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Thursday, December 29, 2011

Wishing Everyone a Happy Meltdown in the New Year!

We'll be flying back from warm and sunny Goa on the 31st and arriving in Vienna in time for last minute shopping for the New Year. Then we'll celebrate and cocoon for a few days to acclimatize to the dreary Viennese winter before resuming this blog (unless something really untoward happens in the meantime).

So here's wishing everyone a happy and uneventful New Year!

Saturday, December 24, 2011

Standing on the Toes of Giants

Many economists have been analyzing the world economic crisis in public arenas these last few years, and particularly the Eurozone crisis since Greece began its slide off the slippery slope. Many of these analyses have been on the mark. A few have been wildly off the mark, and a few, even by outstanding economists, have just missed the bull's eye. The reasons why are illuminating in showing just how easily one can misdiagnose a problem even when coming to it with the best credentials.

Alan S. Blinder (Princeton) and Martin Feldstein (Harvard) are honorable men, but also outstanding economists. And they have both recently published extensive op-eds on the Eurozone crisis in leading newspapers. Yet, informed and astute as they are (Blinder for example published one of the best road maps of the US subprime mortgage crisis in the New York Times in 2009: Six Errors on the Path to the Financial Crisis), their analyses are both flawed, interestingly enough in complementary ways. Putting them together, however, gets us a little bit further on the road to solving the problem.

Let me start with Blinder's The Euro Zone's German Crisis in Dec. 13's Wall Street Journal (unfortunately, WSJ articles are inaccessible to anyone without a subscription). Blinder is on the mark in claiming that the Eurozone crisis is primarily due to Germany. Unfortunately, he makes this claim for entirely the wrong reasons. By examining the statistics on unit labor costs (ULC), he correctly identifies the competitiveness problem between Germany and the EZ periphery (it has been widely known that German unit labor costs are a lower outlier on the index ranking EZ ULC evolution). But by neglecting that unit labor costs are defined as a quotient of nominal wages and productivity, he jumps to the mistaken conclusion that this must be due to some "German productivity miracle." In fact, quite the opposite is the case: German productivity growth in the period 2001-2011 was at best mediocre. The low value of German ULC is almost entirely due to something I (among many others) had long ago identified as what one can variously call "wage restraint" or "wage dumping": German nominal wages have risen much slower than her productivity, and very much slower than her EZ trading partners. Essentially none of Germany's  ULC advantage is due to exceptional productivity growth.

Here are the facts, as I presented them in an (as yet unpublished) letter to the editor of the WSJ on Dec. 18, and in an email on Dec. 20 to Professor Blinder:

I was a not a little taken aback by the premise of your Dec. 13 WSJ op-ed "The Euro Zone's German Crisis," since it is completely unsupported by economic statistics. I sent the following letter to the editor to the WSJ on Dec. 18, which to date has not been published:

"While Alan Blinder's recent piece "The Euro Zone's German Crisis" (WSJ Dec. 13) has the great merit of refocusing attention on the competitiveness imbalances at the heart of the Euro crisis (something that Paul Krugman, Martin Wolf, Paul de Grauwe and numerous others, including my humble self almost a year ago in the New York Times, had also identified), I must take issue with his characterization of the problem as stemming from a "German productivity miracle." OECD figures on labor productivity for 2001-2007 show Germany's annual rate of growth to be only 1.4%, exactly equal to France's and Portugal's, but lower than Austria's (1.9%), Belgium's (1.5%), the UK's (2%), Greece's (2.3%!), Hungary's (3.7%), Ireland's (2.9%), or Sweden's (2.9%), not to speak of non-EU competitors like Japan (2.1%) and the USA (2%). Of the major EU economies, only Italy and Spain had lower rates of productivity growth. Thus Germany's exceptional ability to undercut competitors on unit labor costs can only be due to the evolution of the numerator of that index, i.e., the rate of growth of nominal wages, which has variously been referred to (even by such diplomatic personalities as Mme. Lagarde) as "wage dumping" ("Lohndumping" in German). And indeed independent studies have shown that German wages have significantly trailed German productivity growth and inflation, leading to an absolute fall in median German real wages over the last ten years.

Since these productivity measures do not take qualitative components of competitiveness - the traditional strength of German industry rather than price - fully into account, a stickler could argue that they underestimate German productivity growth. Still, it is highly misleading to speak of a German productivity miracle instead of a German wage scandal."
German productivity growth rates after the onset of the crisis 2008 are even more dismal because of Germany's high export dependency (world trade collapsed faster than domestic demand), the high procyclicity of productivity, and the specific 'labor hoarding' resulting from Germany's extensive use of short-work programs. Thus the German unit labor cost outlier in the 2000 decade is almost entirely due to 'wage restraint' or 'wage dumping.'
The OECD spreadsheet on which I based this analysis is available here.

To his great credit, Professor Blinder readily admitted to this mistake in his analysis in an email reply (I was apparently not the first one to point it out to him). It makes a world of a difference whether German competitiveness advantage is due to superior productivity growth or, if you'll pardon a Marxist terminological indulgence, superior exploitation of her workers. But before wallowing in Marxist self-righteousness I would qualify this observation in two ways. First, a mature open economy in which wage growth systematically lags productivity creates a conundrum for its trading partners, since it is out of long-run macroeconomic equilibrium and can only maintain employment levels by, e.g., generating export surpluses (i.e., it is underconsuming). This characteristic of the contemporary German economy - an excessively low consumption share - has been repeatedly highlighted by Professor Peter Bofinger (the "token" Keynesian on the German Council of Economic Advisers). Thus German employment is dependent on finding someone "willing" to be the consumer of last resort and overconsume, i.e., run a current account deficit (financed by German and other banks), and until 2008 that was to a large extent the EU periphery. This is exactly analogous to the relationship between China and the USA over the last 20 years. German workers may have been content with this "exploitative" relationship since it guaranteed them relatively higher employment rates (by EU standards).

