In a recent blog posting Paul Krugman tried to answer the question whether there had been excessive German unit labour cost growth before EMU and whether a potentially necessary correction for that took place since 1999. I did not fully understand his answer but the question brings back an old argument used frequently by the ECB and the EU commission before the crisis to justify the gap that had emerged between Germany and the rest of EMU in the first  years of EMU.

The simple and straightforward answer to that question is: If German would have accumulated absolute disadvantages before EMU and would have compensated these by wage moderation during the first ten years of EMU it would not have ended up with absolute advantages as evidenced by huge current account surpluses and huge gains in market shares. Germany had a deficit on its current account balance after the reunification, which was due to a deficit of something like 50 percent of GDP in the eastern part. The surplus it records today of more than 6 percent of GDP is clearly associated with EMU.

The more sophisticated version of the answer is that Germany was the anchor of the system (the country with the lowest inflation rate whose inflation rate was the target of the others) prior to EMU and it is more or less impossible that an anchor ends up overvalued. With fixed exchange rates since 1992 (after the crisis and the devaluation of 1992 Italy did not change any more) or even since 1987 (France) the inflation differentials tended to appreciate the converging countries real exchange rate.

The theory of anchoring (as to be applied for example in the case of Argentina) came to the conclusion that the anchoring countries, not the anchor would end up overvalued once convergence is reached. And it was right because the inflation rates of the anchoring countries were all the time higher than the anchor’s in the process of convergence .

The argument that Germany’s wage moderation was wrong has to come from the relationship between unit labour costs and inflation (that is the new inflation theory Paul Krugman has to adopt). If there is a strong correlation between both, and the correlation is undeniable (chart), then wage moderation to an extent like in Germany in the first ten years of EMU violates the commonly agreed inflation target and Germany is to blame as much as those that overshot the target. Moreover, the adjustment has to come from rising wages in Germany rather than from adjustment downward in the other countries if the inflation target shall not be violated in a deflationary way.

To explain the point of departure from the traditional views better (and even Krugman is rather traditional) I am attaching to this note a paper Friederike Spiecker and I had written last summer in German and which served as a background for a lecture that I gave at the invitation of staff members of the ECB at the ECB premises in June 2012. I got the English version in the last days. It is interesting to see that the ECB  has acted meanwhile (Mario Draghi’s “whatever it takes” in September) but that she is still tying her help to counterproductive austerity conditionality. In its next move she has to abandon that conditionality. Let’s see how long it will take to do the final and necessary step for survival of EMU.

 

The ECB has to fight

 by Friederike Spiecker and Heiner Flassbeck, June 2012

In May 2012 Bundesbank President Jens Weidmann refuted claims that monetary policy was departing from the path followed for many years, namely strict adherence to the principle of price stability. With one sentence – “in a currency union it would be rather abnormal if one country was always below the average inflation rate and others were always above it”[1] – he rendered mundane something that for years was a taboo among German central bankers and now suddenly seems to be possible: acceptance on the part of the Deutsche Bundesbank and the European Central Bank (ECB) of inflation rates above 2% in Germany.

The reasoning that this is all right, as long as the average inflation rate for the euro area as a whole remains just under 2%, is disconcerting for German newspaper readers. They can still remember how the previous ECB President, Jean-Claude Trichet, called for particular praise for his work from the Germans on the grounds that the euro had achieved greater price stability in Germany than the Deutsche Mark ever had done.[2] At a purely empirical level, Trichet’s claim was completely true: following the introduction of the euro, the German inflation rate [3] remained below 2% year after year, which had never been the case over a comparably long period of time during the Deutsche Mark era. But what Trichet didn’t say is that this remarkable price stability in Germany is not normal in a currency union with an agreed target rate of 2%, as noted by Weidmann in his interview. For ten years, while Germany was undershooting the target rate, the ECB managed to achieve its inflation objective of 2%, meaning that the inflation rate in other euro area countries stood above the agreed target rate for just as long. And now we’re being told that this arrangement, which until recently Germans were led to believe was commendable, was in fact “abnormal”?

