Back in April 2010 when it first seemed the Eurozone was about to crack up, I did a post on the lessons of the Eurozone crisis. I argued then that the main lessons were, one, countries joining a currency union should take seriously the optimal area criteria and the real exchange rate and, two, central banks should take seriously the task of stabilizing the growth of nominal spending. I still think these points are valid, but I now see a more important lesson from this ongoing crisis: avoid relationships where one party to the relationship is domineering and has a history of abuse. In short, avoid bad relationships.
In the case of the Eurozone relationship the dominant party is Germany. Its desires have largely shaped the direction of the Eurozone and continue to do so today, even though it only has historically made up at most about 30% of the Eurozone economy. This uneven relationship has been very apparent lately as the future of the Eurozone seems to hang on the day-to-day developments in Germany. For example, the fate of the currency union inched closer to collapse a few weeks ago when German's constitutional court ruled against a supranational fiscal authority and when a German vote of no confidence was effectively issued for the ECB by the resignation of the German representative Jurgen Stark from the ECB's board. Then, last week the mood improved when German Chancellor Angela Merkel said the Eurozone must stick together. Now new polls show Merkel loosing influence and the Eurozone's breakup looks more likely. That these German developments can so easily drive the ups and downs of the Eurozone outlook speaks to dominance of Germany in the Eurozone relationship.
Another way to see the inordinate influence of Germany is to look at the inflation-hawk culture of the ECB inherited from the Germans and its influence on the evolution of ECB monetary policy. Many studies, such as this 2010 report from Barclays Capital or this one from the WSJ, have shown using Taylor Rule estimates that while ECB monetary policy has been stabilizing for Germany over the past decade it has been destabilizing for the periphery. In particular, monetary policy was too loose for the periphery when the Eurozone was first formed and more recently have become too tight for them.
This tendency to change ECB monetary in a manner that best serves Germany can be vividly seen by looking at the history of nominal spending for Germany and for the rest of the Eurozone. The first figure below shows the case of Germany along with a trend. It shows that not only has Germany's nominal spending returned to trend, but that it is has slightly exceeded it in recent quarters. This explains why the ECB raised interest rates earlier this year and has failed to cut them despite the severity of the crisis. The German economy needed some tightening and the ECB delivered it.
In the case of the Eurozone relationship the dominant party is Germany. Its desires have largely shaped the direction of the Eurozone and continue to do so today, even though it only has historically made up at most about 30% of the Eurozone economy. This uneven relationship has been very apparent lately as the future of the Eurozone seems to hang on the day-to-day developments in Germany. For example, the fate of the currency union inched closer to collapse a few weeks ago when German's constitutional court ruled against a supranational fiscal authority and when a German vote of no confidence was effectively issued for the ECB by the resignation of the German representative Jurgen Stark from the ECB's board. Then, last week the mood improved when German Chancellor Angela Merkel said the Eurozone must stick together. Now new polls show Merkel loosing influence and the Eurozone's breakup looks more likely. That these German developments can so easily drive the ups and downs of the Eurozone outlook speaks to dominance of Germany in the Eurozone relationship.
Another way to see the inordinate influence of Germany is to look at the inflation-hawk culture of the ECB inherited from the Germans and its influence on the evolution of ECB monetary policy. Many studies, such as this 2010 report from Barclays Capital or this one from the WSJ, have shown using Taylor Rule estimates that while ECB monetary policy has been stabilizing for Germany over the past decade it has been destabilizing for the periphery. In particular, monetary policy was too loose for the periphery when the Eurozone was first formed and more recently have become too tight for them.
This tendency to change ECB monetary in a manner that best serves Germany can be vividly seen by looking at the history of nominal spending for Germany and for the rest of the Eurozone. The first figure below shows the case of Germany along with a trend. It shows that not only has Germany's nominal spending returned to trend, but that it is has slightly exceeded it in recent quarters. This explains why the ECB raised interest rates earlier this year and has failed to cut them despite the severity of the crisis. The German economy needed some tightening and the ECB delivered it.
The next figure shows nominal spending for the rest of the Eurozone. The difference between the two figures is shocking. Not only is nominal spending below trend, but the difference continues to increase. The ECB is failing miserably here to stabilize nominal spending for the other 70% of the currency union. This should remove any doubt about the inordinate influence of Germany on the Eurozone.
Finally, it is worth nothing that the Eurozone crisis is not the first
time Germany's internal policy goals were promoted at the expense of partner countries. The European Monetary System (EMS), which tied
other European currencies to the German Deutsche Mark, erupted into a
crisis in 1992 when the German central bank adopted a tighter monetary policy
that was appropriate for Germany but too tight for the other countries
in the exchange rate system. Thus, there is an tendency for Germany to use its inordinate influence over European monetary affairs in a manner not conducive to the overall monetary system. This suggests to me that maybe the best solution to the Eurozone crisis is not to fix the currency union but for Germany and like-minded countries to leave it. Ambrose Evans-Pritchard, Ramesh Ponnuru, and others have made the case for something like a two-tiered EMU where Germany and other austerity-embracing countries adopt a harder currency while letting France lead the Euro block. Here is Evans-Pritchard's idea:
My solution - like that of Hans-Olaf Henkel, the ex-head of Germany's industry federation (BDI) - is to split EMU into two blocs, with France leading a Latin Union that keeps the euro. This bloc would devalue but not by 60pc, yet uphold its euro debts intact. The risk of default and banking crises would decrease, not increase.