Second, German competitiveness also really does derive from the fact that Germany continues to enjoy an advantageous specialization pattern: it still produces the things high-growth countries demand, both in the rest of the EU during the housing boom, and even now in emerging markets, and that they cannot (yet) produce themselves - specialized capital goods and producer intermediates like chemicals, and high-end automobiles. So hats off to Germany for defending her industrial comparative advantage, but there is no justification in calling this a "productivity miracle." Rather, you can take your pick of "obsessive wage restraint," "wage dumping,", or "super exploitation."

We now come to Martin Feldstein's A weak euro is the way forward in the Dec. 19 Financial Times. Feldstein again identifies the Euro crisis as a balance of payments problem resulting from divergent competitiveness, and like Blinder, attributes this in part to superior German productivity growth ("Productivity in Germany rose much faster than it did in Italy, Spain and France" - while we have already seen that this is true to an extent for the first two, it was definitely not true for France or even Portugal). He then goes on the propose a devaluation of the Euro as an essential part of the immediate corrective for the current account deficit EZ countries.

While it is clear that a Euro devaluation with respect to the rest of the world would boost exports and restrain imports for the block as a whole (but impact individual countries differently, probably benefiting Germany most of all, and Portugal and Spain least), it is less clear that this would provide the internal rebalancing of current accounts within the EZ that the crisis mandates. Feldstein points out that over 50% of peripheral EZ trade is with partners outside the EZ. But to gauge to what extent a devaluation would correct the current account deficits, we need to know where these deficits come from.

To do so, I have looked at the bilateral trade flows between key peripheral and core EZ countries, in this case Italy and Spain on the one hand, and Germany on the other, using the OECD STAN Bilateral Trade database. The disadvantage of this method is that it excludes bilateral trade in services, tourism, transfers etc., that enter into the current account but not the balance of trade. The difference is small for Spain but significant for Italy:

Measure Percentage of GDP
Year 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Italy Current Account -0.48 -0.05 -0.87 -1.37 -0.88 -1.60 -2.50 -2.42 -3.15 -1.93
Italy Balance of Trade 0.13 0.52 0.49 0.13 -0.11 -0.72 -1.42 -0.61 -0.68 -0.41
Spain Current Account -3.97 -3.96 -3.27 -3.53 -5.26 -7.35 -8.95 -10.00 -9.61 -5.19
Spain Balance of Trade -4.61 -4.22 -4.03 -5.13 -6.91 -8.15 -8.66 -9.50 -9.23 -4.34

Italy is actually in trade surplus until 2004, but the current account is always negative and consistently lower than the balance of trade. Where this is coming from deserves further analysis (interest payment transfers to foreigners on national debt?). In any event the trade deficit is a surprisingly insignificant part of Italy's problems.

I now calculate the bilateral balance of trade (BOT) deficit with respect to Germany as a percentage of the country's balance of trade with the entire world:

Measure Percentage of GDP
Year 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Italy BOT World 0.1 0.5 0.5 0.1 -0.1 -0.7 -1.4 -0.6 -0.7 -0.4
Italy BOT Germany -0.4 -0.4 -0.6 -0.7 -0.9 -1.0 -1.0 -1.1 -0.9 -0.9
Italy-Ger  % Share in BOT -298.2 -78.9 -117.1 -542.3 873.1 142.4 70.8 186.7 136.5 222.6

Spain BOT World -4.6 -4.2 -4.0 -5.1 -6.9 -8.1 -8.7 -9.5 -9.2 -4.3
Spain BOT Germany -1.0 -1.1 -1.2 -1.5 -1.8 -1.8 -1.8 -2.3 -1.9 -0.9
Spain-Ger  % Share in BOT 22.0 26.6 30.7 29.2 26.5 21.5 20.3 23.7 20.8 21.6

Thus we see that the Spanish bilateral trade deficit with Germany is a consistently large part of Spain's very large BOT deficit with the world: between 20% and 30%. This will be unaffected by a Euro devaluation, as presumably will be revenues from tourism transfers, etc. from Germany and the rest of the EZ core. (I have to qualify this by pointing out that a Euro devaluation would make holidays in Turkey relatively more expensive for German tourists than one in Spain, thus indirectly benefiting the latter without directly effecting Spanish prices for Germans.) For Italy, the BOT deficit with Germany is as much as 222% of its world BOT deficit, meaning that it is already running a trade surplus with much of the world outside of the EZ core. Its EZ-core trade relations are the overwhelming cause of its trade deficit (what is causing its even larger current account deficit is impossible to say at this point). Thus, while this is only a first-order analysis of the effects that a Euro devaluation would have on the balance of trade/current accounts of Italy and Spain, it should be clear that any change in their "terms of trade" that only impinges on the non-EZ world but not with the EZ-core will not go very far in solving their problems.

We can conclude that any solution to the Eurozone crisis that does not trigger deflation, leaves Germany's competitiveness with respect to the rest of the world unchanged (i.e., avoids a beggar-thy-neighbor devaluation policy) but realigns the internal EZ imbalances, must do the following:
  1. raise German wages with respect to EZ-peripheral wages;
  2. devalue the Euro by a corresponding amount.
This "squaring of the circle" was precisely what  I recommended in my Jan. 19 New York Times op-ed. Either one alone will not do the trick, nor will invoking nonexistent and unrealizable productivity miracles take us far. By stepping on the toes of two economic giants, we can see this more clearly again.

The paradox of why Germany has shunned this mutually advantageous solution while tenaciously clinging to the Euro still remains, however, and is the subject of my last blog, What does Germany want (and why she can't have it)?

Tuesday, December 20, 2011

What does Germany want (and why she can’t have it)?

Economists and indeed the general public are increasingly mystified by the actions and words of the German government. On the one hand, Chancellor Merkel spars no pains in reiterating her commitment to the Eurozone and her willingness to go the distance to restore its integrity and creditworthiness. On the other, her government and the Bundesbank have systematically vetoed all policy measures proposed by reputable economists to accomplish this end: Eurobonds, core-country wage/consumption increases, a credible commitment by the European Central Bank to backstop the sovereign debt of Italy and Spain. Instead they have used the fairy tale of “fiscal irresponsibility” (at best true only of Greece) to railroad austerity and a bogus “fiscal union” onto the rest of the Eurozone.