In the interview cited above, Bundesbank President Weidmann talks of an unchanged monetary policy position, saying that a somewhat higher rate of inflation in Germany is merely due to positive developments in the German economy and is fully in line with the stability-oriented approach of the ECB and the Bundesbank. Weidmann also said elsewhere [4] that monetary policy cannot resolve the crisis because this would call its independence into question, and that would destroy public confidence in the single currency, the most important asset for the central bank. But, German newspaper readers might wonder, why should the stance of great price stability, so vehemently supported thus far, be abandoned just now in Germany, simply because economic conditions are good, i.e. when there is no need? Were we not told for years that it was this very price stability, achieved through considerable sacrifice on the part of wage earners, that had made Germany more competitive and laid the ground for today’s success, a kind of reinsurance against times of crisis, such as those currently being experienced, whereas less careful countries clearly had nothing to offer in response?

An above average inflation rate in relation to our trading partners in the euro area would mean a decline in our hard-won competitive position. To turn the argument on its head, this would mean that we could have spared ourselves the wage restraint seen in Germany over the past ten years, which resulted in annual unit labour cost growth of well below 2%. The rate of growth of unit labour costs in the economy as a whole to a large extent determines the national rate of inflation. But how can this very wage restraint in Germany,[5] which for years was praised as being exemplary and which euro area partners were advised to imitate, suddenly be given up so thoughtlessly? After all, the other countries are now being advised – or even ordered – to adopt the approach followed thus far by Germany in order to overcome the euro crisis. So surely it can hardly be good for Germany to abandon the course which, according to the views of the ECB and the Bundesbank up until now, has protected it from the debt crisis?

No, the Bundesbank President’s arguments are not clear. The public are pleased that the economy is currently in reasonably good shape but continue to demand high price stability, because they are not just wage earners, they are also consumers and savers. However, should the resolution of the euro crisis – contrary to the Bundesbank President’s portrayal of the situation – urgently require an increase in the German inflation rate and thus a fundamental change in the views of (German) monetary policy-makers, the public would not consider a somewhat higher rate of inflation in Germany as an indication that the ECB is no longer credible if it is the result of higher wages in Germany. Because they could then weigh up which would be the lesser evil for them: a slightly worse, maybe even slightly negative real rate of interest on their financial assets, or a sudden depreciation of a large share of those assets in the context of a euro area break-up – not to mention the catastrophic consequences for the real economy and thus for many German jobs.

But why did the Deutsche Bundesbank express itself in this way at all? And what should one make of these comments? Up to now the ECB, and the Bundesbank in particular, has regularly described the euro crisis as a sovereign debt crisis in certain euro area countries.[6] They thus called for strict austerity measures with regard to public spending in order to tackle the crisis in the affected countries, as well as structural reforms, particularly in the context of labour markets, along the lines of the Agenda 2010 in Germany. The ECB, in all the emergency measures that it decided on, was only ever prepared to act while clearly stating that it believed that euro area governments had a duty with regard to these measures and the rescue packages borne by taxpayers.[7]

But it is becoming increasingly clear that this form of crisis therapy is taking us along the wrong track, because austerity measures and structural reforms are, in the short term, worsening the recession in all crisis-stricken countries to such an extent that the long-term gains supposedly beckoning at the end of this tough stretch are proving to be economically unachievable, and the measures themselves are thus becoming ever more difficult to implement in political terms. The ECB’s refusal to clearly declare its capacity to act as lender of last resort further increases uncertainty in the financial markets, with the result that even the ECB’s massive injections of liquidity in December 2011 and February 2012 soon fizzled out, rather than having a durably calming effect. Since these liquidity injections were in part used – as probably intended by the ECB – to buy the government bonds of crisis-stricken countries by banks in those countries, the mutual dependence of commercial banks and sovereigns affected by the crisis has increased further, which could turn out to have a destabilising effect in the long run.[8] In addition, the huge volume of liquidity provided to banks by the ECB has kindled the inflation fears of the German public and thus made them more sensitive to the sort of comment by the Deutsche Bundesbank mentioned above.