The German bloc could launch their Thaler, recapitalizing banks to cover losses from rump euro debt. Disruptions could be contained by capital controls at first. None of this is beyond the wit of man. My bet is that aggregate losses would be lower than the status quo, and the long term outcome much healthier. The EU might even carry on, unruffled.
I haven't always held this view, but am becoming increasingly sympathetic to it. Sometimes it is for the best of all that a bad, abusive relationship gets terminated. Maybe it is time for Germany to leave the Eurozone.
David,
ReplyDeleteWhy not the other way around? Why doesn't Germany just leave the EU? The German people don't want to bail out the rest of the Euro area. A German central bank would perform just as well as the ECB. It is not clear to me that the benefits of EU membership exceed the costs at this point.
This idea of Germany leaving the euro is just silly. A key motivation for the euro was that other european countries, above all France, wanted to match Germany's economic success and understood that a hard currency was part of that. They hoped that building the euro on the foundations of the deutschmark would either appropriate that success or at least blunt Germany's advantage. If Germany wanted to leave the euro, I am sure that most of the northern european countries would want to go with it one way (a new collective currency) or another (by pegging to the German currency), rather than being part of some second class currency deliberately designed to be soft. French pride would force them to follow, and so too would any other country with ambition to be taken seriously as an economic power (eg Spain). According to a BBC report I heard yesterday, even in Greece there is still a majority in favour of keeping the euro. Soft currencies are a fantasy of expedient politicians and too-clever-for-their-own-good economists - the people who have experience of soft currencies don't want them.
ReplyDeleteA hard currency union?
ReplyDeleteWould that not kill the exports immediately?
Which of the export driven countries (GER/FIN/NL) really want that?
I doubt that any of them want that.
No, they want a weak currency without having to bail out the weakest links.
And therein lies the problem.
Rebel Economist has a point. Euro currency regimes are there to stem endemic competitive devaluations. Countries like Italy and France used devaluations to escape the consequences of fiscal and monetary misadventure. The result was higher market risk premia and persistent stagflation.
ReplyDeleteGerman discipline was supposed to put a stop to all that. The Euro "Convergence Trade" -- a popular hedge fund trade -- involved buying periphery debt pre-Euro to benefit from a convergence in sovereign spreads. This convergence was at the heart of the subsequent European credit boom. As a result of that boom, the same German discipline is now inconvenient.
I don't believe that story either Anonymous. Like Japan and more recently Switzerland, I think German industry could cope with a substantial currency appreciation. One reason for this what the Germans produce is so specialised that buyers will pay up, and another reason is that labour and management are relatively cooperative and able to find solutions to competitiveness problems. In England we have a saying that "football is a simple game; 22 men chase a ball for 90 minutes and at the end, the Germans always win." Ditto economics.
ReplyDeletegenauer says, as a German, I also thought for a while, lets make it easier for everybody, let Germany leave the Euro and bear the transaction costs.
ReplyDeleteBut then you look at Greece, no data found on anything at eurostat, now promising since 18 months to liberalize the taxi market, and still nothing done, how difficult is that, could be done in an afternoon.
And Italy, even in the face of immediate insolvency not being able to plot straight with the ecb and raising the taxes on the rich, who are richer than the germans.
But German sheeps as always, talk about raising taxes to support these kinds of people.
No, let them bear the consequences of their own incredible behavior.
I am getting a little tired of this permament german bashing, always trying to extract more money.
Honestly, I think Greece needs to default so that Germans, as a nation, can get over their delusion of their own moral rectitude. Listening to Germans talk about their economy now is like listening to Americans talk about their economy 5 years ago, about how transient features proved their greater virtue, and how obviously this would last forever. It was sickening when Americans did it then, and it's sickening when Germans do it now.
ReplyDeleteThe biggest victim of a euro-zone collapse would be Germany. While "Rebel Economist" might tell himself that Germany will somehow defy the laws of economic gravity, but when the price of German goods jumps 20% on the world market, people are simply going to stop paying for them.
The European financial crisis was Made in Germany. Germany deliberately ran a current account surplus, and they recycled that surplus by lending foolishly. Rather than taking any responsibility for their foolishness, they're lashing out. Hard currency is one of those meaningless things that people who are play-acting at moral rectitude prize. China is deliberately running a soft currency policy, and they're seeing growth rates that Germany could only dream of achieving.
At this point, Greece quitting the euro and defaulting would be the best outcome for Greece, and the worst outcome for Germany. If the Germans want this outcome, then I hope to God they get it.