I am not alone in having proposed a viable nondeflationary and export-neutral alternative in my 19 January NYT op-ed. Such prominent commentators as Paul Krugman in the New York Times and Martin Wolf in the Financial Times have also debunked the fiscal irresponsibility myth (which is beginning to acquire the status of the 21st century’s “Dolchstosslegende”/”stab-in-the-back legend” of World War I vintage) and advanced similar policy prescriptions. So why has the German government been intransigent to the point of undermining its country’s own seeming self-interest?

I can see three alternative explanations, none entirely convincing, which question to varying degrees whether we are dealing with a modern “ruling elite” with a minimum of historical consciousness and economic savvy.
  1. German, and indeed many EZ and ECB leaders, simply do not get it: they lack the most basic understanding of the theory of effective demand, the cascading dynamics of bank runs and crises of confidence, and indeed their own economic history. They are still obsessed with the hyperinflation of 1923 but have completely forgotten the more important lesson from the disastrous 1931 austerity program of the ill-fated Brüning government. While the former wiped out the savings of the middle class, it also erased the nonredeemable German domestic war debt (but not the reparations) from the lost war. It was definitively ended not by austerity but by a currency reform that quickly returned the country to growth until the world crisis of 1929. The latter, however, only exacerbated the 1929 crisis, leading to mass unemployment and the social unrest that actually led to the rise of the Nazis, and did not even accomplish its ostensible but irrelevant justification: the rescinding of reparations. Instead, we hear the Bundesbank’s Jens Weidmann and German Economic Council Chairman Wolfgang Franz’s recurrent mantra that ECB intervention would be a central bank “cardinal sin.”

  2.  The “hidden agenda” or “Prussian designs” theories of such informed commentators as former EU official Bernard Connolly and international affairs analyst Tony Corn. Connolly argues that a Eurocratic Franco-German cabal has deliberately and surreptitiously imposed an ultimately undemocratic and economically dysfunctional currency union on the other EZ states to further its somewhat obscure political ambitions. And in fact five EZ governments have already fallen as a result of the Euro crisis, of which two (Greece and Italy) are now being ruled by unelected ‘technocratic’ (or as Paul Krugman puts it, ‘delusional’) interim cabinets. Corn, in contrast, sees the plot as entirely German, in the tradition of Bismarck’s Prussia, leveraging a customs union into de facto German hegemony. And the Franco-German partnership? “To the extent that the German-French tandem remains today the engine of European integration, Germany is now squarely in the rider’s saddle, while France - to use a Bismarckian metaphor - has to content itself with the role of the horse.”

    Whether one believes in the Connolly and Corn hidden agendas or not, many of their predictions have come to pass: undisputed German hegemony, limitations on democracy and national sovereignty, the rise of xenophobic and racist populist parties and an increasingly nationalist atmosphere in the press and political discourse.

    But is it plausible that a ruling elite would consciously jeopardize the economic well-being of its people to such an extent solely to further some hidden political ambitions? It would not be unprecedented historically, but in an era of democratic elections, a free press and an informed if anxious public it seems like a risky strategy with a rather ambiguous understanding of self-interest. Still, the second Bush administration got away for years with pulling the wool over the American electorate’s eyes over the Iraq invasion, in the pursuit of some elite’s understanding of its self-interest.

  3. The economic competition at a global level thesis. Instead of rebalancing the Eurozone internally without triggering deflation, while maintaining its export competitiveness unchanged, Germany has adopted a different perspective on the role of its EU partners that already proved successful in meeting the challenge of the low-wage, post-communist Eastern European countries after they joined the EU in the first decade of this century. By astutely integrating them into its supply chain, Germany not only did not suffer the loss of manufacturing employment the US has experienced through outsourcing and the ‘hollow’ corporation, it actually boosted its share in world exports and achieved export surpluses second only to China’s. Germany managed to combine its traditional strengths in advanced producer goods and high-end automobiles with low-cost suppliers from low-wage Eastern Europe. At the same time, it benefited from a lower external exchange rate and a consumption boom in the Eurozone periphery due to the Euro and the CDO-like magic of Eurozone interest rate convergence to the undiminished low German level. While the 2000 Lisbon Agenda called for the EU to become the most competitive knowledge-based economy in the world by 2010, this has been an abject failure, with R&D intensity only rising to 1.9% instead of the projected 3% of EU GDP. And with the bursting of the peripheral bubble in 2008, German industry no longer sees the field of battle as primarily within the EU, but rather with China on a world stage. As China moves up the technological value-added ladder, German competitiveness can only be maintained by harnessing all of the EU into its supply chain as low-wage producers, since there is only so much productivity growth and innovation that can still be wrung from its mature economy (the plight of solar panel manufacturers is a case in point). The race to the bottom is on to counter the low-wage Chinese juggernaut. The question is now who can most intensely exploit its migrant/Eurozone periphery workers, China or Germany?
From this global perspective, it is understandable that Germany does not want to jeopardize its favorable borrowing status by mutualizing Eurozone sovereign debt, nor shell out transfer payments and bailouts to keep its partners on the listing Euro boat from going under. Nor will a rebalancing of the Eurozone that rights the ship by increasing German wages, while just keeping German export competitiveness constant, be enough. German needs to increase its export competitiveness at all costs in the face of the Chinese challenge, without a Eurozone reform to weigh it down.

The only drawback of this strategy is that it will not work. Germany cannot have it both ways - the center of a web of low-cost labor feeding its potent export industries (Merkel’s marathon project requiring an endurance of years), while refusing to bear the costs of leadership in a functioning currency zone and true fiscal union in the here and now. And the attempt to drive down Eurozone periphery wages has only unleashed a devastating debt-deflation spiral, apparently to the surprise of EU and IMF economists alike.

