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Sunday, September 25, 2011

Blood, Toil, Tears and Sweat: The Euro Stops Here

The last time Europe tried fiscal austerity to solve an international financial crisis (under Heinrich Brüning in Weimar Germany, 1931), it took 20 years and 50 million deaths to recover. Germany’s current finance minister, Wolfgang Schäuble, seems to want to go down in history as Brüning’s 21st century reincarnation, although at the moment he is only advocating austerity for the Eurozone periphery, the PIIGS (Portugal, Ireland, Italy, Greece and Spain). While it has become clear to the financial markets and even Christine Lagarde of the IMF and Tim Geithner of the US Treasury, that not only does fiscal austerity, perhaps counterintuitively, not solve the debt crises of these states, it actually makes them worse, Schäuble has hitched his banner to the morality tale that if bloodletting has not worked, then insufficient blood has been let, and that we must persist with the failed therapy until the patient has succumbed (with due respects to Paul Krugman for the metaphor).

What Schäuble and many others fail to realize, is
  1. The Euro crisis, with the single exception of Greece, was not caused by the fiscal irresponsibility of the Eurozone states before the world crisis of 2008 (Spain and Ireland were paragons of fiscal rectitude until then – see particularly Paul de Grauwe on this point), but by an accumulation of private debt in housing and consumption booms from which Germany primarily benefited through export surpluses.
  2. Germany is not merely a passive beneficiary of a lower exchange rate by virtue of belonging to a currency zone of countries with weaker export performance. It is also a central perpetrator, since its unit labor costs (wages  divided by productivity) have danced completely out of line with the rest of the Eurozone in the last decade. And not primarily because its productivity has grown so much faster, but because wages have been static, while the periphery has experienced considerable wage and price growth. This disparity between the wage-restraint core and the inflationary wage-regime periphery is the ultimate cause of the Eurozone crisis. Neither party can be considered guiltless in this dance, and they can even be thought of as symbiotic during the boom phase, but ultimately they are incompatible in a currency union (this was already pointed out by Calomiris in 1998).
  3. The model of world economic growth of the last 20 years is unsustainable. This divided the world into export growth-led countries with low consumption shares (China, Germany), high consumption, high trade-deficit countries (USA, Eurozone periphery) and commodity-based, trade surplus (primarily oil) exporters (Australia, Brazil, OPEC countries, Russia, Norway). The increasing inequality of income since the 1980s led to a growth-incompatible lack of underlying effective demand that was compensated by an accelerating and unsustainable accumulation of (mostly) private debt from the exporters to the consumers, mediated by a global financial sector playing an elaborate shell game (see e.g. Ragan 2010, Stiglitz et al. 2009).
As appealing as  the imposition of fiscal austerity after the baby has fallen into the well is to simple-minded economic moralists, and I would be the last person to argue that states should not spend their revenues wisely, it is collectively self-defeating in a world financial crisis. This fact, known in the economic literature as debt-deflation, was already expounded in Irving Fisher’s classic article in 1933 (which incidentally still reads like a résumé of the current crisis). But austerity is being propounded not only because of simple-minded moralism, but because key actors are unwilling to abandon taboo aspects of their growth models:
  1. China will not let the RMB appreciate, thus relieving inflationary pressure without having to apply the monetary brakes, because it would challenge its existing export-led growth model that allows rural workers to migrate to industrial cities but at low levels of domestic demand.
  2. Germany is terrified of letting wage growth return to its underlying productivity trajectory for fear of losing international competitiveness, a problem it successfully finessed with wage stagnation and welfare reform after reunification and the ascension of the Eastern European members to the EU.
  3. The USA is unwilling  or politically unable to reverse the neoliberal tax and financial system “reforms”  and the decline of worker bargaining power that have only benefited the upper 5% of the population, and invest in needed infrastructure, education, health-care reform and (energy and environmental) technologies. Congress is ideologically deadlocked on these issues. The country is wedded to a high consumption, fossil fuel, financial engineering economic model, with information technology the only bright spot.
Since there seems little likelihood that the political system will address these underlying issues anytime soon, current strategies (quantitative easing, timid stimulus packages, austerity) range from “pushing on a string” (QE) to downright counterproductive (the Greek bailout coupled with austerity). Since these issues will reassert themselves one way or another, they will ultimately force the politicians’ hands and impose some kind of solution, just like they did in Argentina in 2001. My short-range forecast is as follows:
  1. Greece will enter a disorderly default within the next few weeks and will quit or be ejected from the Eurozone. This will be the best thing that could happen to the Greek economy, and if domestic banks are closed in a timely manner to prevent a withdrawal of domestic savings before a forcible restoration of the Drachme, its financial system can come out of this intact.
  2. To limit contagion to the rest of the Eurozone banking system and restore relative competitiveness, Germany and the other core Eurozone countries (the Netherlands, Austria, Finland, Luxemburg, possibly France and Belgium) will adopt a Core-Euro (C-Euro, instead of the politically uncomfortable DM) currency, which will rapidly appreciate.
  3. The rest of the Eurozone will devalue to a Peripheral-Euro (P-Euro). 
  4. The resulting tsunami of debt adjustments between the core, the periphery and Greece will be a challenge to master, but is a superior solution to the present underfunded EFSF system that would otherwise have to swallow its own tail, continually bailing out one failing peripheral country after another until the core creditors themselves would be financially and politically undermined.
For all the hopes originally attached to the Euro project, it was doomed from the start and has morphed from a mutually enriching to a mutually impoverishing form of integration. The question is whether, at a world and not just a European scale, time remains to reestablish a new, mutually enriching world economic order before Humpty Dumpty irreversibly shatters. The last time the world economy shattered for lack of a coordinated response (the 1930s), it certainly took an inordinate amount of blood, toil, tears and sweat to put the pieces back together again. Are we prepared to go through this again?

Tuesday, September 13, 2011

Germany would be doing everyone a favor

Posted at the Financial Times on Sept. 13, 2011 as a comment on "Time has come for politicians to back the ECB" by Martin Wolf:

The fundamental imbalance of the Eurozone has always been the relatively low nominal wages of Germany compared to the periphery (low that is in terms of unit labour costs). Until that imbalance was addressed the Eurozone crisis was always just going to be a matter of kicking the can down the road. Germany leaving the Eurozone cuts the Gordian knot because its currency will immediately shoot through the ceiling while the rump Euro will fall. But that will only exacerbate the problems of its banks, since they will now be sitting on devalued Euro-denominated peripheral sovereign debt (in terms of its new currency, call it the post-Euro DM). So the German government would still not avoid a massive bailout, but at least this will be a one-time affair confined to its own banks and not the bottomless pit of the current rescue fond. But it will be a boon for the remaining countries of the Eurozone, since they will now be free to export their way out of recession and debt and rid of senseless, neo-Brüningesque austerity masochism. So Germany would actually be doing everyone a giant favour by unilaterally leaving the Euro.

Since the only alternative, an internal rebalancing that could have saved the Euro through an expansionary domestic German policy (see my, was never considered and is now moot in face of the current run on peripheral Euro debt (see Paul Krugman in today's NY Times), Germany will exit the zone either voluntarily or soon enough by force of catastrophic circumstances. The present Berlin government may think it can continue fiddling while Rome (and Athens and Madrid and Dublin and even Paris) are burning, or deceive itself that ejecting Greece will save its skin, but the writing is already on the wall.