Reflections on the German economy. A macroeconomic approach. Part 3: Reforming economies.

By Egon Neuthinger

1. The need for reforms, but which reforms and by whom?

In part 1 of our series, we explained the imbalances in the European economy and the role that German wage moderation has played to create them. In part 2, we discussed the evolution of prices and wages in Germany.  The third part will start by making much-needed proposals for reform. Most EMU countries show at present slightly positive growth rates, in the average of some 1.5 %. Growth in France and Italy is positive, but sluggish. All these countries still have high public sector deficits – especially Greece, but also Spain, Portugal, France and Italy. While in Germany the current account surplus stabilizes the economy, in the crisis countries the public sector balance continues to destabilize it. Last but not least, all crisis countries have high unemployment rates, upwards from 10% in France, Italy and Portugal to around 20% in Spain and even higher in Greece.

This unsatisfactory course of development in some EMU countries, including France and Italy, strengthens the argument that these countries should start or go on to implement reforms in their labour, product and service markets and, if necessary, adjust their labour costs. There are always areas in the economy in which well-founded competitive and growth policies would lead to better market results. Adequate supply policies are always helpful. However, such reforms are difficult to achieve without negatively affecting demand, which is, of course, crucial. The advice of some German economists to France and Italy and other countries to simply follow the German example must be questioned: should these countries achieve current account surpluses as in Germany and should this be attained by similar wage restraints in line with cuts in public expenditures? Is this even possible? Let us not forget that domestic demand in Germany also became sluggish when structural reforms (wage moderation and labour market flexibilization) were implemented. It attained high foreign demand and current account surpluses, but not the strong boost of internal demand that most observers expected. It is, in any case, highly doubtful whether France and Italy, given their production and demand structure, would be able to generate considerable higher foreign demand for their products, as Germany did, and to create a substantial positive current account balance.

Referring to domestic demand, the experience of the periphery does not confirm the expectation that domestic demand is boosted by structural reforms. There is, rather, the danger that France and Italy would live to see the same fate as the other countries: high and long lasting protracted recession and high unemployment. Therefore, France and Italy should be given the advice of a two handed approach, using supply and demand measures. As domestic demand is comparably greater in France and in Italy than in Germany (in per cent of GDP), restrictive fiscal and other restrictive policies in the private sector would have immediate negative effects on domestic demand and thus on growth and unemployment.

Economic logic tells us that not all countries can achieve current account surpluses – one country’s surplus is another’s deficit. It is also difficult to foresee how market forces react. The example of smaller EMU-countries in which restrictive structural reforms were implemented as a part and parcel of austerity measures have not brought real recovery to these countries. In fact, the reverse is true. This should make everyone very cautious. Strong arguments support the thesis that without a reflationary change in German economic policy through higher wages and higher deficit financed public expenditures (primarily in infrastructure) together with substantial cuts in value added tax and substantial cuts in the tax rates of lower and middle class income taxes, a substantial economic recovery in France and Italy or in any of the other EMU countries, is rather doubtful. This is especially true today, in times of deflationary pressure and stagnation.

Although German wages have in recent year risen more in line with the Golden Rule (productivity growth plus inflation target somewhat below 2 %), a large negative gap in the overall German wage level still exists. Judged by the Golden Rule – the original agreement – the overall German wage level should be 15 to 20 % higher than it is today. Of course, the figure depends on the base year but it is definitively true if calculates since the beginning of EMU. With regard to the necessary adjustments, the current state of the financial balances of all macroeconomic sectors should be kept in mind. In Germany, aside from the traditional surplus of private households, the corporate sector also has a positive financial balance. If in such an environment, the public sector (government) also strives to attain a balanced budget or even a surplus, the pressure is on the foreign sector to absorb German savings. It is useful here to remind the reader that in the wake of the Macroeconomic Imbalance Procedure (MIP) of the EMU countries, a current account surplus up to 6% of GDP is not defined as a fundamental imbalance.