The markets will deliver the verdict on this failing in a matter of days in the form of Eurozone cardiac arrest, before the grand German program can get off the ground. One can only hope that the failure of German leadership is not just blamed on the ‘usual suspects’ (take your pick of international speculators, hedge funds, rating agencies, lazy Greeks, Italians, etc., world Jewry, Muslim immigrants ...).

[A version of this post was submitted to the New York Times as an op-ed on Dec. 15.]

Tuesday, December 13, 2011

Stephen King on the EZ Shining (sorry, Failing... wrong Stephen King!)

Stephen King has an interesting piece on "Why the eurozone deal will fail" in today's Financial Times. This inspired me to write the following comment (and not only to drum up more readership for this blog through a back door - come on readers, start commenting and viral spreading!):

The Euro always was "newly-created pieces of paper uncannily similar to mortgage-backed securities" (see my blog http://silverberg-...-was-like-cdo.html). And that's why it is finally crashing down like a house of cards.

King is right that the only viable rebalancing would have been through higher German consumption (said that as long ago as Jan 18 - - sorry to trumpet my horn again). So why is Germany so adamantly refusing to go that route? Either unimaginable economic incompetence, dark designs on Europe a la Bernard Connolly or Tony Corn [nb Tim Crow in the original - sorry Tony, the heat's getting to me], or the expectations that low-wage deflation in the EZ periphery and full integration into Germany's supply chain [nb "change" in FT original] will eventually turn the EZ into an even more powerful export machine generating even greater export surpluses. The name of the game in the world economy now seems to be a race to the bottom of unit labour costs, not primarily through productivity growth but via old-fashioned exploitation of labour. A game Germany is evidently not willing to cede to "Marxist" China: who can exploit their migrant/EZ periphery workers better on a world scale.
 Since my last post two days ago on "Kowtowing to Berlin" I have been pondering whether there is a third alternative explaining German intransigence somewhere between simple economic pigheadedness and dark designs. This is the best I can come up with without violating the assumption that the German elites, whoever they may be, are guided by some remotely rational interpretation of their own self-interest. Of course, this may not be the first time that an elite's pursuit of its purported self-interest led to disaster (German history is not the only one replete with them - just think of the second Bush's Iraq war).

But this longer term "strategy," if such it may be, will not work if the EZ collapses this week because the "cavalry" of the ECB is not unleashed to rescue Italian and Spanish sovereign debt. Germany cannot have it both ways - the center of a web of low-cost labor feeding its potent industries while refusing to mutualize all the costs of a currency zone, including fiscal transfers and an effective central bank. Even highly corrupt and supposedly governance-incompetent countries like India and China, both vastly larger and more diverse than the EZ, have no trouble successfully managing their currency zones. They have larger regional disparities in productivity, infrastructure, governance, human capital, and language and yet no one fears a run on their sovereign debt or a currency breakup (not that they don't have myriad other problems). Thus one would expect of German leadership a higher level of competence and willingness to bear burdens. Small-mindedness of export surplus countries will be the undoing of the world economy. Either they have the vision to undertake Marshall Plan-like projects in their dependent periphery in their own self-interest (like the previously isolationist USA after WWII), or they have to accept raising their consumption levels. Stephen King is right that the laws of export arithmetic do not leave a third alternative. But the laws of political arithmetic still leave the field open for speculation on German motives, Machiavellian or otherwise.

Sunday, December 11, 2011

Kowtowing to Berlin, or, Niebelungentreue bis zum Untergang?

The smoke is beginning to clear from the EU summit, and the results are not encouraging. We can now start reading between the lines to discover two main results:
  1. They still don't get it, and now with a vengeance (economically speaking);
  2. The purported hidden agenda has finally raised its ugly head (politically speaking).
 The "fiscal union" emerging out of the revamped Stability Pact is nothing of the sort. It does not provide for any automatic transfers from prospering to depressed regions like any true country has nowadays (in Germany it is the "Laenderfinanzausgleich" between the Federal states). What is good enough for Germany domestically apparently is anathema at the European level. Second, it is procyclical rather countercyclical, forcing countries in recession to further cut their budgets. Kevin O'Rourke spells this out thoroughly in a recent blog. Thus in the name of stability it is throwing one of the great accomplishments of twentieth century statecraft out the window - automatic stabilizers (unemployment insurance, budgetary transfers) and discretionary fiscal stimulus programs - that have succeeded in moderating the business cycle since WWII. Germany's own Kurzarbeit program is one of the best examples of such a successful policy. Not only will this not contribute in any way to the immediate problem at hand - the looming disintegration of the Eurozone - but, should the EZ by hook or crook survive, would convert it into a pact for mutual impoverishment. Germany has made no concessions to provide any expansionary impulse, placing the burden of adjustment entirely on the periphery. It is even still unclear whether this finally provides the fig leaf  for the ECB to unleash a defense of Italian and Spanish sovereign debt, something I have no doubt the markets will start testing when they reopen tomorrow. Germany has thus succeeded in foisting the "fiscal irresponsibility" fairy tale (the contemporary "Dolchstosslegende" - the "stab-in-the-back legend" coming out of WWI?) on the rest of the EZ, exploiting the Euro crisis that it has most contributed to exacerbating to bludgeon the other members into acquiescence.

And the "hidden political agenda"? Tony Corn places the European summit within the broader historical context of Germany's designs on Europe since unification in 1871. Just as Prussia converted a customs union among the German states into a Prussian-dominated German Empire, he sees modern-day Germany as freeing itself from the last shackles of the postwar European/Atlantic order to impose a naked power grab on the EU17 (Kleindeutsche Loesung), while excluding countervailing powers (Austria in the Grossdeutsche Loesung, Great Britain today in the EU27 large Europe). So no one should be shedding any tears in Berlin that Cameron has voluntarily excluded his country from the German-enforced new framework, even if outside observers can take issue with his reasons. Even Der Spiegel commentator Christoph Schult is incensed at the return of the "ugly German." While I am still reluctant to sign off on the hidden agenda theory of either Cornian or Connollian provenance, the alternative obtuseness theory is equally unconvincing.