In this muddled situation, voices which challenge the view that the euro crisis was caused by sovereign debt are becoming ever louder and more vehement. There is growing suspicion that the trade imbalances within the euro area are the reason for the euro crisis. Attention is thus being focused on the lack of competitiveness of the crisis countries, since this provides an easy explanation for the increased external debt of a country (whether public or private) and its difficulties in the capital markets. And that is the deeper reason why the Bundesbank is commenting on inflation developments in Germany and deems a less rigid approach to price stability acceptable. Because the macroeconomic price level at which the countries in a currency union enter into trade determines, in the long run, their success in trade terms, since it reflects all aspects of the economy, from microeconomic efficiency and productivity, the level and structure of wages, and the tax and social security system to dependency on raw materials from abroad and even corruption issues. A country that consistently undercuts the overall price level of its currency partners builds up a competitive advantage over them, pushing partners into constant external indebtedness.

If this external indebtedness is to be stopped, or even reduced, a loss of competitiveness for some euro area countries must thus be considered. There is no other lasting solution to the euro crisis. Competitiveness – by contrast with productivity – is a relative concept: one can only be competitive – or not, as the case may be – by comparison with others, meaning that when one party becomes less competitive, another must have become more competitive. In the same way, the crisis countries with high levels of external debt must be offset by “winner” countries with high levels of external assets. And if these debt and asset positions are to be limited, let alone reduced, relative competitiveness must shift in favour of the debtor countries and at the expense of the creditor countries.

There has indeed been talk for some time that the crisis countries must improve their competitiveness, but there has been a pretence until now that this lay entirely within the power of those countries and their citizens. They should increase their productivity and reduce their prices and/or wages so that their unit labour costs fall, resulting in increased competitiveness. But how does a country increase its productivity? Usually through investment. But who is supposed to invest when it is clear from the outset that utilisation and earnings prospects are lacking? And how are either of these things supposed to improve if wage-cutting measures take the economy along a deflationary path? If the crisis countries are left to carry the burden of restoring competitiveness by themselves, they will only be able to manage it through deflationary wage and price adjustment. But since this route reinforces the recession in the affected countries, it is neither economically bearable for the population nor politically viable. It is also completely unappealing for the creditor countries; a debtor whose hands are tied cannot do anything to repay his debts, as all banks know, which is why they do not resort to debtors’ prison. A country mired in recession and political instability is hardly in a position to pay off its mountain of external debt.

It is beginning to dawn on our monetary policy-makers that demands for the circle to be squared are pointless, because it is in fact impossible; in other words, the deflationary path taken through austerity measures and structural reforms does not represent a solution, but leads to deeper crisis. And they are starting to realise that this faulty logic has consequences for themselves, for it is not just that the people living in crisis-stricken countries are suffering as a result of the governments’ disastrous crisis policies, which the ECB has supported and helped to actively pursue; the ECB is in this way doing away with the reason for its own existence, the euro. It cannot be ruled out that this situation may, in one or more countries, also inflict serious damage on the market economy as Europe’s economic system and on democracy as its political system.

There is thus now a growing realisation that there can be no adjustment of competitiveness without concessions on the part of surplus countries. In other words, the inflation rate has to be above the ECB’s objective, in particular in Germany. This is the only way that the countries with deficits can manage to improve their competitiveness without deflation, because it would give them an inflation rate that is below the ECB’s objective, but certainly greater than zero. Without a positive inflation rate, an end to the recession in southern Europe will not be possible. And without an end to the recession, the repayment of external debt and thus an end to the euro crisis are out of the question.

Since a deviation of this nature from the agreed inflation objective in individual euro area countries constitutes an absolutely exceptional measure for the purpose of resolving the euro crisis and not the normal state of a functioning currency union (as indeed the opposite deviation of inflation in the euro’s first decade also was not), it is crucial for the credibility of the ECB and the Bundesbank that, rather than claiming that their change of direction is a normal adjustment to economic developments, they make it clear that it is a strategy to end the crisis. How else can monetary policy one day demand the only thing that guarantees the long-term stability of a currency union, i.e. that the inflation objective it sets is met by means of appropriate wage policies in every single member country at every point of their membership?