It is trivial, of course, but true nonetheless: countries with large public sector and foreign debts are criticized as “living beyond their means.” Apparently, Germany, the country with the highest current account surplus, “lives far below its means.” This open asymmetry is scarcely ever mentioned by the economic mainstream in Germany. The remedy, as proposed by them, “countries with deficits in their public and current accounts must adjust; countries with positive public and current accounts must not”, is asymmetric and not acceptable for the partner countries. The adjustment problem – who shall adjust and who shall not – is an old and controversial issue, which is determined by power and not by economic insight. In reality, the weaker countries have to adjust. This is very one-sided and bad economics. Germany is one of the largest creditor countries. Its dominating economic power buys political power. Economic imbalances lead to power imbalances. However, there are signs that this constellation may be changing. The current economic imbalances are so dysfunctional that serious conflicts between creditors and debtors can be expected. How long will this unstable constellation, which stifles a recovery in Europe, last? It is possible that future conflicts could endanger Germany’s economic and political position in the medium or longer term? Will Germany eventually be forced to pay a high price for its creditor position? The mainstream in Germany does not or barely pay attention to such considerations and questions, although they are of course absolutely critical.

2. A new policy design for Germany

Notwithstanding the silence of the mainstream and the unwillingness of policy-makers to address the main cause of the macroeconomic imbalances, it is possible to implement economic policy that ultimately leads to satisfactory results. A correct mix of monetary and fiscal policies is warranted, as well as microeconomic actions of market participants. One would hope that the academic scientific community would push for change, but the mainstream does not change its position quickly. There is, however, also a positive evolution: an ever growing number of (more heterodox inclined) economists and representatives of the other social sciences have become increasingly unsatisfied with the mainstream view. Yet, one obstacle to change is psychological. It is the traditional belief in the German society that export surpluses and a good export performance is part of the German performance in general.

The problem that our surpluses are the deficits of others and that they hamper demand abroad is hardly ever mentioned. In this context it should be noted that the production structure of the German economy in the past decades has become oriented very much towards foreign demand. This has been heavily influenced by German monetary policies which were very much oriented towards price stability. These policies held back internal demand, strengthened international competitiveness and directed German enterprises to foreign markets. In this context, the manifold German critique of today’s ‘unconventional monetary policy’ of the ECB is highly remarkable. In normal conditions, the adequate and consistent manipulation of the interest rates by the central bank often suffices to stabilize the economy. In the present situation of zero and even negative interest rates and a global liquidity trap, monetary policy has become exhausted. It is therefore absolutely necessary to put fiscal policies (public investments) into action.

3. Policy recommendations

Our analysis leads to the formulation of some policy recommendations. A new vision and concept for wage policy should become an eminent feature of economic policy in the EMU. The internal development of the EMU so far should convince economics and policy-makers that unorganized and uncoordinated wage policies constitute grave obstacles to convergence within the EMU, a real danger to internal equilibrium and a continuous cause of macroeconomic imbalances. The omission of wage policy in the policy catalogue of the Maastricht-Treaty and, later, the disregard of the Golden Rule has had harsh consequences for Europe. Germany has always been the driving force behind EMU-policy. The refusal and the neglect of the Golden Rule for wage policy within the EMU countries indicates that policy-makers and advisers judge wage policy as an instrument to gain competitive advantages by a policy of wage moderation. The function of wage policy in a monetary and currency union is thus gravely misjudged. In such an environment, divergent uses of wage policy are the root of large and enduring disequilibria between the economies of the member countries. Wage policies that do not adhere to the Golden Rule are a device for “catch-as-catch can.” This was not the original deal and it is particularly bad economics. The concept of the Golden Rule was explicitly to hinder the emergence of macroeconomic imbalances. This is not to say there might not be other factors that also cause such imbalances, but those caused by wage misalignments are the most important ones. Budgetary balance rules under these circumstances do nothing to restore equilibrium between countries. The first policy recommendation is therefore evident: wage developments in the EMU need to be coordinated and to follow the Golden Wage Rule.

Second, the inclusion of wage policy in the factual policy catalogue of the EMU should be complemented by a change in the policy approach in the direction of a distinct cooperative policy design, away from the dominant neoclassical pattern that assigns stability, full employment and the allocation of resources separately to the macroeconomic main actors.

Instead, the great economic policy targets should become a common task to be followed by all three macroeconomic policy-makers. This means far more and continuous coordination, harmonization and synchronization of policy measures. Such coordination and, indeed, cooperation, could provide a much more successful climate for necessary but socially painful reforms. Such reforms could find political support sooner in a cooperative environment than in the hard core climate of ‘moral hazard.’ Cooperation should be governed by a kind of “do ut des” (‘I give so that you will give too‘).

Is such a vision a naive assessment of the world? It certainly means that the Maastricht-architecture and other policy frameworks, such as the six pack, would have to be fundamentally amended. The cooperative assignment of the Social Democratic Keynesian Consensus certainly necessitates continuous policy coordination and is therefore a toil-and- tiresome business. But this is also true for the present policy practice.