The irony of this coup, however, is that it will inevitably be a Pyrrhic victory. Merkel has terrorized her fellow passengers on the EU17 into making her unchallenged captain of the already leaking ship by spiking it under the waterline with additional holes. She will have only a short time to enjoy the pleasures of her victory before the ship finally capsizes, mostly due to her own Machiavellian ploy. I have nothing against German leadership in Europe, but leadership requires not only an ability to intimidate one's partners, but also the ability to forge institutional ties that are mutually beneficial and elicit voluntary cooperation. This is an aptitude that has always been singularly lacking in German elites. Niebelungentreue did Germany an immense disservice in two world wars. I fail to see its value now in a post-summit Europe.

Thursday, December 8, 2011

The Showdown at the EU Corral

I've been studiously trying to avoid obsessing about the Euro crisis this week, going out with friends to the (now egregiously commercial) Anjuna Beach flea market and a great dinner in Panaji. But the time has come to confront the crisis again, since this is the week of the great "Showdown at the EU Corral."

Merkel and Sarkozy seem to think they can stampede the rest of the EU into a further renunciation of national sovereignty in the name of another doomed Stability Pact (remember that Germany was the first country to violate the 3% deficit clause of the old Stability Pact in 2004, while Spain and Ireland were actually running fiscal surpluses until 2008). So is this the hidden agenda to railroad a dictatorship on the EU, simple obtuseness, or a fig leaf to provide the domestic political cover to allow the ECB to finally fire the "big bazooka" of a lender-of-last-resort bond commitment? Your guess is as good as mine.

But of course the real problem is that this approach completely fails to address the root of the problem. And everyone know this (except our hapless leaders?), from editorialists in today's New York Times and Der Spiegel, to academics like Charles Wyplosz, to the markets themselves, which are rational enough to price in the fact that austerity in a recession only makes the fiscal quandary of the peripheral states worse. So kicking the can down the road ends here. But an attempt at railroading a defective and undemocratic Franco-German "Stability" Pact will only provoke justifiable reactions on the part of the other EU nations at being treated like truant school children.

Meanwhile, in another article Der Spiegel reports that various national central banks such as Ireland's are reequipping themselves with the printing press capacity necessary for reintroducing national currencies in a hurry should the failure of the EU summit call for a Plan B. So the writing is on the wall, or going to press. I'm going to the beach...

P.S. The combinatorially simplest breakup of the Eurozone would just have Germany and Greece exit. It would also be morally equitable, since only the truly guilty parties would be relegated from the group (Greece for being Greece - cooking the books and being a patronage state, and Germany for the fundamental problem - wage dumping - and vetoing a mutually constructive solution). I pointed this out as long ago as Sept. 11. Seems like ancient history now...

Friday, December 2, 2011

My Sincerest Apologies to the Great German Nation (for having an imbecilic government)

In my last post I got carried away and turned Polish Foreign Minister Sikorski's description of Germany as the 'indispensable nation' into 'imbecile nation.' Of course what I meant was the current German government, not the industrious, intelligent and forbearing people of Germany, who, like their similar compatriots in other EU countries, are confused and anxious about the Eurozone turmoil. The ordinary people of the Eurozone (from Germany to Greece, yes, even the Greek people are innocent) did nothing to bring this tragedy unto themselves, but they will be the chief victims of the misguided policies of their deluded leaders. I trust that intelligent followers of this blog were clear about this distinction, but I want to spell it out explicitly  once again just so that there is no misunderstanding about where I stand.

And today, what does a quick perusal (despite spotty Internet connections from Agonda Beach) of the New York Times reveal but another instance of extreme cognitive dissonance. First, we have Paul Krugman succinctly summarizing the basic economics of the Eurocrisis, and why fiscal irresponsibility does not lie at its heart. Then we have German chancellor Angela Merkel, in a speech before the German parliament, comparing her rescue efforts with a marathon that will take years to finish. And what do these rescue efforts consist of (as far as I can make out)? Fiscal control of the debtor countries and more spending cuts, just what Paul Krugman points out will only accelerate the collapse, when what is needed is expansion and more inflation in the core. Two more contradictory takes on the same reality are hard to imagine. Yes, in the words of Martin Wolf  in the FT (citing an unnamed observer from 'outside the eurozone'), 'they just do not get it.'

So, instead of years of a recovery marathon, we appear to be facing just days of unprecedented (and avoidable) economic turmoil. Ein Ende mit Schrecken, statt ein Schrecken ohne Ende.

Tuesday, November 29, 2011

When Even the Poles Plead for German Leadership...

When Polish Foreign Minister Radoslaw Sikorski feels compelled to make a dramatic appeal for Germany to show more leadership in the crisis, we know we are up sh-t's creek.

According to Reuters,

"You know full well that nobody else can do it," he said in a speech in Berlin Monday evening, referring to efforts to save Europe's monetary union. "I will probably be the first Polish foreign minister in history to say so, but here it is: I fear German power less than I am beginning to fear German inactivity. You have become Europe's indispensable nation."

I would rather say Europe's imbecile nation. I mooted the point that Germany, the ECB, the European Commission, somebody, anybody, might be pursuing a hidden agenda, but now I'm convinced Merkel, Schaeuble and Draghi are intent on outdoing Bruening and going down in history as the world's greatest gratuitous economic blunderers. I fail to perceive any logic in their public pronouncements. It should be clear by now that fiscal austerity and central budgetary control, not to mention ECB fiddling while Italian bond auctions burn, are not going to save the Eurozone. Some modicum of a basic understanding of the origins of the crisis are a prerequisite for solving it, and these people do not seem to partake of any. Not that Germany and other EU countries do not possess outstanding economists who have been providing sensible policy advice all through the crisis (such as Peter Bofinger in Germany and Paul de Grauwe in Belgium). So the incorrigibility of the central bankers and politicians is really inexplicable. They seem to be trapped in a simplistic, moralistic universe, not unlike Bruenings obstinate clinging to the idiotic Notverordnungen that led to Europe's twenty years of despair.

