Krugman on Cluster's Last Stand

Paul Krugman has an interesting op-ed in the NY Times on industrial clusters, jobs, and economic policy (specifically the appropriateness of the US auto bailout, and it role in the US electoral debate). So I'll use the hiatus in the Euro crisis (a brief one, I expect) to talk about one of the other great applications of complexity theory to economics, the relationship between increasing returns, economic geography, and trade, and what it might mean for current issues like manufacturing job creation/destruction, the rise of China and the decline of the rest...

I needn't mention that Paul got the Nobel Prize for his work on trade, economic geography and agglomeration economies (see his Nobel Prize speech  and 2010 New Economic Geography paper for very readable summaries). And very fine work it was, especially since it made the case in a way academic, neoclassical economists could finally take seriously, using general equilibrium and 'micro-founded' optimizing behavior, which says more about the state of American academic economics than how plausible the argument is. For it is actually a very old argument (and even more, implemented national policy), going back to Alexander Hamilton and Friedrich List (as well as Alfred Marshall), and known as the infant industry and the industrial district. Industrial activity is characterized by a variety of forms of increasing returns - learning by doing, innovation performance curves (e.g. Moore's Law), scale economies, network externalities, rich labor markets, informational spillovers, agglomeration economies due to the presence of clusters of suppliers... The list of possible sources is long and I won't go into details, but the results are similar. Under certain circumstances geographical concentrations of activity will emerge, patterns of specialization arise, a core-periphery structure becomes dominant. It's why cities exist, as well as Silicon Valleys, Wall Streets. It's an old phenomenon: in the 19th century a 50 square mile district of Lancashire, England, produced 80% of world cotton exports, although it was located halfway around the world from its raw cotton sources. It exists at many scales: from small market towns to globally dominant industrial districts or even nations. And whether it comes about is more or less a function of the strength of the increasing returns factors compared to the classical determinants of location: transport costs, factor prices, comparative advantage. And where it comes about can be almost accidental: early adventitious  advantages can grow into insuperable barriers to change.

Now we come to the jumping-off point of Paul's op-ed. An extensive feature in the NY Times on "How the U.S. Lost Out on iPhone Work" examines the question of why Apple moved its production of iPhones to China, and whether these jobs will ever come back to the US. The authors come to the conclusion that Apple's principal contractor there, the Taiwanese company Foxconn (the largest electronics contract manufacturer in the world) and its labor force are so proficient, flexible, and dedicated in what they do, that no American firm could ever hope to compete with them. (The article fails to mention the other reasons Foxconn's Chinese plants have been so much in the news: an epidemic of overworked employees jumping off their rooftops, and the casualties from aluminum dust explosions due to poor workplace ventilation in the iPhone plants - the unsung costs of globalization). It is not so much wages that drove this outsourcing, according to the Times authors, but the Chinese complex of skilled engineers, disciplined workers, and suppliers. In Paul's terminology, in other words, an industrial cluster!

I would not dispute the importance of industrial clusters in explaining much of economic geography. However, it does not seem to be the case that Apple outsources the final assembly of products like the iPhone to China because so much of its supply chain is already located there, as Paul claims.

Quite the contrary: Xing (2011) shows that only 3.7% of the iPhone's final cost of production is due to Chinese value added, based on 2009 data for the iPhone 3G S (original data from iSuppli teardown). The rest comes from imported high-valued electronic components from Korea (12.8%), Japan (33.8%), Germany (16.8%), and yes, the USA (6.2%), with 26.8% of unspecified (non-Chinese?) origin, including Corning's acclaimed Gorilla Glass for the screen, manufactured in Harrodsburg, Kentucky and Shizuoka, Japan . Thus the fact that the entire cost of the finished iPhone shows up as an export from China to the USA is highly misleading, since 96.3% of its manufacturing value added was produced elsewhere, including a substantial amount in the USA (not to mention Apple's 64% markup on unit costs!). And much of that huge Apple margin goes to software development, R&D, and marketing, the bulk of which I presume is still being done in the US.

While there are certainly agglomeration (and scale!) economies in final assembly of electronic goods (after all, Foxconn has huge assembly plants with campuses of highly disciplined and docile Chinese workers, when they are not jumping off rooftops or getting killed by exploding aluminum dust), one shouldn't underestimate how much wage and transport costs are still driving factors. Another recent Times article reports that GE is repatriating water heater assembly from China to the US because the fall of entry-level wages in the US by $10-15 due to the economic crisis now makes it profitable to do so. Thus wage and transport costs still play a substantial role in location decisions, and can even result in manufacturing jobs returning to the US (or migrating even further to lower-wage countries like Vietnam, Bangladesh and Indonesia).

Now come the caveats. The data are from 2009. The Chinese value added may have grown since then. Second, Xing assumes that none of the unidentified 26.8% of iSuppli's teardown represents Chinese production (and even some of the identified Korean, Japanese, Germany and US input may indirectly represent some Chinese production).

Nevertheless. the fact that "Designed in California by Apple, Assembled in China" is printed on iPhones, and that the direct bilateral trade gap between the US and China is so wide, create a misleading picture. Very little of the iPhone is made in China. From a technological and value-added standpoint, one would be more justified in saying "Made in Japan, Germany, Korea, and the USA", in that order, before adding "And then Assembled in China." And in many ways the Chinese contribution is still the least industrial cluster-like part, namely final, labor-intensive assembly. So, no, Apple doesn't assemble the iPhone in China because so much of its supply chain is already there. It really does seem to be just about low wages.

