensure growth and prosperity. We are structurally free riders. We siphon aggregate demand from the rest of the world running increasing current account balances, and we are not capable of implementing an autonomous monetary policy.
The world’s second largest economic area remains a parasite of the global economy, and it is incapable of living up to its responsibilities. Nothing good can come out of this.
Olli Rehn wrote a balanced piece on Germany’s current account surplus. To sum it up:
- He acknowledges that Germany’s surplus is a problem.
- He acknowledges (albeit indirectly) that the initial source of the problem were capital flows from Germany and the core to the periphery; flows that did not go into productive investment but fueled bubbles.
- He (correctly) argues that over the long run some excess savings from Germany is justified by the need to provide for an ageing population.
- He points out that investment has been too low and needs to increase (possible within the framework of an energy transition).
- He also mentions, without mentioning it, the problem of excessively low wages and pauperisation of the labour force, calling for increases in wages and reduction in taxes to boost domestic demand.
This seems to me a reasonable analysis, and I would welcome an official position of the Commission along these lines. Yet, I think that what is missing in Rehn’s piece, and in most of the current debate, is a clear articulation of between the long and the short run.
I would not object on the need for Germany to run modes surpluses on average over the next years, to pay for future pensions and welfare. It is after all a mature and ageing country. Even more, I would agree with the argument that low wages need to increase, and that bottlenecks that prevent domestic demand expansion should be removed. In other words, I would most likely agree on the Commission’s prescriptions for the medium-to-long run.
Nevertheless, there is a huge hole in Olli Rehn’s analysis, that worries me a bit. Rehn seems to overlook the need to do something here and now. Today, with the periphery of the eurozone stuck in recession, emerging economies sputtering, and continuing jobless growth in the US, the world desperately needs a boost from countries that can afford it. And unfortunately there are not many of these.
Germany is instead siphoning off global demand, making the rest of the world carry its economy when it should do the opposite. As a quick reversal of private demand is unlikely, (this, I repeat should be a medium run target), I see no other option in hte very short run than a substantial fiscal expansion.
A cooperative Germany should implement short run expansionary policies (the need for public investment is undeniable), while working to rebalance consumption, investment and savings in the medium run, with the objective of a small current account surplus in the medium run.
That, incidentally, would not make them Good Samaritans. Ending this endless recession in the eurozone (yes I know, it is technically over; but how happy can we be with growth rates in the zero-point range?) is in the best interest of Germany as much as of the rest of the eurozone (and of the world).
A clear articulation between the different priorities in the short and in the medium-long run would benefit the debate. The problem is that then Olli Rehn should acknowledge that in the short run there is no alternative to expansionary fiscal policies in the eurozone core. That would be asking too much…