So I'll just throw my hands up in disgust and hit the beaches. Let's all enjoy the little bit of life we are still vouchsafed while the imbecilic politicians do their best to destroy it.

Monday, November 28, 2011

Why the Eurozone is (was) like a CDO

Eva and I flew into Goa on Saturday morning, so I'm just coming up to speed on the state of the world. Unfortunately, the state of the world (i.e., the Eurozone as far as I am concerned) is showing no signs of coming to its senses. Merkel is still blaming the other member governments for fiscal irresponsibility (not low German wages), and thinks a last minute installation of central fiscal administration, should this even be possible, will accomplish anything except make the situation worse (that is, as long as austerity is the call to arms). The ECB is still sitting on the fence and washing its hands of the affair, as if it were the central bank of a different planet. So the expedition to Mt. Euro has gone astray and looks like the heroic tomfoolery of Scott's expedition to the South Pole.

In the meantime, after moving into our superior cottage up the hill, in among the palm trees, I had a minor satori that the Euro was the currency-zone equivalent of a CDO (collateralized debt obligation, of subprime mortgage notoriety). Why that? The Euro, like a multi-tranche CDO, combines assets of different creditworthiness into a pooled asset which, by dint of financial engineering, has a higher creditworthiness than the weighted average of its components. The Euro amalgamated different countries with varying creditworthiness, from the marginal like Greece to the gold-standard like Germany, and, despite the no-bailout-clause of the Maastricht treaty, allowed them all to enjoy near-German creditworthiness. Spreads over German Bunds began to disappear and everyone could now borrow on near-German terms. This was even better than if, like in a normal currency union, the risks of the constituent parts were simply pooled by a Federal government (like in the US), with a bonus due to the gains of diversification. Countries like Greece were now benefiting from borrowing rates well below anything they deserved as independent countries, and even better than the weighted-average creditworthiness of the entire Eurozone, had sovereign debt been entirely mutualized in Eurobonds from the beginning. A CDO, in other words, distilling triple-A status from the dross of subprime mortgages.

The reason? As far as I can see, the 'senior tranche' of the Eurozone - the AAA-rated countries like Germany, France, the Netherlands, Austria - was assumed to be ready to pluck the chestnuts out of the fire should the EZ ever get into difficulties. Thus, the 'senior tranche' bootstrapped the creditworthiness of the group through implicit CDO-like financial engineering above the average of its underlying assets. But after the 2008 world crisis, and even more, after the haircut on Greek debt, the curtain was jerked from the emperor's new clothes and, just as in the subprime mortgage crisis, the structured asset was revealed to be naked. The irony is that the creditworthiness of the EZ member countries, due to the competitiveness straightjacket of the common currency, is now lower than if they had remained independent, and plummeting fast.

Wednesday, November 23, 2011

Tuesday, November 22, 2011

The Slippery Slope or, Is There Method in This Madness?

Why is the Eurozone like a bunch of mountaineers, roped together in a line, dangerously ascending an icy precipice overlooking a chasm, and not a group of solid economies, pooling their resources and reserves to create, via the laws of diversification and scale, a more stable and robust economic entity? After all, EZ indebtedness and deficits are lower than those of the US, the UK or Japan. The way things now work, one climber after another is slipping off the ledge and falling into the chasm, pulling the next candidate with him by the rope, the Euro, that was originally meant as a safety device. As more and more climbers slip off the precipice, the weight on the remaining climbers only increases, accelerating the tragedy and making a mockery of the rope.

But the situation is even worse than this. Well before the first climber started slipping, the lead climber was surreptitiously loading the other climbers' backpacks with stones (otherwise known as current account deficits). And a helicopter to whisk the climbers off the mountain and land them on flatter terrain was not available because the pilot did not consider it to be his job.

The Eurozone is in free fall because markets, rightly, have woken up to the fact that sovereign debt issued by countries that do not possess a central bank is almost worthless, even more worthless than the debt of emerging market countries issued in hard currency. The latter can at least devalue their national currencies to increase their export competitiveness, and adjust their central bank discount rates, while the former are locked into a currency they do not control and cannot defend.

The ECB has shown itself to be the central bank, not of the Eurozone as a whole, but in essence of Germany and the Bundesbank, the lead climber. Thus as the crisis has unfolded, yields on German Bunds have fallen while spreads on other EZ debt have soared, even on AAA rated ones like France, the Netherlands and Austria.

So today, once again, the Bundesbank's Jens Weidmann says that Italy and Spain should be able to solve the crisis by their own efforts, without ECB intervention. The only thing we have to fear is fear itself, i.e., a crisis of confidence. And Merkel reiterates that austerity, austerity, austerity is the only solution. How can they fail to see that the absence of a central bank backstopping (not financing) periphery EZ debt, and periphery austerity, are leading inexorably to exactly the crisis of confidence they think they can exorcise with incantations of more austerity?

Or is there method in this madness that we mere mortals are unable to perceive? A darker plot to impose a (Brussels/Paris/Berlin based?) Eurocratic dictatorship over recalcitrant peripheral, and with the increasing unpopularity of the bailouts, also core democracies, as intimated by former EU official Bernard Connolly (see Milken Institute 2011 panel and his 2002 Dark Vision document)?

I'm not much of a fan of conspiracy theories, but one is forced by the Euro crisis to make a choice between two incredibly difficult assessments. Either the German government and Bundesbank are being unbelievably obtuse, acting against their own long-term interests, and are just 'unbelehrbar' (German for incorrigible). Or they are complicit in some darker antidemocratic project that we mortals can only faintly adumbrate, a project that has already brought down the democratically elected governments of five EZ countries (Portugal, Ireland, Greece, Italy and now Spain), with two of them now being governed by Eurocratic unelected governments. The peripheral countries' governments are now essentially impotent to carry out any policy except that dictated to them by Germany. That's why the election of a new conservative government in Spain, and the consolidation of the Monti government in Italy, have brought them no relief on the interest rate front. The future of the Eurozone is being decided exclusively in Frankfurt and Berlin, and my impression is that these people do not have the faintest idea what they are doing. But I could be wrong, which might just be even worse.

