As the Eurozone experiences a prolonged demand-deficient recession, and given Germany’s pivotal role in making that happen, it is important to get the argument against current German policy right. It seems to me there are two wrong directions to take here. The first is to argue that Germany needs to undertake fiscal expansion because it has more ‘fiscal space’, to use a phrase the IMF use a lot which I dislike. The second is to argue that Germany needs to expand to help its Eurozone neighbours.
The problem with the first argument is that it legitimises the fiscal rules which are ultimately the source of the Eurozone’s current difficulties. If we look at the Eurozone as a whole, its fiscal policy is tighter than in the UK and US. As Fraser Nelson notes, the UK has a larger structural deficit than any other EU country. With interest rates at their zero lower bound, this shows that UK policy - while far from appropriate - is not quite as inappropriate as in the rest of the EU. The right policy when you are in a liquidity trap is to have a fiscal stimulus large enough to get you out of that trap. Within the Eurozone, the only countries that mightbe exempted from this fiscal expansion are those on the periphery. Otherwise we need a fiscal expansion in France, Italy, Spain, the Netherlands etc, as well as Germany.
The problem with the second argument is twofold. First, it tunes in with the popular sentiment in Germany that the country is yet again being asked to ‘bail out’ its Eurozone neighbours. Second, it implicitly suggests that the current German macroeconomic position is appropriate, but that Germany must move away from this position for the sake of the Eurozone as a whole. The obvious German response is to list all the reasons why their economy is currently on track (see, for example, Otmar Issing in the FT recently), and suggest therefore that other countries should look at their own policies for salvation. This is how we end up needlessly discussing structural reforms in France, Italy and so on.
The uncomfortable truth for Germany, which both the previous arguments can miss, is that the appropriate macroeconomic position for Germany at the moment is a boom, with inflation running well above 2%. The current competitiveness misalignment is a result of low nominal wage growth in Germany over the 2000 to 2007 period, which was in effect (and perhaps unintentionally) a beggar my neighbour policy with respect to the rest of the Eurozone. Germany’s current position is unsustainable, as its huge current account surplus and relative cyclical position shows. It will be corrected by undoing what happened from 2000 to 2007. Over the next five or ten years, German inflation will exceed the Eurozone average until its long term relative competitive position is restored.[1]
The only choice is how this happens. From the perspective of the Eurozone as a whole, the efficient solution would be above 2% inflation in Germany, and below 2% inflation elsewhere. That is what would happen if the ECB was able to do its job, and Germany would get no choice in the matter. Normally above 2% inflation in Germany would require a boom (a positive output gap), but if it can be achieved without that fine, although I would note that current German inflation is only 0.8%. Arguments that point to currently low unemployment and a zero output gap in Germany are therefore irrelevant while German inflation is so low. The inefficient alternative solution is for 2% or less inflation in Germany, and actual or near deflation outside. Why is this solution inefficient? Because to get inflation that low outside Germany requires the Eurozone recession we are now experiencing.
This is where structural reforms enter. Many German commentators say ‘why cannot other countries do what we did from 2000 to 2007’? But low nominal wage growth in Germany from 2000 to 2007 was accompanied by a recession in Germany! Furthermore, that recession was not so bad as the current Eurozone position, because the ECB was able to do its job and cut interest rates, so inflation outside Germany was above 2%. So from 2000 to 2007 many countries had to experience above target inflation because of low nominal wage growth in Germany, [2] yet many in Germany want to avoid above target inflation while imbalances are corrected.
If your starting point is what happened in Germany from 2000 to 2007, then current German arguments can look incredibly self-centred. They seem to say: we suffered a recession from 2000 to 2007 which led to a beggar my neighbour outcome, now you have to suffer a worse recession to put right the problem we created. But as I have argued before, and which comments on my recent posts and readings confirm, I think the German position is more about ignorance than greed. I also suspect there is a great deal of macroeconomic ignorance outside Germany as well, which is why Germany has been able to impose a recession on the rest of the Eurozone. Take for example this paper by Michael Miebach, who speaks from the left of centre in Germany.
Miebach presents a wide range of macroeconomic fallacies or irrelevant arguments. Germany’s fiscal position is not good (irrelevant in a liquidity trap), its macroeconomic position is not too bad (when it should have above 2% inflation, which probably requires a boom), fiscal expansion in Germany would have only a small impact on the periphery (but what we should be talking about is fiscal expansion in all the main Eurozone economies, which this paper confirms would help the periphery as well as France, Italy etc, and expansion in Germany would benefit countries like the Netherlands), and the old canard about how focusing on demand distracts attention from dealing with structural weaknesses in the Eurozone. But most revealingly we have this:
“Also, how can Germany demand fiscal discipline from other countries if it strips away its own principles at the first opportunity?”
You can only write this if you just do not get the idea of a liquidity trap, when demanding fiscal discipline from other countries is the source of the problem! What makes Germany’s current position unforgivable is not that it is refusing to undertake a significant fiscal stimulus of its own. It is that it is doing what it can to make other countries persist with austerity, and at the same time making it difficult for the ECB to do what it can to offset this. The ultimate problem is that what Germany sees at virtue is pre-Keynesian macroeconomic nonsense, nonsense that is doing other countries a great deal of harm. The best one can say in mitigation is that, in a sort of collective stockholm syndrome, too many in these other countries also mistake nonsense for virtue.
[1] Economists would naturally talk about real exchange rates here, rather than use the term competitiveness, because the latter invites a confusion between firms and nations. The first point to note is that if Germany had its own exchange rate, the impact of low nominal wage growth on competitiveness would be undone through a nominal appreciation. (There are no benefits of a nominal appreciation if everything real is unchanged.) The second point is that a competitive market is beneficial when it encourages improvements in productivity. For a single nation to gain a competitive advantage in a currency union by cutting nominal wages just causes problems.
[2] Looking at consumer prices tends to mask national differences, because of imported goods. Over the 2000-2007 period average Euro consumer price inflation was 2.2%, and in Germany it was 1.7%. However if we look at output prices (the GDP deflator) we get a clearer picture: average Eurozone inflation was just above 2%, but inflation in Germany was 0.8%.
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