Where the Chinese electronics industrial cluster (not to mention the Chinese automobile cluster) will really be flexing its muscle in the near future is in the rise of domestic Chinese producers of smartphones like Huawei and ZTE . They have been growing very rapidly in the Chinese domestic market but increasing are targeting the export market, either as OEM suppliers or under their own brand names. I have no doubt that they are or will become focal points of true industrial clusters,  while Foxconn is still just the end node of the value-added chain, however proficient it is at what it does.

So what does this imply for a theory of economic geography and international trade?. In a world in which supply chains now twist and turn through a large number of countries, a network or international input-output approach is needed to understand what is happening and who is contributing what, both in monetary and technological terms. Johnson and Noguera (2011) have applied this value-added approach to recalculate the net international flows (of course, making a number of simplifying assumptions in order to do the calculations with the available data). The result is that, on a value-added basis, China's trade surplus with the US is 40% smaller and Japan's is 33% larger than when measured in bilateral terms (all those Japanese components in iPhones assembled in China again - see figure below).

US trade deficit with six Asian countries, measured bilaterally and using value-added concept (Johnson and Noguera, 2011).

And what do the seemingly contradictory stories in the Times about Apple and GE manufacturing in China tell us? To the extent that these companies subcontract work to China rather than invest in manufacturing capacity themselves. they are  completely footloose. Apple can decide, on the basis of shifting currency exchange rates, wage and transport costs, to pack up and move its production tomorrow to another country, conceivably even back to the US, as GE, for much more transport-intensive products like water heaters and refrigerators, already seems to be doing. A purported Chinese industrial cluster and existing supply chain is no constraint (unique high-technology components from Japan, Korea and Germany are more critical, but these can easily be shipped anywhere). It's Foxconn that has made the sunk investments in plant and trained workers in China. Of course, Apple might have a hard time at first finding the massive assembly capacity somewhere else that Foxconn already provides. But remember, an industrial district north of Bangkok manufactures 40% of the world's hard drives (it was badly hit by the recent flooding), so this kind of electronics capacity could and has been recreated in another low-wage country when costs warranted it.

That said, Paul's main point, that the Obama administration acted correctly in bailing out the auto industry and preserving American industrial capacity in the whole value-added chain of auto manufacturing, is well taken. But the iPhone is not really a comparable case, and Apple and Corning have actually done a fine job of at least keeping the highest paid and most innovative work at home (it could have gone entirely to Samsung and Schott).

While industrial clusters are a fact of economic history, the long-term process of creative destruction means that eventually even the most successful clusters decline. Would it have made sense for England to pour money open-endedly into preserving her textile industries through the 20th century against Japanese and other low-wage competition (the same applied even to Japan 50 years later)? Time and the product cycle march on, and wait for no man. The real problem in high-wage countries is to find other employment opportunities in time to maintain international competitiveness (much as Germany has done) before existing clusters collapse. And the growth of domestic and financial services have not done the job in the US.

This tale has one epilogue I will come back to in a later post: China's refusal to let the RMB appreciate to balance out real exchange rates has unleashed a race to the bottom (not even exempting Germany), forcing the rest of the world to lower their real and even nominal wages to stay in the game. This deflationary spiral will prevent the industrialized countries from returning to vigorous growth (more on that later).

Central Banking Works!

Some readers of this blog have been wondering why I haven't posted anything since returning to Europe from Goa on New Year's Eve.

The reason is Mario Draghi, who proved in late December that central banking works, at least for the time being. While he didn't deploy the 'big bazooka' of a credible backstop for Italian and Spanish bonds (or massively buy them up on the secondary market), as many people had expected, he did do the next best thing. And a very unconventional thing it was, squaring the circle of not explicitly monetarizing sovereign debt (the great German taboo) while bringing down intra-EZ spreads. He provided massive three-year liquidity to EZ banks, accepting national bonds as collateral. This has induced creditors to return to these bond markets, reducing spreads of Italian and Spanish bonds over German Bunds, substantially on maturities below three years, but even on longer term ones. Yes, Victoria, central banking works!

But does this put an end to the Eurozone crisis, as even Reuters BreakingViews has argued? Was the Euro crisis a figment of our imaginations (as a self-fulfilling prophecy, of course there is always something to that)?

Unfortunately, I think the ECB has only bought us an admittedly much needed respite by bringing us back from the brink. The fundamental issues I and many others have discussed still remain: the real exchange rate imbalances in the EZ, austerity as a self-defeating deflationary policy prescription, and the lack of a governance structure that would turn the Eurozone into a viable currency zone instead of a fixed exchange rate regime with a central bank with one hand tied behind its back. I'm currently working on a fundamental treatment of the latter - what does it really mean to be a currency, and why the Euro never was one - which will appear either has an extended post or a working paper, hopefully sometime soon.

In the meantime the threat of a disorderly Greek default looms, as does Italy and Spain's (not to mention Ireland and Portugal) increasingly desperate search for a growth alternative to the Greek austerity death spiral.

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!

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
Country
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
Country
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)?

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 21^st 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.]

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 - http://sites.googl...site/savingtheeuro - 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.

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.