The self-destruction of the Eurozone will be one of the signal events of modern European (and world) history. But whether it was the result of method or of madness will be a matter for future historians to decide.

Saturday, November 19, 2011

Speed and Overwhelming Force Meet the Two Deadly Sins

Yesterday I pilloried German economist Wolfgang Franz for what he viewed as the"deadly sin" of central banking: intervening to support illiquid/insolvent governments.

With a credit crunch in the Eurozone looming and ECB President Mario Draghi passing the buck to EZ governments and the EFSF to do the rescuing themselves, I find the words of former IMF chief economist Simon Johnson, writing in 2009 in the Atlantic Monthly, salutary:
In a financial panic, the government must respond with both speed and overwhelming force. The root problem is uncertainty—in our case, uncertainty about whether the major banks have sufficient assets to cover their liabilities. Half measures combined with wishful thinking and a wait-and-see attitude cannot overcome this uncertainty. And the longer the response takes, the longer the uncertainty will stymie the flow of credit, sap consumer confidence, and cripple the economy—ultimately making the problem much harder to solve. Yet the principal characteristics of the government’s response to the financial crisis have been delay, lack of transparency, and an unwillingness to upset the financial sector.
Of course, he's referring to the US Treasury and the Fed in 2008/2009, but it describes the Eurozone and the ECB even better.

Thus we now have two deadly sins of central banking: ongoing monetarizations of government deficits, and failure to decisively prevent a financial panic. Looks like we are going to get two for the price of one.

Friday, November 18, 2011

Austerity is the Problem, Not the Solution

And inflation isn't the immediate danger either.

Angela Merkel and the Bundesbank have demonstrated once again that they just doesn't get it. In a speech yesterday in Berlin, she ruled out letting the ECB act as lender of last resort, proving one may have a PhD in physics and still not understand the rudiments of economics (but then, how many economists know anything anymore about those old Keynesian - and Fisherian - canards effective demand, debt deflation, financial panics and liquidity traps).

Instead, German economists are obsessed with the inflation of 1923 ("That path “belongs to the deadly sins of a central bank,” Wolfgang Franz, chairman of the German Council of Economic Experts, an official panel that advises the government, said in an interview with the Frankfurter Allgemeine newspaper" - excerpt from the same NY Times report). This from an old colleague of mine at the University of Stuttgart, who may know some conventional wisdom about labor markets but evidently hasn't an inkling about bank runs, financial panics, cascades in complex systems, and the lender of last resort. The issue is not whether the ECB proceeds to open-endedly finance the deficits of Greece, Ireland, Italy and Spain (soon to be joined by France, Belgium, Austria...), but whether it declares a creditable commitment (like the Swiss National Bank has made) to prevent a firesale of their sovereign debt and a flight to security (to German Bunds, dollars, gold, Swiss francs). Such a declaration would actually avoid having to buy up these country's debt to any large extent, while purchases in drips and drabs without such a commitment just buy time and waste money. (If the commitment somehow were not credible enough to intimidate markets, then the jig is up and we can all go home. But it has to be seriously tried.)

Why aren't German economists more obsessed by the lessons of 1931 - the Brüning austerity "Notverordnungen" ("emergency decrees") that induced mass unemployment, spiraling deflation, the collapse of the Weimar Republic, the discrediting of democracy and market capitalism and the rise of the Nazis, which until then had been a marginal party? The inflation of 1923 was ended, not by austerity, but by a currency reform that wiped the slate clean of the domestic war debts (not reparations) that were unredeemable anyway after the lost war. Inflation was a lousy way of doing the job - destroying the life savings of large parts of the middle classes, but the economy then turned around and growth resumed strongly until the New York stock market crash of 1929. (By the way, buyers of German WWI war debt were allowed to leverage their purchases by using previous purchases as collateral, something the American ambassador James W. Gerard, in his memoir "My Four Years in Germany", predicted would bring them no end of grief in the postwar period. Sounds familiar? Securitization avant le lettre!)

They have learned the wrong lesson - 1923 instead of 1931 - and are not going to admit they're wrong. Instead, they apparently will stick to austerity to the end, with one Eurozone country after another being sucked into the vortice of self-imposed sovereign default. Mind you, these are all countries that would have been perfectly viable economically on their own (maybe Greece is an exception...), if they weren't straight-jacked into the Euro corset. None of them was any more guilty of fiscal mismanagement than Germany (Ireland could have regulated its banking sector more carefully, but then it was providing a service to the rest of the EU's risk-loving banking community, acting as a Trojan Cayman Island). What they weren't guilt of was German "Lohndumping" - constraining their wages to stagnation, so that they systemically lagged productivity for over ten years, just avoiding deflation and accumulating cost advantages in the export sector at the expense of domestic demand (Germany having a good traditional industrial specialization in high-end cars, specialized capital goods and industrial chemicals also helped).

So it looks at the moment like we are condemned to relive the gratuitous policy blunders of 1931 (see my 25 Sept blog), with all the consequences like mass unemployment, bank runs, and the rise of xenophobic and racist extreme right parties. All useless sacrifices to the gods of 1923 because, inexplicably, we are unable to learn the lessons of 1931. Even though austerity naively looks like the answer to a debt crisis (belt tightening), in fact, by inducing a collapse of domestic demand and a fall in nominal wages, it actually increases the effective debt burden and induces investors to flee. If we haven't learned this lesson by now from Greece, Italy, and Spain, apparently we never will.