Aside from a pro-active announcement of this change of approach, a few other things need to be done to end the euro crisis. The ECB, with the agreement of all euro area governments, must be prepared to act as lender of last resort, without any ifs or buts, for the interim period until the crisis countries have become competitive again.[9] Because only then can interest rates on public debt be kept low and a situation thus be avoided in which the public savings orgies that would otherwise inevitably follow result in a very long wait for a recovery in the private sector of crisis countries. The ECB can choose whether to go for a longer period of adjustment (around ten years) by maintaining its objective of an average euro area inflation rate of 2%, or to shorten the period of adjustment by temporarily allowing a higher average inflation rate. The greater the difference is between the inflation rates of creditor and debtor nations, the less time it will take for crisis countries to become competitive again. But if deflation is to be avoided in the crisis countries, as it needs to be, the difference can only be increased through correspondingly higher inflation rates in the surplus countries, which has an impact on average euro area inflation. What concrete measures the ECB and the governments should take in the period of adjustment to ensure that countries affected by the crisis can finance their budgets and that the banking sector is thus stabilised – in the form of eurobonds, government bond purchases on the secondary markets or the acceptance of ESM debt instruments – is a secondary but not unimportant question of distribution.

The urgently needed coordination of wages between the euro area countries is a no less complicated area, because it requires social partners to assume overall macroeconomic responsibility. If the parties involved in the wage negotiation process in Germany do not join in with a strong upward push, the ECB will be powerless, because it cannot steer the inflation rates of individual countries. But it should not be completely impossible to effect a change of views in the right direction; it needs to be made clear to employers that the alternative to sizeable German wage hikes is a break-up of the euro area followed by the excessive revaluation of the resulting currency and a sudden fall in German export markets – and not just within Europe. Not to mention the catastrophic consequences for the real economy of the global financial crisis that would almost certainly follow a crash of the euro, a crisis that would make the aftermath of Lehman’s collapse look like a walk in the park. The surprising interference of the German finance minister Wolfgang Schäuble in the wage negotiations of the metal industry in favour of the workers demonstrates that developments can be steered at the highest level. The wage agreement itself, however, provides less reason to hope for a speedy adjustment.

Despite signs of a dawning realisation on the part of the ECB and the Bundesbank, it is unlikely, unfortunately, that the euro can still be saved. The overdue changes of direction are too slow and timid for the media, voters, governments and social partners to understand. They are not just being overtaken by the yield spreads on the financial markets and the unemployment figures in southern Europe, they are above all being steamrollered by the political processes in Europe triggered by catastrophic crisis policies. Debates about growth packages with or without public spending programmes, measures to foster investment or deposit guarantee funds with supranational banking supervision are no help either. For one thing, they have come much too late to even begin to offset the damage that has now been inflicted on the private sector in crisis countries and has destroyed public confidence in politics. And for another, they all deal with what might be termed secondary issues and fail to find a way of getting to the root of the euro crisis, the problem of diverging competitiveness. This is particularly evident when increasing the competitiveness of Europe as a whole vis-à-vis the rest of the world is cited as way out of the mess.[10] Proponents of this approach are aiming to replicate the German strategy of undercutting at the European level, i.e. on a larger scale, which means that they have learned nothing from the euro crisis. They also overlook the fact that, because of – one is tempted to say, thanks to – the exchange rates, this strategy is not as easy to replicate as it was for Germany to adopt within the euro area.

Only if it has the courage to go on the offensive including in the public the ECB will have a slight chance of helping to save the euro. An turnaround of this nature would be a crucial service to Europe and would finally enable the ECB to call, in a logically consistent manner, for the solution strategy to be supported in full by fiscal and wage policies. The ECB has to fight, and it is a fight for its own survival.

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