Why don't the lovers of naive economic morality tales and sartorial metaphors reason instead as follows? To pay off our debts, we have to roll up our sleeves, increase employment and work harder (at frozen wages), not fire workers, depress activity, and thereby lower productivity (note to business cycle wonks: productivity is procyclical). Choose your morality tale, choose your historical catastrophe wisely.

Thursday, November 17, 2011

Last Man Standing

Now that it is clear that the Eurozone is in a free-fall unraveling (see e.g. Wolfgang Münchau in Der Spiegel), with panic enveloping the sovereign debt of every country except Germany (even such paragons of virtue as the Netherlands and Finland), the solution is clear. If Germany will not agree to the ECB acting as lender of last resort, as somebody must to stop a financial panic, then it should leave the Eurozone and let the remaining countries put their house in order themselves.

This is much simpler without Germany than with it:
  1. First, the rump Euro will devalue with respect to the new DM, restoring the rump EZ's competitiveness with respect to Germany (Germany was always the outlier in the unit labor cost ranking);
  2. The remaining EZ members can abandon the masochistic and self-defeating austerity approach (not that this absolves them from other important reforms);
  3. Germany will be left sitting on devalued Euro sovereign debt and will have to massively bail out its banks;
  4. Everyone else will enjoy windfall profits on the appreciating German sovereign debt they own (assuming it is redenominated one-to-one into DM, as it must be for German domestic creditors);
  5. The rump EZ can finally empower the ECB to act as lender of last resort and restore their national creditworthiness. (Greece might still be a problem...)
Hats off to Germany for being the last man standing, but it will be a Pyrrhic victory over its European partners that will only bring it grief. A serious attempt to create a workable, mutually advantageous Eurozone would have been preferable, but too much Borniertheit stood in the way. RIP

Post mortem exam question for economists: why was a domino effect hidden within the governance structure of the Eurozone, but not in the Dollar, Pound, RMB and Yen zones?

Wednesday, November 16, 2011

We Now Welcome the Financial Times Deutschland to Meltdown Economics

Thomas Schmoll in today's Financial Times Deutschland calls it "core meltdown" - the exploding spreads between German Bunds and other Eurozone bonds, now including even previously healthy states like Austria and the Netherlands. Welcome to meltdown economics!

This is something many of us have been predicting for months. If you build a leaky, ramshackle boat (the Euro currency zone) and pilot it against the laws of effective demand, bailing out water with a small bucket once it starts falling apart is not going to help for long. And drilling new holes below the waterline (aka austerity) does not help things either. You need an immediate battening of the hatches (a credible and unlimited commitment of the central bank to scare off attacks) and a plan to increase buoyancy (create effective demand).

The problem with the Euro was that it had secret little time bombs built into it. Once they were activated, they took on a life of their own. There's no point blaming the markets or the speculators. If you build in false incentives and governance structures and no automatic stabilizers, once the ship starts capsizing the process only gains momentum as people rush around on the deck, every man for himself.

It's a lot like nuclear reactors. The uranium fuel is clad in zirconium cans. Once the core exceeds a certain temperature, the zirconium starts reacting with the cooling water and releases hydrogen (something experts for years denied could happen). Any spark will now set off a hydrogen explosion, leading the reactor to self-destruct. Blame the spark, blame the operators (Chernobyl), blame the tsunami (Fukushima)? Or blame the design, which was inherently unstable to a loss of coolant accident such as could be triggered by a single valve jamming (Three Mile Island).

Martin Wolf on Rome's Burning

Martin Wolf in the FT makes an interesting case for Europe (i.e., Germany) saving Italy from self-immolation. Unfortunately, he seems to suggest that this can only be done by Germany coughing up lots of dough. Why this is both economically and politically not a sensible approach is explained in my comment on his article (but his charts are well worth examining - click on the link on the left half way down the text):
What is more important than new governments in Italy and Greece is a new economic approach in Germany. Letting the ECB act as lender of last resort and pursuing German expansion and upward wage revision would be a much more effective and socially just approach than deflation and austerity in the periphery. It would not even cost Germany anything, would compensate in a timely manner for the slacking off of external export demand, and address the competitiveness problem constructively. The notion that Germany should bear the costs of a periphery condemned by its own wage restraint to basket-case status is economically senseless and a political nonstarter. Especially when a mutually profitable solution is available - core expansion - once the blinders of received wisdom are abandoned. If the new Italian and Greek governments' only raison d'etre is to force more deflation on their peoples their prospects are bleak.

Tuesday, November 15, 2011

German Intransigence Crumbling as EZ Spreads Explode?

Deutsche Bank chief economist Thomas Mayer, in today's Financial Times Deutschland, calls for "unlimited commitment to intervention" from the ECB to stop the collapse of the Eurozone as spreads on Italian, Spanish and French bonds over German Bunds get out of hand (see yesterday's blog "Is France Next?"). This just after Bundesbank President Jens Weidmann reiterated the no-lender-of-last-resort orthodoxy yesterday (blog "All Quiet on the German Front"). Will the walls of German orthodoxy crumble before the Eurozone is toast? If the Deutsche Bank can see the light, there's still hope for the Bundesbank and the German government. But is there time?

Let the EconoMonitor Speak (While I Get Back to Explaining the Industrial Revolution)

You won't find more trenchant analyses of the Euro crisis than these blogs on Roubini's EconoMonitor (from ‘EconoMonitor Highlights,’ 15 Nov. 2011). The complacency and sangfroid of Jens Weidmann yesterday in Frankfurt in the face of an oncoming freight train called market panic/the "Lehman moment" are breathtaking (see Jack Ewing in yesterday's NY Times).

We are now thinking about the unthinkable. Many are saying that we are watching a slow motion train wreck as the risk is rising that the Eurozone will break up. So now what?  Nouriel Roubini, Rebecca Wilder, Randy Wray and William Oman weigh in:

Monday, November 14, 2011

Is France Next?

If this isn't a meltdown signal, I don't know what is (Source: Reuters, 10 Nov 2011; current quote 14 Nov 15:00 GMT+1: 1.49):